Financial due diligence is a prior research about the target company before entering into any complex transaction, such as mergers and acquisitions (M&A). It ensures that both the companies involved in the transaction have a full understanding of financial health, performance, and risk involved. This assessment is often referred to as an accounting investigation, and it evaluates the financial health of the target company by reviewing its balance sheets and its profit and loss statement. This creates a comprehensive image of the target company’s stability and potential.

Before any merger and acquisition, a company cannot overlook this step. It is a process to validate whether the business is truly worth it or not. Overlooking any part of this process may result in unforeseen challenges or may even lead to the collapse of deals.

What is Financial Due Diligence?

Definition: Financial due diligence is a procedure of carefully studying and confirming the information before making any decision or moving ahead with any action or agreement.

In Detail: Financial due diligence means to examine the financial health of a company through the thorough analysis and verification of information to spot any potential risk before entering into any transaction, agreement with another party, or making any significant decision.

While performing this process of financial due diligence, the analyst studies the company’s historical and current financial data, facts, figures, and performance. It is done with the purpose of identifying any potential risk, detecting whether the facts and figures are true and accurate, and making future financial forecasts.

Key Insight:

Its strategy is similar for the types of investment
The investors can conduct this process for any investment using the readily accessible public information

Financial Due Diligence Checklist –

A financial due diligence checklist is a procedure for checking or analyzing all the areas of a company, such as ownership and organization, assets and operations, financial ratios, shareholder value, practices and policies, long-term viability, management, and workforce management.

The final objective behind this process is to spot the potential risk, irregularities, and areas of concern before making any decision.

Checklist: While performing the financial due diligence, the team must act like an audit committee so that they will closely check the company’s financial performance. The checklist requires the past five years’ financial documents of the company, which include:

• 10 annual reports (Files)
• 10 quarter Reports (Files)
• Proxy reports ( information for the shareholder ahead of the company’s annual meeting)

1. Income Statement (Last Five Years)

Check the consistency of financial performance, i.e, earnings. If the earnings are not consistent, then examine the causes behind it and measure whether this inconsistency is likely to be continued in the future.

Analyze the expenses for inconsistency. For instance, executives’ salaries are increasing faster than earnings. Or marketing investment is done, but sales are not increasing.

Review the quality of earnings. Is the income generated from the single client or the customer segment diversified? This study helps in identifying whether the company will suffer if potential customers stop investing or have a stable income growing client base.

Identify unusual or extraordinary items. Because sellers often highlight events that generate potential risk for the company, such as the shutdown of a factory due to a strike. Assess whether this is a true, unusual event, or a possibility that could happen again within a five-year period.

2. Balance Sheets (Last Five Years)

Assess whether the company has liquid or tradable assets that could be easily sold in the market. Are these assets expected to generate more or less value recorded on the balance sheet?

Check for other valuable assets that are not used in daily operations, like patents or unused real estate. Such assets can contribute as an unrecognized value in the transactions.

Closely evaluate the debt-to-equity ratio and make a comparison of it with the company’s ratio and industry standards. Preferably, the target company’s debt should be less than that of your own company.

3. CashFlow Statements (Last Five Years)

Calculate how much cash the company is generating annually after accounting for finance and investment expenses. If the cash flow is near zero continuously, then identify the reason.

Study the quality of cash flow, whether they are positive and driven by operational growth, or the company is selling its assets to maintain liquidity.

Perform a sensitivity analysis to check if the company’s operating cash flow drops due to the loss of potential clients, so it would be able to meet the interest payment.

4. Financial Statements and Health Dashboards

Study the financial statement to measure the key financial ratios over the past five years, and create a broad view of the company’s financial health. At the minimum side, it should include the following:

• Operating margin
• Gross margin
• Interest coverage
• Profit margin
• Current ratio
• Debt ratio
• Debt to equity ratio
• Asset turnover
• Earnings on assets
• Earnings on equity

Measure these ratios against industry standards. For instance, if the company’s operating margin is lower than the industry average, it indicates operational inefficiency.

5. Management Discussions and Analysis

Study these filings to find the quality of financial statements. The management discussion and analysis provides the information or insights on financial trends and alerts the team if a new question arises.

