Due Diligence and Ongoing Monitoring

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  • 1.  UK Financial Statements and Cash Flow Concern

    This message was posted by a user wishing to remain anonymous
    Posted 05-11-2023 01:39 PM
    This message was posted by a user wishing to remain anonymous

    Our first U.K. vendor, two questions:

    1) Does anyone have experience with financial statements prepared in the UK?  Specifically - are there any significant differences that I should watch for?  While the presentation is different, I believe I have all of the information in the corresponding U.S. presentation categories, but want to be sure I'm not missing a "known" difference.

    2) Depending on the response to Question 1 above, cash flow may be a concern.  Is there anything we can do contractually to mitigate the cash risk?  In the Notes to the financial statements, the company's Board stated they have reasonable belief that they have enough resources to keep going.  

    Since I'm not familiar with U.K. financial statements or accounting practices, this is new territory.  

  • 2.  RE: UK Financial Statements and Cash Flow Concern

    Posted 05-17-2023 10:49 AM

    Hi there - here are some thoughts to help make this "new territory" for you seem more familiar and easy to navigate!

    1) Generally speaking, UK companies follow either IFRS (International Financial Reporting Standards) or UK GAAP (the UK's Generally Accepted Accounting Principles) standards. Both of these vs. US GAAP presentation are quite similar, but there are some notable / general differences that you and your team should be aware of, which are highlighted and outlined below. In summary, there should be minimal material differences for the purposes of your financial reviews and analyses, and the more you dig into the presentation and information provided with these UK companies, you will understand that the analysis and understandability is very similar to US accounting with notable differences.

    1) Terminology differences: examples include revenue (US) vs. turnover (UK); income statement (US) vs. profit and loss statement (UK); 
    2) Intangible asset recognition: UK standards follow amortizing the intangible assets over their useful life, whereas US standards land at amortizing these intangible assets over 20 years
    3) Revenue recognition: UK standards generally point to revenue being recognized when realized / realizable, whereas US standards point to revenue being recognized when it is earned
    4) Financial instruments: UK standards generally measure financial instruments at cost or amortized cost whereas US standards allow for these to be measured at a fair value measurement

    2) 'Cash is king' so your concerns are certainly warranted. Without assuming any work / analysis you have already done, it's good to first start by understanding why cash flow is trending the way it is, with an extra focus on the 'cash flow from / used by operating activities' given that is the best indication of the vendor's normal operations and business activities.

    Questions you'll ask and hopefully answer with your review here: 1) does the vendor struggle to produce profitability (via net income); why is net income negative; 2) what other components of its operating activities are driving a significant or consistent use of cash? is it something related to the working capital trends of the business (i.e., does the vendor have large vendor payments, causing use of cash? does the vendor struggle to collect outstanding invoices in its accounts receivable, thereby delaying cash inflows?)

    Then pivot to understand its investing and financing cash flow activities - investing activities can expose if the vendor is spending too much on things like capital expenditures or perhaps if it is capitalizing software expenses (typically related to personnel costs in the R&D teams of the business). This helps provide additional context behind why the vendor's cash flow is struggling. On the financing cash flow side, focus on whether or not the vendor has been using cash to pay down equity or debt obligations. For example, if the vendor generates positive cash flow from operations (generally a positive trend) and uses that cash to pay down debt, that may show the vendor with negative cash flow in that period. However, the context behind that example is not negative despite the negative cash flow headline because the vendor is reducing / paying down its debt burden with its operating cash flow. On the other hand, if the vendor is reliant on debt draws for cash inflows (which would show as a positive cash flow from financing), you'll want to understand that as the vendor could eventually have a larger debt / liability burden that they must repay in the future.

    This review of cash flow will include / crossover into the balance sheet review and income statement review of the vendor based on the example factors I provided above.

    Once you have the analysis of the quantitative / qualitative factors, you should document questions / follow-ups to send to the vendor or look into pertaining to this potential cash flow risk. Beyond the audit opinion that points to a "going concern" or management commenting on their ability to generate cash / capital to sustain operations beyond 12-18 months, you can inquire directly to the vendor to help address or provide necessary context behind your inquiries. Their management should answer these and hopefully alleviate your documented and analyzed concerns, and at the end of the day, if the cash flow risk is not palatable for your organization, then it may be a good idea to seek an alternative solution/service provider that best fits your team's needs.

    Hope this helps!

    Ramin Zacharia

  • 3.  RE: UK Financial Statements and Cash Flow Concern

    This message was posted by a user wishing to remain anonymous
    Posted 05-17-2023 11:17 AM
    This message was posted by a user wishing to remain anonymous

    So helpful - thank you!