It is well-known, and the issue has been discussed at length: The industry barometers are not indicating an improvement in the IT spending environment anytime soon. With that in mind, the health of a company’s balance sheet has, will and should be a differentiating factor in the sales process. In these difficult times, an increasing number of prospective IT software customers are putting greater emphasis on financial due diligence and, more specifically, the balance sheet to ensure the vendor’s long-term viability. This is very smart on the part of the buyer, but in some cases it will put them in a bind in terms of choosing the best technology or the best balance sheet. Our due diligence has confirmed several instances of companies eliminating good technology solutions based on the risk shown in the vendors’ financial statements. Here are several of the red flags that should trouble a prospective buyer about a vendor’s financial statements:
- Cash and Equivalents: Obviously, cash is king and can end any issues around solvency, but customers should not overlook a company’s cash burn rate before making a final purchasing decision. In this market, a company can quickly burn through its cash reserves if it is not careful. In some cases, when cash is short, a vendor may quote working capital, which includes accounts receivable. This can be dangerous depending on the quality of the receivables.
- Accounts Receivable and Days Sales Outstanding (DSOs): This can be a serious red flag. A measure of the quality of the receivables is DSOs or days sales outstanding. If this has been rising for several quarters, a vendor may be financing their sales with extended payment terms or having collection issues. Make sure DSOs are within the industry-standard range. This range varies widely from industry to industry. While the ideal is about 60 days, it should not be longer than 90 days or concentrated with a small number of customers.
- Deferred Revenue: In some situations, deferred revenue can also provide insight into the health of a company. Customers should look for increases in deferred revenue as strong visibility into the future revenue stream of the company, which is often the case with revenue recognition methods of subscription or service-model business. A decline in deferred revenue may be seasonal, but make sure the vendor provides solid evidence regarding a slippage in this line item.
- Debt Levels: Debt levels can also be troublesome down the road for a vendor depending on the covenants or terms of the loan agreement. A vendor that may look modestly healthy could be put out of business quickly if they were not in accordance with all covenants of their loan. It is very important to understand the terms of the debt to assure that no issue will arise at a later date. There are often very interesting details within debt covenants that can trip immediate action by the lender. The most onerous and troublesome of lenders can be financial sponsors, which have shorter time horizons, higher required rates of returns and less diversification.
Other items to look for in the balance sheet include capital expenditures and revenue recognition policies. These items can be found in the footnotes of the financial statements of the company. Capital expenditures on R&D are extremely important to the future prospects of the company in terms of new products and continued support of existing products. In tough financial times, capital expenditure is often cut to limit the cash burn. Secondly, revenue recognition policies that are aggressive also provide insight into the integrity and financial health of a company, i.e., WorldCom. In many instances, one or several of these items has affected the choice of a vendor. As we continue in this environment, it will get even more difficult for companies with weak balance sheets as customers make decisions based not only on product strength but also on financial viability. In these times, the strong often get stronger.
Peter L. Martin, CFA, is a managing director in the Equity Research department of Jefferies & Company Inc., providing in-depth coverage of the knowledge services industry.
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