6. Tax Statement Analysis

It is a crucial aspect that has its own checklist. Make sure to check the tax filings and compliance to detect potential obligations.

7. Fraud Detection

While conducting this process, it is essential to stay alert for the red flags of fraud. The ordinary types of fraud are as follows:

• Inventory theft: It includes the occupational fraud by an employee or any insider who improperly uses the organization’s assets for personal benefit
• Financial statement fraud: It is an intentional misrepresentation of financial reports with the purpose of misleading the stakeholders, such as financial regulators, investors, or creditors
• Corruption: It includes false transaction descriptions to manipulate the financial records. Stay alert for red flags of fraud in such areas

You may also like to read about:

• Ratio Analysis
• Equity Market Analysis
• Financial Statement Analysis
• Financial Planning and Analysis
• Financial Modeling

Types of Due Diligence –

It has different forms depending on its purpose:

Context-Based DD –

• Commercial Assessment: Commercial Due Diligence includes a study of the company’s market share, financial positioning, future opportunities, and growth prospects. It will look at the company’s supply chain, market analysis, dealer pipeline, and the research and development process. It will also consider the company’s overall operations, management, and workforce management
• Legal Assessment: To confirm that the company is operating within a defined framework of legal laws and regulations, and compliance standards. It also considers all the unresolved legal disputes, intellectual property ownership, and verifies that the company was correctly incorporated under the legal laws
• Financial Assessment: It includes the review of financial statements and books, and checks whether there are any unusual or irregularities, and verifies whether the company is financially stable or not
• Tax Assessment: It includes verification of the company’s current and past tax exposure, verifying the unpaid taxes, and determining ways to reduce its future tax burden
• Hard Assessment: Refers to the financial figures and information found on the financial statements, such as the balance sheet and revenue reports. It involves the fundamental analysis and use of financial ratios to understand the company’s financial position and forecast future performance. This type identifies accounting inconsistencies and any red flags
• Soft Assessment: Refers to a quality approach that verifies the various aspects, such as the quality of management, the workforce within the company, and the commitment of its customers. It is more helpful to evaluate the business success in comparison to financial figures and information, like employee unity, the company’s work culture, and leadership. When a merger and acquisition agreement fails, it is mostly due to ignorance of the human factor

How to Conduct Financial Due Diligence?

The financial due diligence can be conducted on both the buy-side and the sell-side.
Here we will study how to conduct financial due diligence on the buy side:

The following are some financial due diligence steps that any company should conduct before making an acquisition. The time required to perform this process varies depending on the size of the firm being acquired. The team performing this process should raise questions on documents such as legal, commercial, financial, human resources, intellectual property, information technology, environmental health and safety, tax, marketing, compliance, and regulatory matters. The executives performing duties in these areas should be the first individuals to ask questions.

1. Prepare an Action Plan

The action plan’s processing time depends on the document analysis and the speed at which the target provides you with the required financial documents. The completion time of this assessment process may be delayed due to some urgent matters or emergencies that have arisen in the company.

But preparing for the action plan gives a foresight into the process to be followed. It also prepares the legal team with a checklist to be ticked off after completion, and coming back to areas that need more attention.

2. Evaluate Red Lines Issues

Conducting an assessment is of no use if you plan to acquire a target company without knowing its outcomes or results.

The motive of performing these steps is more than only gathering the company’s financial figures or information. Its objective is to uncover the misguided information, even for those that aren’t critical, because it will give a clear idea whether it would be comfortable if the company faces similar misleading information in the future.

Some other red flag risks include breaking of contracts earlier than expected, pending legal issues, or intellectual property that isn’t secure as represented by the company’s owner.

3. Measure the Quality

Before gathering the information about the target firm, it is essential to prepare a framework to measure the qualitative elements. It will allow you to make a comparison between your own firm and others in the same sector. Provides a clear picture of what the current performance is and what needs to be improve in each area of the company.

4. Efficiency Rules

The process requires both time and money, and it depends on the size of the company. Some companies may feel it is a burden, especially for those who present accurate and clear financial statements. To streamline this process, set two limits for assessment as follows:

The first time limit: the date that you inform the target company that you aim to complete the process of assessment.

