Secrets of Doing Financial Due Diligence


John-BrooksErwin KrasnowBy John R. Brooks and Erwin G. Krasnow, Esq.

One of the key goals of due diligence is to avoid unpleasant surprises at various aspects of an acquisition. You must know what you’re buying. Financial due diligence is central to that process, because if you get it wrong on the front end – and risk over-paying – don’t count on making it up by over-performing on the back end … and good luck trying to sue for fraud say finance expert and mental health advocate John Brooks and Garvey Schubert Barer’s Erwin Krasnow in part one of this two-part series.

This article is Part I of a two-part series intended as a primer for those who need to make sure that the financial condition of the business they’re buying is as represented by the seller. As Ronald Reagan famously said, “Trust but verify.”

Many times, deals are done based on unaudited financial statements, even deals involving divisions or subsidiaries of large companies, because the audit usually doesn’t go deeper than the consolidated numbers. If you are buying from iHeart Media or Cumulus, you may only be provided with the internally prepared division or subsidiary numbers without access to the backup, and that may have to suffice. After all, these are public companies that adhere to strict financial compliance regulations. So chances are that their numbers are quite reliable.

But what about a station owned by a smaller independent? How do you verify that the financials conform to generally accepted accounting principles (GAAP) and can be cross-checked against raw data? Here’s the answer: You ask for the raw data in addition to balance sheets, income statements, and tax returns.

There are three ways to verify and crosscheck the accuracy of reported revenue:

  1. Look at corresponding traffic billing records for the same period from the station’s traffic system. Is there a discrepancy between the traffic system and the financials? How large is it? It could be due to a make-good or other miscellaneous adjustment.
  2. Calculate the sum total of bank deposits for the period plus the change in Accounts Receivable to estimate the accrued revenue. If there is a meaningful variance, question it. Oftentimes, accounting programs like QuickBooks can provide a wealth of information and reports with the click of a mouse.
  3. Review revenue reported on tax returns against a corresponding internally prepared or audited financial statement. Check on what the seller has reported to the IRS.
  4. Check to determine whether the accounts receivable are collected in a timely manner, whether debts are being paid on time, whether there is an inordinate amount of trade and how much bad debt is written off each year.

Verifying expenses is a bit easier, even though the process is essentially the same.

  1. Compensation and benefits. This unusually makes up at least 50% of a station’s operating expenses. A payroll register should be available through the accounting software or payroll vendor and crosschecked against checks written to the bank account. How much does the station remit for its health insurance, and how much is picked up by the employee? What is the sales commission structure? Does that match up with reported sales commissions and draws?
  2. Other variable expenses. Agency, rep commissions and music license fees should be readily verifiable against identified commissionable revenue.
  3. Lease expense. If the studio and/or tower site are leased, their contracts spell out clearly what the monthly lease expense is. (Watch out for provisions in leases for periodic increases in rent and escalator clauses).
  4. Utilities. These can be verified for reasonableness against bills and random check samples.

These four expense categories may get you as much as 80%-90% of the way toward verifying all operating expenses. You can use the seller’s tax returns to verify what was reported as a deduction against what was reported as an expense on the financial statements.

In Part II, we’ll look at add-backs, “below-the-line,” and other non-financial issues.

John Brooks had been a media banker and CFO for over 30 years until losing his teenage daughter Casey to suicide in 2008. Since then he’s turned to mental health advocacy, writing and working with teens in Marin County, California. His memoir, The Girl Behind The Door, was released by Scribner in February, 2016. Reach him at: [email protected] and (415) 272-5123.

Erwin G. Krasnow, a partner with the firm of Garvey Schubert Barer, is a former General Counsel of the National Association of Broadcasters, Washington counsel to the Media Financial Management Association and coauthor of Profitably Buying and Selling Broadcast Stations. Reach him at: [email protected] and (202) 298-2161.