What's behind the other firm's numbers?

This article looksat the process ofappraising the

other company’s situa-tion—from both afinancial as well as anoperational basis—asto a possible merger oracquisition with your company.Typically, the potential buyerexercises due diligence by assur-ing themselves as to the value ofthe company based on asset val-uation and income potential as agoing concern, and the accuracyand reliability of the numberspresented on the company’sfinancial statements, such as:

• Balance sheet• Income statement

In most instances, and thisforms the foundation of this arti-cle, the purchaser and seller ormerger parties are privately held,many times family owned andoperated. Thus, these companiesare subject to greater ownermanipulation, with less relianceon proper internal controls thana larger publicly held companythat is subject to stricter Securi-ties and Exchange Commission(SEC) legislation and Sarbanes-Oxley requirements. Such a pri-

vately held company may oper-ate in a manner that producesquestionable nontaxable businessexpenses that go into the own-ers’ pockets. In addition, theremay be unreported cash salesand unreported inventory with-drawals that are in reality properbusiness transactions. In consid-ering acquiring or merging withsuch a company, due diligencemight ignore these factors—especially in arriving at a pur-chase price. However, these fac-tors have an impact on thecompany’s current and continu-ing operations.

The purchasing companymay have its own financial per-sonnel or hire outside financialexperts to perform such a duediligence appraisal prior to orsubject to a bona fide offer.These personnel will reconcileaccounts, confirm balances withvendors and customers, verifythat transactions such as salesand accounts receivable are

legitimate, and per-form other tests of thefinancial records thatthey deem appropriate.While they may reviewthe company’s opera-tions and note somedeficiencies, their

emphasis is normally focused onfinancial, not operating, proce-dures. This article attempts tomove the focus to companyoperations behind the financialnumbers.

THE OTHER COMPANY’SNUMBERS

Let’s look at a sample set ofstatements, balance sheet andincome statement, that the othercompany might present todetermine what critical opera-tional areas might be disclosed(see Exhibits 1 and 2). Typical-ly, these amounts will be ana-lyzed as to their validity andwhether your company can relyon them as a basis for valuingthe other company. In addition,these amounts and operatingtrends as shown on these state-ments must be analyzed as toproducing reliable financialrecords from proper and effi-cient operations.

You’re considering an M&A deal. How do youappraise the other company’s situation—fromboth an operational as well as a financial per-spective? This article looks at the operationsbehind the financial numbers. © 2006 Wiley Periodicals, Inc.

Rob Reider

What’s Behind the Other Firm’sNumbers?

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© 2006 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20177

ANALYSIS OF FINANCIALSTATEMENTS

The analysis of The OtherCompany’s balance sheet andincome statement, besides vali-dating the numbers, might dis-close the following operationalconcerns.

Balance Sheet

Assets• Cash Management: decreas-

es in cash (from $400 to$450 to $100) with corre-

sponding sell-off of mar-ketable securities. This is anindication of sacrificingshort-term liquidity, makingthe company vulnerable tocash demands, while invest-ing in long-term property,plant, and equipment—hop-ing for a favorable return oninvestment. The companybarely has enough cash tooperate safely on a dailybasis and has greatly sacri-ficed its buffer cash positionfor emergencies, necessities,and opportunities. They have

also maximized their use ofaccounts payable to satisfytheir immediate and short-term operating needs. Theyhave placed themselves in avulnerable position, ripe fora reasonable offer.

• Accounts Receivable:increase of 18 percent, from$1,600 to $1,900. Based onindustry and companynorms, this could also belarge in relation to sales($12,500/$1,900 = 6.58 per-cent). The increase in sales,but not necessarily in collec-tions, has resulted in somecorresponding increase inaccounts receivable. Howev-er, these sales need to beanalyzed to determine thepresence of poor operatingpractices such as:•• Selling excessively to

present customers farbeyond reasonable creditlimits;

•• Selling to new cus-tomers of a questionablenature; and

•• Selling out of inventoryat markdown prices tomake the sale and turninventory into cash.

This situation could alsoindicate ineffective billingand collection procedures.

• Inventory: increase of 33percent, from $1,650 to$2,200. Possibly, to justifythe company’s long-termcapital investment, and onceall possible sales have beenexhausted, there is stillexcess capacity, and so thecompany produces invento-ry. This could also indicateweaknesses in inventorycontrol and related purchas-ing, vendor relations, receiv-ing, and storeroom proce-dures.

