As the economy improves, many company owners begin to think about ways to develop their businesses and capitalise on a better financial backdrop. One way to expand is to make an acquisition.
I’ve often spoken of the dangers of seeing an acquisition as a way of creating value for a business. As Frank McKinney Hubbard, the journalist and humourist said, “The safest way to double your money is to fold it over once and put it back in your pocket”. Acquisitions are innately risky.
Look at the Slater & Gordon/Quindell situation, for example. If one of the world’s leading law firms can end up losing around half of its market value following an acquisition, then what hope is there for the rest of us? Slater & Gordon acquired the professional services arm of former stock market star Quindell for £637m in cash back in June, only for Quindell (at its high point worth £2.7bn) to be hit by an SFO enquiry into its “aggressive” and “inappropriate” accounting policies.
And that’s the point. The accounting policies that some companies choose to employ, whilst technically not violating GAAP, can make a massive difference to the picture the accounts paint of their financial health. There’s a huge pressure, particularly on listed companies with a requirement to report quarterly, to account for revenue as soon as possible. There are many reasons they do this - for example, to meet analysts’ expectations, to meet debt covenants or to meet stock option performance bonuses based on the share price.
A major league example is Tesco, which was warned back in 2010 about its “aggressive accounting” by analysts at the American bank Citi. The company is now taking steps on the long road back to recovery but was hit by scandal after it revealed in September that it had overstated profits to the tune of around £250m, relating to the way it recognised income from suppliers. Even Warren Buffett, who rarely puts a step wrong, admitted he’d made a “huge mistake” in investing in Tesco.
It's clear that making an acquisition can be a big risk because what you see is not necessarily what you get. So what precautions can you take to avoid making your own “huge mistake”?
Firstly don’t invest in anything you don’t understand properly. As Timothy Sloan, the Senior Executive Vice President of Wells Fargo said: “Our business is really simple. When you look at a deal and its structure looks like an octopus or a spider, just don’t do it”. Wise advice.
Secondly, and the most important thing of all, is to follow the money. Cash is king.
Cash flow is the key indicator of operational health. Just because a company shows a profit on the P&L does not mean it won’t get into trouble in the future because of insufficient cash flows. Understanding the cash flow statement of any business you are seeking to acquire, and understanding how those cash flows correlate to the P&L, are absolutely fundamental to understanding whether the company is truly in good health and whether it’s worth investing in.
As Chris Chocola, the American businessman said: "The fact is, one of the earliest lessons I have learned in business was that balance sheets and income statements are fiction, cash flow is reality". This is the key lesson to bear in mind when considering an acquisition, and one that so many business owners overlook despite the lessons of history.
For further advice on this issue contact the Peninsula Advice Service on 0844 892 2772.