The second time limit: a shorter time frame (roughly two or three weeks less) in which the legal team aims to complete the process. It will prepare the team to perform effectively and efficiently in achieving the set goal for the target firm.

What is a Financial Due Diligence Report?

Financial due diligence report includes the financial reviews and analysis of different areas of business, which include legal, financial, and operational risks. These reports evaluate the performance of your company and provide suggestions on areas that need improvement and insight into the potential of new products or projects.

This report is especially prepared on a particular topic, and if multiple reports are needed on one transaction or events, then it is prepare by different advisors.
Commonly, it includes:

Financial and Tax evaluation: gives a detailed examination of key financial metrics of the company and determines any potential issues and opportunities.

Legal assessment: gives a summary of the legal framework in the company and the key laws and regulations considered. It also includes the evaluation of any significant risks within the available legal document.

Commercial assessment: provides a detailed survey of the market within which the company is operating, its position, and the risks and opportunities in the same market. It also provides an insight into the future pricing and volumes.

Technical assessment: gives an outline of the available physical assets of the company and its geographical location in which the company is operating. Additionally, it informs about the status of those assets and their quality for the ongoing and future operations. Further, it informs about the risks that may arise due to physical assets or geographical locations, and the predicted operating costs and capital expenditure.

Environmental assessment: provides an outline of the actions of the business that are subject to environmental regulations, the applicable regulatory framework, and an analysis of significant material environmental risks.

Insurance assessment: provides a summary of current insurance policies followed and their alignment with the company’s risk profile. While performing this, it will reflect any shortfall in insurance coverage and identify areas where insurance costs could be reduce.

Conclusion –

Financial due diligence is a crucial process of assessment that involves collecting, reviewing, and analyzing the target company’s financial data. It is done before making any critical business decision or entering into any agreement. The main objective behind performing this process is to get a clear insight into the company’s financial health, which enables the investors, acquiring firms, and other shareholders to make an informed decision by reducing the potential risks. By performing a thorough investigation through this process, the target company and the acquiring party know about the hidden liabilities, verify the financial statements, evaluate the income and cash flow trends, and ensure that the company is operating under legal compliance. Hence, it empowers the investors, stakeholders, and the acquiring company to make informed decisions and maximize the value and success in the transaction.

Frequently Asked Questions (FAQs) –

1. What is the objective of financial due diligence?

The primary objective of financial due diligence is to reduce the risk factor for the target company. The process assures the company is well aware of all the details of transactions before they enter into an agreement. For instance, an intellectual property dealer will share outcomes of an assessment report with the investor to clarify that they are not responsible for any loss after the agreement has been informed of the investor in advance.

2. How much time does the financial due diligence process take?

A small business company generally requires 45 to 60 days to complete its assessment process. This time period is sufficient for the buyer to complete the evaluation of the entire financial statements, including the other areas. The big-sized business companies usually take 60 to 180 days to complete the same assessment process, as it includes more complex deals and large amounts of data.

However, when the seller enters into an agreement without being prepared for this process, it can delay the delay. That is why it is always essential to be prepare with this process from the seller’s side for a successful deal.

3. What are the critical points to be asked while performing financial due diligence?

While preparing for the process of assessment, it is also essential to prepare a list of the critical questions. The following are some of the questions that need to be ask:

• Complicated business arrangements and uncommon transactions
• The quarter-end transaction seems to raise red flags
• The frequent change in auditors and the reasons behind those changes
• Fast business growth over a short period of time, and the supporting factors for the same
• Non-standard financial changes, such as accelerated growth in receivables compared to sales
• Modifications in the accounting practices
• Sales of shares by the company shareholder

These are some exceptional key questions that need to be evaluate by the legal team performing a financial due diligence to understand the financial health of the target company. It enables them to make strategic decisions to reduce the risk for the upcoming transactions.

4. How does financial due diligence differ from an audit?

An audit is perform by an evaluation that includes an analysis of financial transactions, verifying compliance, and determining the internal controls. Its focus is mainly on financial accuracy and compliance. Whereas financial due diligence includes a thorough and personalized investigation of each aspect of business.

5. Which areas of business does financial due diligence cover?

Financial due diligence covers the areas that affect the financial position of a business, supply chain, and its operational performance, which include income, working capital flow, balance sheet, and liabilities.