• Property, Plant, and Equip-ment: large increase of 110

10 The Journal of Corporate Accounting & Finance / January/February 2006

DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.

The Other Company: Comparative Balance Sheets as ofDecember 31 ($’s in 000s)

xxx1 xxx2 xxx3ASSETSCash $ 100 $ 450 $ 400Marketable securities -0- 500 300Accounts receivable 1,900 1,600 1,700Inventory 2,200 1,650 1,600

Current assets 4,200 4,200 4,000

Property, plant, equipment 6,500 3,100 2,800

TOTAL ASSETS $10,700 $ 7,300 $ 6,800

LIABILITIES & EQUITYAccounts payable $ 1,350 $ 900 $ 750Other payables 400 350 500

Current liabilities 1,750 1,250 1,250

Long-term debt 3,250 1,100 1,250Total liabilities 5,000 2,350 2,500

Paid-in-capital 2,200 2,200 2,200Retained earnings 3,500 2,750 2,100

Total equity 5,700 4,950 4,300

TOTAL LIABILITIES & EQUITY $10,700 $ 7,300 $6,800

Exhibit 1

percent, from $3,100 to$6,500, indicates largerecent expansion that mayhave been unnecessary, con-trolled ineffectively, or usedimproperly. Based on thedecision to invest long-term,it appears that the companyis trying to operationally jus-tify its decision by hypingsales and creating inventory,while devastating its balancesheet.

Liabilities• Accounts Payable: increase

of 150 percent, from $900 to$1,350, indicates unneces-sary purchasing, overexten-sion of expenditures, andweakened ability to pay.

Reliance on vendors, espe-cially those critical to itsoperations, has been weak-ened, with resultant increas-es in prices, cash-only poli-cies, and cutoffs ofmaterials. Going to othervendors has resulted in priceincreases, with a resultantstoppage in supply lines.

• Long-Term Debt: largeincrease of almost 300 per-cent, from $1,100 to $3,250,that indicates substantialchanges in the organization,resulting in increased prop-erty, plant, and equipment,with a correspondingdecrease in the company’scash position. It is question-able as to whether the com-

pany can justify its decisionwith any semblance of anadequate return on invest-ment. To take this on wouldbe a severe burden on yourcompany. You would have tobe certain that you couldhandle such long-term debt,correct the cash managementsituation, and produce anadequate return on invest-ment.

• Retained Earnings: increaseof $650 and $750 for thetwo years that indicates thatthe company has increasedtheir net income as the resultof changes noted earlier. Itneeds to be determinedwhether this is real netincome that can be collectedor merely booking of salesand accounts receivables.Also, is this significantexpected change, and shouldthe company have been ableto do even better?

Income Statement

• Sales: sales have increasedfrom $10,500 to $11,000 to$12,500 over the past threeyears. Analysis by productline should be made todetermine the causes forsuch an increase in sales.Should they have done bet-ter, are they all good sales,are they selling to less thandesirable customers, and arethey exceeding realistic cus-tomer credit limits? Lookingat the entire situation, this isinadequate real growth tojustify the devastation of thebalance sheet.

• Cost of Goods Sold: hasincreased in total from$6,800 to $7,300 to $8,100.However, material costs arethe major contributor to thisincrease, indicating a possi-ble major critical operational

The Journal of Corporate Accounting & Finance / January/February 2006 11

© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf

The Other Company: Comparative Income Statements for theYears Ended December 31 ($’s in 000s)

xxx1 xxx2 xxx3Net sales $12,500 $11,000 $10,500

Cost of goods soldMaterials 3,500 2,400 1,600Labor 2,200 2,700 3,200Manufacturing expenses 2,400 2,200 2,000

Total cost of goods sold 8,100 7,300 6,800

Manufacturing Profit 4,400 3,700 3,700

Selling expenses 1,200 1,050 1,100General & administrative expenses 1,200 1,300 1,200

Total operating expenses 2,400 2,350 2,300

Operating profit 2,000 1,350 1,400

Provision for income taxes 800 450 500

NET INCOME $1,200 $ 900 $ 900

Exhibit 2

area. Factors responsibleinclude price increases;increased production;increased scrap, rejects, andrework; inability to pay in atimely fashion; and materialwastage due to the learningcurve of new equipment(and possible employee sab-otage). In addition, laborcosts have decreased overthe last three years (from$3,200 to $2,200). This indi-cates a possible shift in man-ufacturing. But has the com-pany reduced labor andincreased productivity to the

extent possible using thenew equipment?

