Financial Due Diligence for SME Acquisitions

Financial due diligence on a Malaysian SME acquisition is not an audit, and expecting it to behave like one causes problems. An audit tests whether historical financial statements are free from material misstatement, against a defined framework, for the benefit of members. Due diligence asks a different question for a different reader: what is the buyer actually acquiring, and what would change the price, the structure or the decision to proceed?

The difference in scope is the whole point

Because the questions differ, so does everything else. An audit works to a materiality set by reference to the financial statements as a whole; due diligence works to a materiality set by reference to the price and the buyer's risk appetite, which is often far lower. An audit is concerned with the reported result; due diligence is concerned with the result a buyer would inherit, which may be very different. An audit expresses an opinion; a due diligence report expresses findings, and expresses them so they can be negotiated.

One consequence matters at the outset. A clean audit report on the target is useful background, not a substitute for the work. It says nothing about whether earnings are sustainable, whether working capital has been managed ahead of completion, or whether the business depends on a person who is about to leave.

Quality of earnings is the central question

Reported profit in an owner-managed company frequently reflects choices that will not survive the transaction. The adjustments that matter most are usually:

• Owner remuneration set for tax or cash-flow reasons rather than at a market rate for the role, in either direction, together with related statutory contributions.
• Personal expenditure borne by the company: vehicles, travel, subscriptions, family members on the payroll.
• Related-party transactions not on arm's length terms. Rent paid to a director-owned property company is the common Malaysian example, and the rent payable after completion may differ substantially.
• Non-recurring items presented as ordinary, or genuinely recurring items presented as exceptional.
• Revenue recognition timing, particularly around period ends.
• Provisioning policy for receivables, inventory and warranty claims, and whether it has been applied consistently across the period examined.

The output is a normalised earnings figure the buyer can rely on, with each adjustment separately evidenced and quantified. This is where a purchase price most often moves, and it is also where a seller who has prepared can protect value: an adjustment supported by a benchmarked salary, a tenancy agreement or a board minute is accepted far more readily than one supported by an explanation.

Run the analysis monthly rather than annually where the data allows. An annual figure conceals a trend; twelve monthly figures reveal whether the run rate the buyer is paying for is rising, flat or already turning.

Working capital determines what the buyer pays on day one

Frequently underestimated, and expensive when it is. A business handed over with depleted working capital requires immediate funding the buyer had not planned for.

Establish the normal working capital cycle across a full year rather than at a single date, identify seasonality and any single large contract that distorts it, and test whether the position at the likely completion date is representative or has been managed. Collections accelerated, payables stretched, inventory allowed to run down and capital expenditure deferred in the months before completion all flatter the position without improving the business.

Understand how the completion mechanism will operate in practice, because the mechanism rather than the headline price determines the cash that changes hands:

• Completion accounts settle the position after the event, adjusting the price against a normalised working capital target. The target is the negotiation. So is the definition of what counts as working capital and what is treated as debt.
• A locked box fixes the position at an earlier balance sheet date, with the buyer taking the economic risk from that date and protection provided by leakage covenants. It requires more confidence in the reference accounts, and the definition of permitted leakage is the negotiation.

Neither is inherently better. What causes disputes is agreeing a mechanism without agreeing the definitions, or setting a target from an average that includes a period the parties later argue was not normal.

Net debt and debt-like items are negotiated, not read off the balance sheet

Where a price is agreed on a cash-free, debt-free basis, the argument moves to what counts as debt. Borrowings and hire purchase are straightforward. The contested items in Malaysian SME transactions are usually director and shareholder balances, unpaid dividends, accrued but untaken leave, deferred or unfunded bonus arrangements, overdue statutory liabilities, provisions for known disputes, deferred consideration on earlier acquisitions, and capital expenditure already committed but not yet paid.

Each of these reduces the value of what the buyer receives whether or not it is described as debt. Identify them early and list them explicitly. A category argued about after heads of terms costs more than one argued about before.

Undisclosed and contingent liabilities

The areas that most often surface after completion:

