Case Study: Mini Due Diligence for a Small Business Acquisition
Normalising earnings, verifying assets and liabilities, and testing the economics behind a Rs 2.5 crore acquisition price
Executive Mandate Summary
Key Transaction & Governance Challenges
- •The seller reported Rs 45 lakh of annual profit, but the earnings required multiple normalisation adjustments before they could be used for valuation.
- •The owner withdrew approximately Rs 18 lakh annually through drawings without an equivalent management cost appearing in the profit and loss account.
- •Rs 6.4 lakh of aged receivables had limited recovery prospects, while Rs 4.8 lakh of inventory was slow-moving, expired or damaged.
- •Equipment recorded at Rs 32 lakh had an assessed realisable value of approximately Rs 18 lakh.
Northrop Execution Architecture & Methodology
Executive Mandate Overview
A promoter was considering the acquisition of a food-processing and distribution business for Rs 2.5 crore.
The seller's financial statements showed approximately Rs 45 lakh of annual profit.
At the proposed price, the transaction implied approximately 5.5x reported earnings.
The buyer required an independent assessment of whether the reported earnings and underlying assets supported the proposed valuation.
Northrop conducted a 21-day financial due-diligence engagement covering three years of financial information, bank records, Tally data, physical assets, liabilities and key post-acquisition risks.
The analysis reduced the sustainable earnings estimate to approximately Rs 18 lakh and identified multiple asset and liability adjustments.
Reconstructing Sustainable Earnings
The reported Rs 45 lakh profit was deconstructed transaction by transaction.
Owner Personal Expenses
Rs 8.2 lakh
Vehicle, travel, household, family medical and family mobile expenses were identified within business expenditure.
Replacement Management Cost
The owner drew approximately Rs 18 lakh annually through drawings, but no equivalent management salary was charged to the P&L.
Northrop included approximately Rs 10 lakh of replacement management cost in the normalisation.
Bad Debt
Rs 6.4 lakh
Receivables older than 180 days with limited recovery prospects were identified.
The ongoing normalisation included approximately Rs 2 lakh of annual bad-debt cost.
Non-Recurring Income
Rs 3.5 lakh
A one-time insurance settlement was included in other income and removed from sustainable earnings.
Inventory
Rs 4.8 lakh
Physical inspection identified expired, damaged and slow-moving inventory requiring adjustment.
After the identified adjustments and rounding for ongoing normalisation, sustainable annual profit was assessed at approximately Rs 18 lakh.
Asset Verification
Financial statements alone did not establish the economic value of the target's assets.
Northrop physically verified material assets including:
- Production equipment
- Vehicles
- Inventory
- Furniture
- Other material operating assets
The most significant variance related to equipment.
Book Value
Rs 32 lakh
Assessed Realisable Value
Approximately Rs 18 lakh
The Rs 14 lakh difference reflected factors including age, condition and technological obsolescence.
Inventory was also tested physically, resulting in the identification of approximately Rs 4.8 lakh of slow-moving, expired or damaged stock.
Liability Verification
The diligence also examined liabilities that could transfer to the buyer following acquisition.
The review covered:
- Trade payables
- GST obligations
- TDS obligations
- Employee obligations
- Leave-related liabilities
- Gratuity obligations
- Supplier disputes
Supplier confirmations identified an undisclosed Rs 3.2 lakh supplier dispute that was not reflected in the financial statements.
The finding reinforced the importance of independently verifying liabilities rather than relying solely on seller-provided schedules.
Verifiable Institutional Outcomes & Value Realized
- Aged receivables and slow-moving or unsaleable inventory were identified as requiring financial adjustments.
- Seller-reported profit of Rs 45 lakh was adjusted to approximately Rs 18 lakh of sustainable earnings.
- Equipment carried at Rs 32 lakh in the books was assessed at approximately Rs 18 lakh of realisable value.
- Supplier confirmation identified an outstanding dispute that had not been disclosed in the seller's financial statements.
Ashish Chaudhary
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