ANALYZING ORGANIZATIONALOPERATIONS

An initial step in analyzingthe other company’s operations isto ascertain and compare thecompany’s operating principles asrelated to your standards of prop-er practices. These operationalprinciples encompass the organi-zation as an entity as well as itsmajor functions. An example ofsuch an operational analysis isseen in Exhibits 3 through 8.

The comparison of suchoperational principles to the othercompany to evaluate their currentpractices, identify critical prob-lem areas, analyze detailed opera-tions, identify best practices, andimplement corrective solutions isan effective method to determinewhether their operating practicesare adequate to consider anacquisition or merger—and thevalue to place on the company.

OPERATIONAL FOCUS

When considering a mergeror acquisition, you need to main-



Operational Analysis: Organization-wide

1. Operate all activities in the most economical, efficient, and effective manner possible.2. Provide the highest-quality products to our customers at the lowest possible cost.3. Satisfy our customers so that they will continue to use the company’s products and refer the company to others.4. Convert the cash invested in the business as quickly as possible so that the resultant cash in exceeds the cash

out to the greatest extent possible.5. Achieve desired results using the most efficient methods so that the company can optimize the use of limited

resources.6. Maximize net profits without sacrificing quality of operations, customer service, or cash requirements.

Exhibit 3

Operational Analysis: Sales Function

1. Make sales to the right customers that can be collected profitably.2. Develop sales forecasts that are realistic in that the forecast results in a present or future real customer order.3. Sell those products as determined by management to the right customers, at the right time, in the right quantities.4. Actual customer sales should directly correlate with management’s long- and short-term plans.5. Sales efforts, and corresponding compensation systems, should reinforce the goals of the company.6. Customer sales should be integrated with other functions of the company such as manufacturing, engineering,

accounting, purchasing, and so on.

Exhibit 4

tain an operational focus on theother company’s operations. Anespecially significant aspect iswhether the company’s opera-tions, once acquired, can bemaintained in an economical,efficient, and effective manner.With these principles in mind, theother company’s operations canbe analyzed to identify areas forimprovement. Significant positive

improvements can be made, asyou ask questions such as:

• Is that activity needed?• Why do we do that?• Is that position/material real-

ly needed?• Can the activity be done bet-

ter in another manner?• Is that step necessary? Does

it provide value added?

In this regard, there are otheroperational questions that willneed to be addressed as well,including those in Exhibits 9through 14.

THE OPERATIONAL SURVEY

To achieve the greatestresults from the limited time youhave to review the other compa-



Operational Analysis: Manufacturing

1. Operate in the most efficient manner with the most economical costs.2. Integrate manufacturing processes with sales efforts and customer requirements.3. Manufacture in the timeliest manner, considering processes such as customer order entry, timely throughput, and

customer delivery.4. Increase productivity of all manufacturing operations on an ongoing basis.5. Eliminate, reduce, or improve all facets of the manufacturing operation, including activities such as receiving,

inventory control, production control, storeroom operations, quality control, supervision and management, pack-ing and shipping, maintenance, and so on.

6. Minimize the amount of resources such as personnel, facilities, and equipment that are allocated to the manu-facturing process.

Exhibit 5

Operational Analysis: Personnel

1. Provide only those personnel functions that are absolutely required as value-added activities.2. Maintain the levels of personnel at the minimum required to achieve results in each functional area.3. Provide personnel functions such as hiring, training, evaluation, and firing in the most efficient and economical

manner possible.4. Develop an organizational structure that enables each function to organize in the most efficient manner for their

purposes.5. Minimize the hiring of new employees by such methods as cross-training and interdepartmental transfers and

other best practices.6. Implement compensation systems that provide for effective employee motivation and the achievement of compa-

ny goals.

Exhibit 6



Operational Analysis: Purchasing

1. Purchase only those items where economies can be gained through a system of central purchasing.2. Implement direct-purchase systems for items that do not need to be processed by the purchasing function, such

as low-dollar purchases and repetitive purchases.3. Simplify systems so that the cost of purchasing is the lowest possible.4. Effectively negotiate with vendors so that the company obtains the right materials at the right time, at the right

quality, and at the right price.5. Maintain a vendor analysis system so that vendor performance can be objectively evaluated.6. Develop effective computerized techniques that provide for economic processing, adequate controls, and reliability.

Exhibit 7

Operational Analysis: Accounting

1. Analyze each of the accounting functions and activities—such as accounts receivable, accounts payable, payroll,budgeting, and general ledger—as to their necessity.