• Withholding tax. Payments to non-residents — interest, royalties, technical and service fees, contract payments — carry a deduction and remittance obligation on the payer, generally within one month of paying or crediting. Where the tax was not deducted, the exposure is the tax plus the statutory increase, and the underlying expense is disallowed for deduction until the position is settled. This is a common and quantifiable finding in businesses using overseas software, consultants or group services.
• Transfer pricing. Where the target has controlled transactions, examine whether contemporaneous documentation exists, is current, and could actually be produced. Under section 113B of the Income Tax Act 1967, failure to furnish it within 14 days of a written notice may attract a penalty from RM20,000 to RM100,000, and under section 140A(3C) a surcharge of up to 5% may be imposed on a transfer pricing adjustment — including where the target is in a loss position and no additional assessment arises.
• Indirect tax. Whether the target should be registered for service tax on any of its supplies, whether the correct rate has been applied, and whether registration was made when a threshold was first crossed. The scope of taxable services has been expanded, so a position that was correct historically may not be current.
• e-Invoice obligations. Whether the target is within the applicable implementation phase, whether validated documents are being issued and retained, and whether self-billed documents are being raised where required. Confirm the target's phase and obligations against HASiL's own current material rather than assuming it from turnover.
• Statutory arrears — EPF, SOCSO, EIS and monthly tax deductions, including on benefits and director remuneration.
• Employee entitlements — accrued leave, gratuity arrangements, and any unwritten practice that has become an expectation. Long-standing custom is difficult to withdraw after completion.
• Guarantees and security given by the company, including for connected entities, and whether they can be released at completion.
• Litigation and disputes, including those not yet formally commenced, and correspondence that indicates one is likely.

Whether the business survives the seller's departure

The commercial risk specific to owner-managed companies: how much of the business is the owner?

Examine customer concentration and whether relationships are institutional or personal; whether key supplier terms, credit lines or pricing depend on the owner; whether major contracts contain change-of-control or assignment provisions; whether licences, permits and approvals transfer or must be reapplied for; and whether the second tier of management has ever operated without the owner present. Where the seller is to remain for a transition period, establish what that period is actually for, what would demonstrate it has worked, and what happens if it has not.

A business whose principal relationships leave with the seller is a different asset from the one the financial statements describe.

Scope, access, and what verified actually means

Two disciplines protect the buyer more than any single procedure.

The first is defining scope by reference to the decision. Scope should be set by asking what would change the price, the structure or the decision to proceed, then working outward. Scope set instead by a standard list produces a long report that examines the wrong things thoroughly.

The second is distinguishing what was independently tested from what was inquired of management and accepted. Both have a place — time and access are always limited — but the distinction must be recorded item by item, because it determines who bears the risk if something surfaces later, and it directly informs which points need a warranty or an indemnity rather than a price adjustment.

Where access is restricted, say so and say what could not be examined as a result. An unstated scope limitation becomes the buyer's problem at exactly the wrong moment.

From findings to the agreement

Due diligence output is only useful if each finding leads somewhere: a price adjustment, a warranty, a specific indemnity, a condition precedent, a change in structure, a retention or escrow, an adjustment to the completion mechanism, or a decision not to proceed. A report listing observations without connecting them to the negotiation has not done its job.

The routing is not arbitrary. A quantified and certain item generally belongs in the price. A quantified but contingent item generally belongs in an indemnity or a retention. An unquantified risk that only the seller can know about generally belongs in a warranty. A matter that must be resolved before completion belongs in a condition precedent. Findings that cannot be routed to any of these are, in substance, reasons to reconsider the transaction.

Sequencing the work

1. Define scope by reference to the decision and the risks that would change it.
2. Agree what will be verified and what will be inquiry-only, and record the distinction as the work proceeds.
3. Establish the completion mechanism and the working capital and debt definitions early — they drive cash at completion.
4. Analyse earnings monthly, not only annually, and evidence every normalisation adjustment.
5. Coordinate with the legal, tax and commercial workstreams so that gaps between them are visible rather than assumed away.
6. Map each material finding to a specific negotiating action before the report is issued.
7. Re-test the key findings against any information provided late in the process.

Wider transaction preparation is addressed under corporate finance and transactions.

When a full scope is more than the transaction needs

Not every acquisition warrants the scope described above. A small purchase, priced modestly relative to the buyer’s own balance sheet, of a business whose records are already audited and whose earnings are stable, is often served adequately by a focused review of the two or three matters that could actually change the price. Commissioning the full exercise in that situation adds cost and delay without altering the decision.

The considerations shift where the consideration is material to the buyer, where earnings have moved sharply or depend on a small number of customers or contracts, where the seller will remain involved after completion, where liabilities may exist that the accounts do not show, or where the seller is professionally advised and the buyer is not. Scope should follow the risks that are actually present in the transaction, and be agreed in writing before work begins rather than expanded once it is under way.

General-information limitation

This article is general information, not transaction, valuation, tax or legal advice, and it does not determine whether any acquisition should proceed or on what terms. Due diligence scope is fact-specific, does not constitute an audit, and provides no assurance on financial statements. Tax and regulatory requirements are periodically revised and their application depends on the facts. Confirm the current position against the issuing authority's own published material and obtain advice based on your circumstances where the amounts are material.

To discuss your circumstances, contact Saifudin & Co.