There may also be some not so legitimate reasons, reasons that are not good for the long-term survival and/or continued growth and profitability of the company.
I was involved in a situation with an electronics firm that had set themselves up for sale. As most individuals, whether they be corporate entities or private businesses, set the selling price of their business based on profitability, especially over the past couple of years. It is definitely in the best interests of the seller to increase profit levels as high as possible in the short term. In the situation that I was involved in we did an exhaustive amount of due diligence and discovered that the seller had cut back on almost all of its R&D (research and development) over the last two years.
As most of their products had a three-year design life cycle, the products that they designed three years ago were still current and sales were strong and growing. The problem that we, as the potential buyer were facing is that as there was little new R&D in the past two years, the products that the company was currently selling would soon become obsolete with nothing in the design and development pipeline to replace them.
If in the previous example there had been a fifth column, that was investment in R&D, the situation could very easily look like this.
Year |
Sales $M |
Net Profit $K |
% Profit |
R&D $K |
2005 |
4 |
400 |
10 |
400 |
2006 |
5 |
500 |
10 |
500 |
2007 |
5.75 |
575 |
10 |
575 |
2008 |
6.5 |
1,300 |
20 |
0 |
2009 |
7.5 |
1,500 |
20 |
0 |
The same situation or scenario can apply to advertising. A company can reduce its advertising dramatically, and depending on the type of business it is, the short-term effect could be barely negligible and yet the long-term effect could be devastating (there are statistics that indicate it can cost as much as 100 times more to get a new customer as it does to maintain an old one).
Year |
Sales $M |
Net Profit $K |
% Profit |
Advertising |
2005 |
4 |
400 |
10 |
400 |
2006 |
5 |
500 |
10 |
500 |
2007 |
5.75 |
575 |
10 |
575 |
2008 |
6.5 |
1,300 |
20 |
0 |
2009 |
7.5 |
1,500 |
20 |
0 |
The examples that I have shown above are extreme and usually the “set-up” is not quite as obvious as eliminating any specific expenditure completely. The “set-up” is usually done with a lot of finesse and is much more subtle. The scenario that follows is probably more realistic as to what a potential buyer may identify after careful due diligence.
Year |
Sales $M |
Net Profit $K |
% Profit |
R&D $K |
Advertising |
2005 |
4 |
400 |
10 |
300 |
100 |
2006 |
5 |
500 |
10 |
350 |
150 |
2007 |
5.75 |
575 |
10 |
400 |
175 |
2008 |
6.5 |
1,300 |
20 |
100 |
75 |
2009 |
7.5 |
1,500 |
20 |
100 |
25 |
If the company is a “manufacturer” of some sort of product whether it be a finished item or processed raw material there are additional ways of increasing profits and providing a dramatically improved balance sheet. One method that is commonly used is to restate or inflate the value of the inventory. GAAP (Generally Accepted Accounting Practices) allows a manufacturer to apply or add labor and overhead on any manufactured assemblies or processed raw material that they have in inventory. The calculation of overhead is an area of accounting that can be massaged and manipulated in many manners. The more overhead that a company can apply or add to manufacturing labor the higher the inventory value will be and hence the higher the profits at yearend. What you want to look for is not really what is put into overhead but the consistency of what has been put into overhead. As long as the overhead calculation has remained the same over the last three years then it is what it is and the profits and other values that you have been shown are consistent. Consistency is all that really matters in the due diligence exercise of verifying the overhead amounts applied to inventory. To put it in simple terms always make sure that you are comparing apples to apples (one year’s overhead calculation to previous year’s overhead calculations) and not to a fruit salad!