2. Operate each of the accounting functions in the most economical manner.3. Implement effective procedures that result in the accounting functions becoming more analytical than mechanical.4. Develop computerized procedures that integrate accounting purposes with operating requirements.5. Develop reporting systems that provide management with the necessary operating data and indicators that can

be generated from accounting data.6. Eliminate or reduce all accounting operations that are unnecessary or provide no value-added incentives.

Exhibit 8

Questions to Ask About Sales of Products or Services

• Are sales made to quality customers with the right products at the right time?• Does each sale make a contribution to profits?• Are all costs compared to the sale such as product costs (direct material and labor), assignment of product-relat-

ed activity costs (e.g., manufacturing processes, quality control, shipping, receiving, and so on), functional costs(e.g., purchasing, accounts payable, billing, accounts receivable, and so on), and customer costs (e.g., marketing,selling, support services, customer service, and so on)?

• Do sales relate to an agreed-upon sales forecast? Is the company selling the right products to the right customers?• Do sales integrate with an effective production scheduling and control system?

Exhibit 9



Questions to Ask About Manufacturing or Production of Services

• Are sales orders entered into an effective production control system, which ensures that all sales orders areentered into production in a timely manner to ensure on-time, quality deliveries?

• Is work-in-process kept to a minimum so that only real customer orders are being worked on rather than build-ing up finished goods inventory?

• Are the most efficient and economical production methods used to ensure that the cost of the product is kept toits realizable minimum?

• Are direct materials and labor used most efficiently so that waste, reworks, and rejects are kept to a mini-mum?

• Are nondirect labor (and material) costs such as quality control, supervision and management, repairs and main-tenance, materials handling, and so on kept to a minimum?

Exhibit 10

Questions to Ask About Billing, Accounts Receivable, and Collections

• Are bills sent out in a timely manner—at the time of shipment or before?• Are accounts receivable processing procedures the most efficient and economical?• Is the cost of billing, accounts receivable processing, and collection efforts more costly than the amount of the

receivable or the net profit on the sale?• Is the number and amount of accounts receivable continually analyzed for minimization?• Are any customers paying directly or through electronic funds transfer at the time of shipping or delivery?• Are bills and accounts receivable in amounts exceeding the cost of processing excluded from the system?• Has consideration been given to reducing or eliminating these functions?

Exhibit 11

Questions to Ask About Inventory—Raw Materials and Finished Goods

• Are raw materials and finished goods inventories kept to a minimum?• Are raw materials delivered into production on a just-in-time basis?• Are finished goods completed in production just in time for customer delivery?• Is the company working toward getting out of these inventory businesses?

Exhibit 12

ny’s operations, you should iden-tify those areas of major impor-tance to your company. To assistyou in evaluating the other com-pany’s operations, an operationalsurvey consisting of some typeof management and operationalquestionnaire can be used quiteeffectively. The purpose of thesurvey is to determine whatfunctions are performed, whoperforms each function, whyeach is performed, and how eachis performed. Answers to these

questions provide insight into theother company’s objectives,activities, work performance,systems and procedures, and soon. The survey questionnaire isused as a guideline and does notrely solely on yes or no respons-es. This is a quick review tool tohelp identify critical areas ofeffectiveness and deficiency.

The purpose of the opera-tional survey is to identify areasof major importance in the totalorganization or specific opera-

tions. The survey should providefor more detailed answers, ratherthan simple yes or no responses.The same questions are reviewedwith various personnel—such asdepartmental management, func-tional supervision, and opera-tions and support personnel. Inthis manner, patterns of agree-ment and disagreement are iso-lated, as well as various interpre-tations and perceptions that leadto the correct conclusions. A sur-vey is shown in Exhibit 15.



Questions to Ask About Purchasing, Accounts Payable, and Payments

• Are all items that are less than the cost of purchasing excluded from the purchasing system—with an efficientsystem used for these items?

• Are all repetitive high volume and cost items (e.g., raw materials and manufacturing supplies) negotiated by pur-chasing with vendors as to price, quality, and timeliness?

• Does the production system automatically order repetitive items as an integrated part of the production controlsystem?

• Has consideration been given to reducing these functions for low- and high-ticket items, leading toward the pos-sible elimination of these functions?

• Does the company consider paying any vendors on a shipment or delivery basis as part of its vendor negotiationprocedures?

Exhibit 13

Questions to Ask About Other Costs and Expenses—General, Administrative, and Selling

• Are all other costs and expenses kept to a minimum? Remember, an unnecessary dollar not spent is a dollardirectly to the bottom line.

