Digging Up the Dirt on a Balance Sheet
In past articles, The Ambulatory M&A Advisor has discussed common red flags in a healthcare transaction. In this article, readers can look deeper into red flags as the focus is placed on red flags found on a balance sheet of the selling business and how they can have an impact on the buyer after the deal is done.
Michael J. Reilly, CPA/ABV, CVA, partner in charge of the tax and valuation departments at Dannible and McKee, LLP explains that in an M&A situation, the balance sheet is a display of a business’ specific assets and liabilities at a specific point in time.
“You are looking at your cash, accounts receivable, equipment, and you are looking at the liabilities. In an M&A situation, you generally will make a determination as to whether you want to acquire all the assets or just specific assets” Reilly says.
“You may not want to acquire some of the assets such as cash and accounts receivable. The seller might retain the cash and might also keep and take responsibility for collecting the receivables. Or, if you do acquire the receivables, you will want to check the quality of those receivables. Are they all collectible? Are there adequate reserves against them?”
Common Red Flags
Marc Lion, partner at WeiserMazars LLP says negative capital would be a huge red flag in a healthcare business.
“If you had distributions in excessive basis for some reason, then that could come into play as a significant red flag on the balance sheet. Distributions in excess of basis need to be explained; and it would be in terms of did this create the debt on the books?” Lion asks.
Reilly says that another red flag that he would look at are past lawsuits and litigation.
“I would ask why there was litigation. The seller may say it was a one-time occurrence that had to be paid. I would say “Yes, that might be a one-time situation, but what caused that lawsuit?” I would want to know if there are weaknesses in the company’s internal controls that caused the lawsuit that we have not identified yet. I certainly would look at all past litigation issues to develop a comfort level that they are not recurring issues from a red flags perspective,” Reilly says.
“I would also perform a ratio and trend analysis on the company. For example, I would look at key expense categories such as salaries, occupancy expense, marketing, etc. as a percentage of revenue. I would then compare those ratio percentages to the prior years’ ratios to identify upward or downward trends. I would also compare the company’s ratios to the industry norms to see how the company performs compared to its peers. Where upward or downward trends or disparities with industry norms exist, I would seek an explanation as to why. The ratio and trend analysis is extremely important to evaluate the financial strength of the company and the quality of its earnings.”
Jennifer Reedstrom Bishop, principal, Health and Nonprofit Chair for Gray Plant Mooty Law Firm says when she examines a balance sheet for red flags, she looks at how many days cash on hand the organization has, and if the amount is within industry norms. She says if that base cash on hand is outside industry norms, the buyer should look at what is causing that, because that is the result of other errors in the business’ practices.
“Looking at accounts receivable, in the healthcare world there is lots of room for games to be played with regard to how accounts receivable are displayed on a balance sheet. You have to make estimates of what the right contractual allowance is, to be presenting what your actual accounts receivable are on your balance sheet. You want to be looking and understanding how they are making those calculations and it also drives you into asking questions about their payor mix, if they have a lot of self-pay etc.
If they have a lot of self-pay, those are usually harder to collect and it leads to how much bad debt they have. That bad debt calculation also comes into play when you have co-pays and deductibles because it is harder to collect from individuals than from payors,” Bishop says.
The other piece Bishop says to look at when searching for red flags is how many days outstanding is the business’ accounts receivable. According to Bishop, there is usually a difference between payor payments and contractual payments.
“If you have a physician group that sells services to a hospital, but also bill third party payors for other professional services they are providing, that provider AR is down to the mid-30s with regard to the days outstanding they have from accounts receivable,” Bishop says.
“If you are seeing that their day’s outstanding is really long, you are going to want to go in and look at their collection practices. Are they having disputed bills? Are they trying to bill for things that the payors don’t think they are allowed to? That amount should be pretty short these days compared to what we used to see.”
Reilly says that another red flag is when a business suddenly begins selling off shares of the company.
“That’s always a concern and you really need to look behind as to why those shares are being sold. A significant sell-off of shares may be a sign from an insider point of view that the owners think the company is at the highest value indicating that it is time to get out before the company declines in value,” he says.
However, Reilly adds that the reasoning behind the sale of shares might not always be a negative situation. Reilly says the sale of shares could stem from an older individual that just wants to cash out and diversify his or her portfolio in conjunction with his or her retirement from the healthcare business.
Lion explains that just because a red flag pops up on a balance sheet during due diligence, it is not always have a negative impact on the deal.
“Understand that the balance sheet is the history of the company. The profit a losses are what is going on today, and the balance sheet is the history,” Lion says.
In terms of acquisitions when purchasing urgent cares and ambulatory surgery centers, Lion says when examining the balance sheet the buyer may want to look into the fixed assets and establish how long they are on the balance sheet, how old they are, and if they even still exist within the company.
“Every once in a while, I will pick up a client with a balance sheet that has assets going back into the 1990s. I think it is fairly safe to assume that those assets do not exist anymore. You want to verify that,” he says.
In the acquisition period, Lion says a buyer should begin verifying assets through a lot of due diligence. This includes looking at the business’ financials and the balance sheet gives you a snapshot of the health of the company over the past several years.
“You want to be checking debt, you want to be checking to see if there is any intercompany transactions, are there any related companies, etc.”
Reilly says that in due diligence, the buyers generally can’t catch everything. In this instance he says a buyer would generallyset up an escrow account.
“For example, if you are buying a company for 10 million dollars you might withhold$500,000 from the sales proceeds and put it in escrow for a year. Now, if after the closing, a liability becomes known that the seller did not disclose, or didn’t present at the time of the closing, the buyer can charge the seller for that liability cost using funds from the escrow account. This protective measure eliminates the need for the buyer to chase the seller for damages related to liabilities the buyer was not made aware of,” Reilly says.
How often should a seller check up?
Reilly says avoiding red flags as a seller requires constant diligence and is really an on-going process.
“They should be looking at their financials very strongly on at least annual basis. They should be working with their CPA and gain advice on the strength of the company and where it is headed. Even internally, with their own management, or with the help of their CPA, they should be looking at the statements on a quarterly or monthly basis and do their own ratio analysis to evaluatethe financial strength of the company compared to the rest of the industry,” he says.
“If you are positioning yourself for a sale, that is the time to clean up the statements and take away the possibility of red flags. This should especially happen within the five years prior to the sale. The buyer’s focus will be on the last 3 to 5 years of the business operations.”
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.