Due Diligence Pitfalls: What are the biggest barriers to doing Due Diligence?

When buying a business one has to see what is not on the financial documents provided by the seller.

To do that you need to graduate the Sherlock Holmes College of Observation.  Mr. Holmes was famous for seeing small clues that appeared to other to be meaningless, but in truth, were the keys to solving the case.

In the 20 years of doing business due diligence I have concluded it is not about the information that is given to me but the information that is withheld or forgotten to be provided.

Examples

#1: I am doing due diligence on a shoe store.  I started looking at what is the profit margin on the shoes.  The profit and loss statement says that the cost of goods sold is half the gross sales income.  The business does over half its volume from on-line sales.  The prices are listed on the website.  When we looked on-line we find that they are selling shoes at a 25% discount, off of the list price.  The invoices show that the store cost is half the list price.  How can you double your cost when you sell shoes on your website at a discount.

The purchase orders show the shoes are marked-up only 50%.  I have sent Dr. Watson (the prospective buyer) into the store to investigate this little inconsistency. I look forward to finding out the answer to this mystery.  In the meantime, I have to find a British store that sells pipes and wool hats with mufflers on it.

#2: Every month I am given a financial statement for a business showing a bottom line profit of 20% of the gross sales. That alone is a much higher profit margin than anyone would expected of a franchise fast food restaurant. Then when I looked at the monthly rental amount it turns out to be 30% of the gross income. It is impossible for any fast food or sit down restaurant, regardless of the type of food, to make even a dime profit when the rent is that high.

#3: The labor shown on a profit & loss statement, I was presented with, was for a Chinese Fast Food restaurant. The labor percentage showed as 15% of the gross sales. This is a very low number for any kind of food sales. What is not on the financial report is why is the labor so low. Chinese restaurants have been famous for over 200 years for being a family business. The wife and kids all work in the business, regardless of their ages and no wages are paid to them. Then the bottom line profit receive a double bonus. Because no one is being paid a salary, there are no employer payroll taxes and no workers compensation premiums being paid. This payroll system is great for the head of the household. I personally am still trying to figure how to get my children to even work, and I am willing to pay them double the going rate.

Due Diligence Defined: The phrase is composed of two words.  Due, which the dictionary defines as “proper or adequate”, and Diligence, which is defined as “Degree of care or caution expected of a person. Especially as a party to an agreement.” Caution: is the watchword in this definition.

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Image credit: OSTILL iStock
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