• Are selling costs directed toward customer service and strategic plans rather than maximizing salespeople’scompensation?

• Is there a system in effect that recognizes and rewards the reduction of expenses rather than the rewarding ofbudget increases?

• Are all non-value-added functions (e.g., management and supervision, office processing, paperwork, and so on)evaluated as to reduction and elimination?

Exhibit 14



Operational Survey Form

PLANNING AND BUDGETING1. How does the company plan? Describe the system of planning.2. Does a long-range plan exist? If so, attach copy.3. Do current short-term plans exist? If so, attach copy.4. What are plans for expansion or improvement?5. What are plans for physical plant development?6. What are plans for future financing?7. What are personnel plans?8. How does the organization budget? Describe the system.9. Does a current budget exist? Provide copy.10. Do budget versus actual statistics exist for the last two full years of operations?

PERSONNEL AND STAFFING1. Does an organizational chart exist? If so, provide copy.2. Do functional job descriptions exist for each block on the organization chart? If so, provide copies.3. Do staffing statistics by functional area exist? If so, provide copy.4. Is there a system of employee evaluations? Describe.5. How are employees recruited, hired, and fired?6. How are employees oriented and trained?7. What are promotional policies?8. How are raises determined?9. Is there a grievance mechanism?10. What type of personnel records are maintained?

MANAGEMENT1. Who is considered top management? Provide list of names.2. Who is considered middle management? Provide list of names.3. How adequate are existing reports in furnishing information for making management decisions?4. Are there internal downward communication tools available to the staff?5. Is authority effectively delegated to management and lower levels?

POLICIES AND PROCEDURES1. Do written policies exist? If so, provide copy.2. Are systems and procedures documented? If so, provide copy.

INFORMATION TECHNOLOGY1. What computer equipment is used? Provide list and locations.2. What major applications are computerized? Provide list.3. Are management, operational, control, and exception reports provided? Describe.

(continued)

Exhibit 15

ANALYZING OPERATIONS

As I have suggested, while itis extremely important to validatethe reliability and accuracy of thenumbers shown on the othercompany’s financial statements

so that such figures can be reliedupon in a merger or acquisition,it is also extremely important toanalyze its operations. It is theeconomy, efficiency, and effec-tiveness of operations that manytimes is the crucial element in

such a merger and acquisition.With proper systems, the othercompany can be more easily inte-grated into your operations; with-out such systems, the other com-pany will continue on its path todestruction.



Operational Survey Form (continued)

MANUFACTURING SYSTEMS1. Is a computerized manufacturing control system being used? 2. What type of manufacturing processes is being used? Describe.3. How are jobs controlled in manufacturing?4. Is a manufacturing cost system used by job?5. Are operational and management reports provided to control manufacturing operations? If so, provide copies.6. Is an inventory control system being used? Computerized?7. What type of inventory control procedures are being used?8. Are inventory statistics and data maintained? Do they include data such as items in inventory, dollar value,

usage, on-hand balances, and so on?

RESPONSIBILITY AND AUTHORITY1. Are responsibilities clearly defined and understood by managers and staff personnel?2. Has authority been delegated effectively to managers and lower levels within the organization?

Exhibit 15

Rob Reider, CPA, MBA, PhD, is the president of Reider Associates, a management and organizational con-sulting firm located in Santa Fe, New Mexico, which he founded in 1976. Dr. Reider has been a consultantto numerous large, medium, and small businesses of all types in both the private and public sectors. He isthe course author and sought-after discussion leader and presenter for more than 20 different seminarsthat are conducted nationally for various organizations and associations. He has conducted more than1,000 such seminars throughout the country and has received the American Institute of Certified PublicAccountants’ Outstanding Discussion Leader of the Year award. He is also the author of the following bookspublished by John Wiley & Sons:• Operational Review: Maximum Results at Efficient Costs (text and workbook);• Benchmarking Strategies: A Tool for Profit Improvement; • Improving the Economy, Efficiency, and Effectiveness of Not-for-Profits; and• Managing Cash Flow: An Operational Focus (coauthor, with Peter B. Heyler).

Dr. Reider is also the author of the work of fiction Road to Oblivion: The Footpath Back Home, a novel ofdiscovery that looks at life after being downsized. For more information about Rob Reider and Reider Asso-ciates, visit his Web site at www.reiderassociates.com or e-mail him at [email protected].

Documents

What's behind the other firm's numbers?