When buying a business, you want actual cash flows to tie to the reported financials of the company. If the actual flows of cash differ materially from the reported numbers, you'll want to dig in.
One exercise to evaluate this uses a tool called a 'cash proof template'
One exercise to evaluate this uses a tool called a 'cash proof template'
Filling out the template (you can find versions online) is much like balancing/reconciling a checkbook. With the company's financials and its bank statements, you can measure how close the reported numbers are to the bank account activity.
This is simplified, but you'll:
This is simplified, but you'll:
Get the net revenue by month (per P&L), subtract out any deferred revenue (if any, from BS) and any change in AR (subtract increases, add decreases). This gives implied cash revenue for the month.
Next, per bank statements, note the cash deposited into each account.
Next, per bank statements, note the cash deposited into each account.
Remove any non-related revenues from that month (intercompany transfers, cash in transit, etc.). Add all of this deposit activity and then subtract out the implied cash revenue. The difference should be tiny...a few percent or less.
Next you can make a similar test of expenses.
Next you can make a similar test of expenses.
While cash isn't usually included in a deal, tracking the $ will familiarize you with accounting practices, deepen understanding of the cash conversion cycle & business, and point out areas for further diligence.
When a CPA does a Quality of Earnings study, this is usually part
When a CPA does a Quality of Earnings study, this is usually part
But you can also do your own version, either before you spend money on a QoE, or instead of a formal 3rd party review if you are really controlling transaction costs and feel comfortable with the work.
This article shows other cash tests: mastandards.com/blog/due-dilig…
This article shows other cash tests: mastandards.com/blog/due-dilig…
