There Are Many Hidden Expenses That You Can Remove
Identify unnecessary expenses and push your company’s operating profit
Other operating expenses form a significant part of many income statements. Rental, legal, or consulting costs are part of other operating expenses (“OOE”). OOE consist of a fixed and a variable portion, e.g. rental expenses represent fixed costs up to a certain point. Also, legal expenses or annual audit expenses do not change significantly if the level of revenue varies. Other items, like travel expenses, might change based on the respective level of revenue. This is why OOE consist of a fixed and a variable portion.
OOE offer a rich set of potential normalization items. In any due diligence, the fixed vs. variable portion needs to be understood. This helps understand movements and to identify potential normalization items. Please note that the normalization should only cover the portion exceeding the recurring level.
In the following article, I am going to share with you what to focus on in a financial due diligence when it comes to analyzing OOE.
Understanding OOE
It is important to understand which items are reported under OOE, what drives OOE, and what it is composed of. This helps grasp movements across different periods more easily. Once you understand the composition of OOE, you can start to analyze movements as well as ratios. Movements include understanding an increase or decrease from one year to another. Ratio analysis includes the relative changes, i.e. relative to revenue or total output.
The following section focuses on the main items.
Legal and consulting
Lawsuits, ongoing restructuring, development of a new strategy. Depending on the company’s current situation, legal and consulting costs fluctuate. Within a due diligence, identify the normal level to adjust for the non-recurring portion.
Warranty expenses
Companies typically report warranty expenses as OOE. This comprises, for example, damage claims. Also here, be able to quantify the normal/recurring level.
Foreign exchange losses
Here, try to understand the exposure to foreign exchange (“FX”) fluctuations, that lead to distortions in revenue and EBITDA. Also, you should understand the company’s hedging strategy. Distortions and fluctuations can be due to transactional and translational effects. Transactional effects impact the cash flow, e.g. due to the purchase of a product in a foreign currency. Translational effects come from the translation of (for example) the subsidiary’s profit into the company’s main currency.
Headquarter allocation
In any larger company, there are central services for subsidiaries or divisions. For example: Research & Development, Treasury Management, Human Resources, Facility Management, or Corporate Development.
In turn, the headquarter charges a fee to its subsidiaries, based on headcount, revenue, or other metrics (always check them!!) for these services. Hence, one large expense item will comprise several services. There are two issues with that:
- Going forward, these services need to be performed by the acquirer, who needs to understand the composition in detail.
- The headquarter allocation comprises items from several income statement lines. For example, Human Resources, Maintenance, Cleaning. This limits a meaningful ratio analysis. If possible, a reclassification can be performed during the financial due diligence to allocate those costs by nature.
Loss from the sale of fixed assets
Often, a sale of an old machine, vehicle, etc. occurs. If the price is above its book value, a gain is reported (under other operating income). If it is below, a loss is reported. In many transactions, this represents a normalization, since it is not part of the normal course of business.
Key takeaways
- Identify the fixed vs. variable portion, this is also important to verify if the business plan assumptions are valid
- Understand which level of expenses is recurring and what needs to be adjusted
Final thoughts
OOE offer a rich set of potential normalization items. In this article, I intended to share the main points that typically call for an adjustment. The adjustments can be identified once you understand the structure of the expenses. Also, only then you can derive the fixed vs. variable portion and draw meaningful conclusions.
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