Client Profile
A diversified conglomerate of industrial companies with operations spanning scrap metal recycling, zinc- and aluminum-based products manufacturing, and reusable materials advisory services. The Client was evaluating the acquisition of a scrap metal processor to enhance its vertical integration strategy and expand domestic market share.
Target Business
A family-owned, full-service scrap metal recycling company specializing in the processing and resale of ferrous and non-ferrous metals, including copper, aluminum, steel, and lead. The Target also offered demolition material processing and railcar dismantling services across its regional footprint.
Situation
At the time of diligence, the Target had limited financial infrastructure:
- Lean Finance Team: The company’s finance and accounting function was limited to a CFO and two supporting personnel. The CFO, new to the business, served as the primary point of contact but was unable to answer several historical financial and operational questions in detail.
- Reliance on Third-Party CPA: The company depended heavily on an outside CPA firm for adjusting journal entries, tax preparation, and financial reporting. As a result, internal staff lacked visibility into key financial assumptions, particularly those related to historical inventory adjustments.
- Manual Inventory Tracking: Inventory was tracked outside the general ledger using a separate system reliant on manual inputs. Inventory balances were only adjusted quarterly—based on staff estimates of material on hand, not physical counts or verified weights—creating significant uncertainty around margin accuracy and asset valuation.
- Related Entities: The Target operated with multiple related entities, which introduced complexity in identifying a normalized level of standalone business activity. These intercompany relationships lacked transparency and contributed to inconsistencies in financial reporting.
Solution
Our team delivered a targeted Quality of Earnings analysis that focused on presenting a normalized and credible financial picture for the Client’s acquisition decision. Key areas of focus included:
- Capitalization Adjustments: Several capital expenditures were recorded directly to the income statement rather than being capitalized. We identified and reclassified these costs appropriately, increasing adjusted EBITDA.
- Margin Normalization: We conducted a detailed analysis of reported COGS and operating expenses to reclassify costs into appropriate categories (COGS vs. period costs). Discussions with Management and inspection of underlying transactions enabled us to adjust gross margins to a normalized level across historical periods, providing a more accurate view of profitability.
- Inventory Assessment: Though constrained by the manual nature of the Target’s inventory system, we evaluated the methodology used for quarterly inventory adjustments. Due to the lack of physical counts and management’s inability to explain CPA-prepared entries, we advised the Client to treat inventory valuations and gross margins with caution and include appropriate diligence reserves in the proposed deal structure.
Outcome & Impact
Our limited scope review provided the Client with a clear, normalized financial profile of the Target in a highly manual and fragmented reporting environment. The findings:
- Identified and corrected material misclassifications that impacted EBITDA and valuation
- Informed purchase price discussions by introducing run-rate capital expenditure considerations
- Flagged structural weaknesses in financial reporting and inventory controls for post-acquisition remediation
- Enabled the Client to structure the deal with proper diligence protections based on identified risks
Value Delivered
- Delivered actionable financial insights despite limited internal systems and third-party dependence
- Enhanced confidence in adjusted EBITDA and gross margin accuracy
- Helped quantify and isolate operational risk
- Provided strategic recommendations tied to capital intensity and inventory practices that influenced both valuation and deal terms