Due Diligence – Have you done your homework?
An opportunity to expand your business may appear worthwhile but any wise management team will always do their homework before plunging into a new market or growing their existing business. We at Forward Financials explain how to be top of the class.
The well worn anecdote “turnover is vanity, profit is sanity but cash is king” was never more appropriate than in today’s challenging marketplace. Recently, we’ve seen businesses benefit from very focused due diligence to help them know their risk and make the right strategic choices.
The Big Picture
Often when expanding too many companies lose sight of the Big Picture. Some also spend far too long focusing on the past instead of the future leading to missed opportunities or challenges that could have been avoided. A business must have financial insight in order to help it make well informed growth plans but it must also understand the wider impact of that growth on its business as a whole.
Market due diligence
One company that did exhibit a successful global expansion policy was Pernod Ricard, the world’s co-leader in wines and spirits. This was particularly the case in terms of its entrance into the lucrative markets of India and China where it conducted rigorous local market due diligence and had a solid strategy based on the promotion and distribution of some of its “prestige” spirit brands such as Chivas Regal Whisky and Martell Cognac.
Expansion is not an easy task, however, and even huge groups such as Tesco Plc, have made costly mistakes when entering new markets. In 2007, the Group entered the US with its new “Fresh and Easy” stores and found it to be anything but easy with location and store format proving that a clear understanding of local culture and consumer preferences is imperative.
Rather than organic growth, an acquisition or investment is a quick way to enter a new market. However, we have seen many acquisitions fall through once essential due diligence has taken place in respect of future prospects and returns. Similarly, joint ventures are commonly seen as a risk averse method of participating in a new region particularly if this is a new international opportunity where local knowledge is priceless. Nevertheless, any collaborative party would still be wise to do their homework on both the market and their partner to ensure the venture is stable from the outset.
Client due diligence
Due diligence should also be key when a business seeks to grow by taking on board any sizeable new contract. This was the case recently when one of our own clients was asked to complete a sizeable contract and offer extended credit terms. Far too often businesses gobble up the opportunity of new work without thinking it through. In this instance payment and the impact on cash flow was key.
Instructed to prepare a due diligence report we highlighted their client’s deteriorating trading and cash flow position (reflecting recessionary pressures and the conclusion of key contracts) and the fact that it was unable to cover its interest costs through normal trading activity. Furthermore, its funding gap was becoming wider (hence its request for increased credit terms) and its Balance Sheet ready to topple over with low net worth and weighty goodwill/intangibles. In mitigation, however, it was making a number of positive changes to management, was releasing cash by disposing of non core activities and was set to make an acquisition in a high growth market. It was therefore imperative to assess whether this action would be enough to turn the business around.
Forecasts were built to show a likely base case and downside scenario. Cash flow analysis was key, particular the sustainability of working capital after the proposed acquisition and disposals. Using our banking knowledge an informed view also needed to be taken as to what lending support their client would require going forward, whether this was feasible and covenant headroom. Once their client’s risk was clear we could then factor this into their own cash flow forecast.
Our due diligence indicated that the contract should be undertaken but that its length was critical. Non-core asset sales would provide valuable breathing space for their client but longer term the cash from the acquisition would be insufficient to avoid a further injection of funds. A call to shareholders was not possible and so their client would need to rely on extended bank support which we considered unlikely. Contract exposure therefore needed to be systematically reduced before their client’s existing bank facilities expired.
The decision to take on the contract had real consequences, get it right and reap the benefits or get it wrong and jeopardise the whole future of their own business so due diligence had been vital. The contract was taken on board and armed with our due diligence management also made the further decision to sell their own company when a generous offer came along in the medium term.
Ongoing market and financial analysis
Expansion may mean exploring a different product entirely or offering a product in a new geographical area. Once market research, market positioning, competition analysis, sales points, promotion plans and realistic financial forecasts have been completed, however, the effort should not stop there. As expansion plans are fulfilled the ongoing position needs to be closely monitored.
The fashion brand, Zara, owned by Inditex S.A., has a formidable track record in expanding into new territories having now taken its Spanish brand to over 70 new countries. Key to its success has been its adaptation of its fashion formula to local tastes and trends. Communication is key with every store manager in weekly contact with the design team in Spain and twice weekly consignments of stock unique to each individual store depending on its needs.
Monitoring is pointless, however, if strategy is not flexed as conditions dictate. Ladbrokes Plc, one of the world’s leading betting and gaming enterprises, is one such business where the recession swiftly impacted both profitability and cash flow. The Group nevertheless responded by conducting an in depth review of its operations and financials, formulating a new strategy focused on its traditional key retail strengths and digital technologies in the online/eGaming arena.
So, as much as no one likes homework, if you want to get ahead and make well informed strategic choices it will literally pay dividends going forward. It is important not to always take opportunities at face value but to conduct due diligence, focus on future outlook, never lose sight of the Big Picture and, once your decision has been made, to constantly review and adapt your position. Remember it is the effort you put in outside of class that makes the difference in the long run.