Written by Colin Haslett and Grayson Terrell, CPA
Healthcare transactions are known for their complex nature, given their rigorous regulatory compliance requirements, diverse revenue streams, intricate insurance and reimbursement policies, and significant capital requirements. Like a medical examination, financial due diligence evaluates the vital signs of a healthcare business, providing a comprehensive assessment of its financial health. By identifying potential financial risks and validating the company’s underlying valuation, due diligence helps to diagnose the current state of the business and predict its future health. No matter the size of the healthcare transaction, financial due diligence is a necessary element in the process. It provides valuable insights into the buy-side and sell-side, ensuring all parties clearly understand the financial aspects of the deal.
One important aspect of financial due diligence in healthcare transactions is the quality of earnings process, which focuses on adjusting or normalizing EBITDA. This process involves adjusting or removing the impact of any non-recurring or one-time items from EBITDA, providing a more accurate picture of the company’s true cashflows. Throughout this process, key facts about the company that could impact the company’s EBITDA may arise, highlighting the importance of thorough financial due diligence relative to the healthcare transaction. During the quality of earnings process, it is important to carefully examine the impact of various factors on EBITDA. Some potential examples include:
- Changes in reimbursement rates with payors
- Gain/loss of providers
- New and discontinued service lines
- Shareholder and employee personal expenses existing within the reported financial statements
- Cash-to-accrual conversion of revenues and expenses
In addition to examining the impact of adjustments to EBITDA, the letter of intent (LOI) will include language outlining that the proposed transaction will be completed on a cash-free, debt-free basis. As such, another focus of due diligence is identifying the debt and debt-like items within the company’s financials. These items may include deferred revenues and compensation, outstanding legal proceedings and exposures, and accrued interest. Sometimes, these items are not included in a company’s financial statements, especially if they are on a cash-basis or are off-balance sheet. Furthermore, the LOI will state a normalized level of net working capital (NWC), agreed upon by the buyer and seller, needed to run the business post-transaction. Diligence procedures will often include an NWC analysis that ensures the buyer or seller is not allowing the targeted NWC to be set too high or low, which can be costly if the target levels are not met.
In conclusion, financial due diligence is not just a check-the-box exercise, but a critical process that mitigates risk and safeguards the likelihood of success for the transaction. Therefore, it’s an investment worth making. Adjustments to EBITDA made during the diligence process can often pay for the cost of diligence itself when the multiple of the transaction is considered. Neglecting to perform financial due diligence can have serious repercussions. Without a thorough understanding of the involved entity’s financial health, companies may overlook hidden liabilities, overestimate current and future earnings of the company, or underestimate the costs associated with integration.
