What is a due diligence? (Pharmacy Guild – November 2013)

A due diligence is a sort of “business investigation” that is commonly undertaken by a prospective purchaser prior to acquiring a target business. This is somewhat similar to a building inspection you may carry out before completing the purchase of a property. The process involves verification of financial data and representations made by a vendor about the target business. A due diligence can reduce uncertainties and any potential post settlement “surprises”. Preparation of a due diligence report is often a condition required by the lenders (bank) before they will fund the acquisition.

When is it carried out?

After initial negotiations have taken place between the prospective purchaser and the vendor, the purchaser will commonly appoint someone (such as ourselves) to perform an indicative valuation of the business based on the information available in the most recent financial statements. The prospective purchaser and the vendor will then negotiate acceptable acquisition terms based on the valuation. Once a conditional agreement is in place, the purchaser will have a limited time period for a due diligence assignment to be performed.

What is involved?

The focus of the due diligence is usually dominated by confirming the following items are stated correctly in the financial statements (usually covering a two or three year period) as these items would have been essential to calculating the value for the business acquisition:

  • Gross Profitability – Dispensary and retail sales are compared year to year and various trends are established. The dispensary totals are then confirmed to buyer created invoices, bank statements and dispensary summary reports, retail sales are compared to till summary reports and often analysed by category. Total sales are compared to GST returns filed with the IRD. Purchases are confirmed to bank statements and supplier statements. Any significant changes to the gross profitability in both percentage terms and in dollar terms are noted and explored.
  • Debtors and Creditors – The debtor and creditor listings are obtained and matched to the financial statements. Debtors are reviewed to determine collectability and to ensure the correct number of weekly script batches have been accrued in the accounts. This is an area where variances have been identified recently and this may have arisen from the change to the way pharmacies receive their revenue from the Ministry of Health. Creditors are reviewed and compared to supplier statements to assess completeness.
  • Inventory – Reports are obtained to determine the stock figures in the financial statements have been recognised appropriately and if any allowances have been made for old or obsolete stock. Stock costing and discounting methods are also examined.
  • Payroll – Reconcile wage records to financial statements, review employment contracts and test calculation of pay. Investigate any working owners or associated party wages. Identify key staff involved in the business.
  • Fixed Assets – The fixed assets are sighted and matched to the asset schedule included in the financial statements. Assess condition of assets, useful life and determine if any major capital expenditure will be required in the near future.
  • Other considerations – the legal advisors for the prospective purchaser will also address issues including leases, contracts and warranties.

Result of a due diligence?

Once a due diligence has been completed, if there were no material issues identified in the financial statements, this helps justify the agreed price for the target business and provides a greater degree of certainty regarding the expected future performance and earnings of the target business. A due diligence can also reveal any potential risk areas of the business or identify potential benefits to the prospective purchaser. If any material misstatements were identified during the due diligence process, this report can help determine the basis for a price adjustment before the transaction is completed.

Published in Contact Magazine November 2013 written by Atul Mehta.

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