Understanding Financial Due Diligence – Importance, Scope and Requirements

Due diligence report is a part of mergers, acquisition and investment deal. In order to make this report, the analyst holistically investigates the target company. As a whole there is one report, however, it has several sub-types. Following is the list of all the sub-types of a due diligence report –

  • Financial Due Diligence
  • Legal Due Diligence
  • Commercial Due Diligence
  • HR Due Diligence
  • IT Due Diligence
  • Intellectual Property Due Diligence
  • Operational Due Diligence
  • Tax Due Diligence

In a series of article, we will try to cover each type of due diligence in detail, starting today’s article with financial due diligence1

Financial Due Diligence

Financial due diligence basically means deeply analyzing the overall financial health of the target company before making a merger, acquisition or investment decision. Let us first understand the scope of financial due diligence –

Scope

The scope of financial due diligence differs from one company to another depending on the size and the industry of the target company. Generally, the scope of financial due diligence would involve –

Historical Quality of Earnings

When we use the term quality of earnings, it means we want to analyze the reported earnings of the target company. The question here is – If the company earned X amount of money in the past, did that money add value to the owner’s capital? Some companies show artificially inflated earnings and profits. Sometimes companies provide very large credit periods to increase sales. This does eventually lead to higher sales and higher profits, but no cash is coming in.

Understanding these factors help determine the strength and capability of the target company. Therefore it is very important to understand the quality of earnings of the target company before making the buying decision.

Quality of Net Assets

Assets are the backbone of any company, so while conducting financial due diligence it is very important to analyze the quality of net assets of the target company. In this first, all the assets of the target company are listed – be it owned, leased or rented. Any company has a wide variety of assets, for example – core assets such as land and factory; vehicles such as cars and buses; technological assets such as machinery, computers, and software; also intangible assets such as patents, trademarks, etc. All these assets are valued and the total net worth is calculated. Thereafter the net assets are compared with the net debt to understand the quality of net assets.

Capital Expenditure Requirements

Capital expenditure is the money invested by a company to acquire, maintain and improve fixed assets such as factories, machinery, building, equipment, etc. When we analyze the capital expenditure requirement, we try to understand how much funds in capital expenditure will be required to maintain and grow the target company’s earnings. There may be many reasons for which the capital expenditure would be necessary. For example, the current machinery might be near the state of obsoletion and may need replacement, or production facility needs to be expanded for future growth.

When we calculate future capital expenditure, we understand how much the buyer will have to pay over and above the purchase price. It is good to make a capital expenditure schedule to make a smart buying decision.

Financial Debt and Liabilities

Debt and liabilities, two words that scare even the most rational investors. Nobody wants to take on the debt that comes with mergers and acquisitions, and for a very good reason too – the costs attached with debt and liabilities can turn a very healthy cash flow into negative cash flow and make the company bleed.

However, the analysts also understand that debt is part of the business and necessary for expansion. In this area of financial due diligence, the analyst wants to make sure that the target company has a rationale behind the debt it owes. Also, the analyst wants to make sure that the target company is not over-leveraged and it is capable to repay its debt in a timely manner from its own earnings.

Understanding Financial Due Diligence

Forecasted Financial Results

All the large, well-managed companies forecast their financial results for the next five years. They calculate the projected revenue and net income based on assumptions. These assumptions are drawn from well-researched data as well as the company’s own strength and capabilities. The data points include factors such as estimated future growth of the economy and particular market in which the company operates, projected social and demographic shifts, company’s production and marketing strength, the capability of future capital expenditure and much more.

An analyst conducting financial due diligence must thoroughly research the assumptions on which the target company has forecasted its financial results in order to understand the future growth prospects of the target company.

Information and Documentary Requirements

When we understand the scope of financial due diligence, we ask another question – “Where will I get the information to conduct the financial due diligence?”

This information required comes from various sources. Following is the list of documents from which an analyst can get the information to conduct financial due diligence –

  • Historical financial statements
  • Detailed trial balances
  • General ledgers
  • Detailed management accounts and reports
  • Current operating results
  • Business plans
  • Budgets and forecasted financial information

Even though the information that we get from these sources maybe complete and valid, the actual availability of the sources depends on the size and reporting capabilities of the target company. For example, if the target company is a small family business then it may not have its business plans or future forecasts in place. In this case, financial due diligence becomes tricky and requires deep investigations within and outside the target company.

Importance of Financial Due Diligence

One can put financial due diligence as the number one priority in the due diligence process. There are many reasons due to which this particular due diligence is very important, some of them are –

  • Financial due diligence helps to answer the following questions –
    1. Is the information provided by the target company reliable?
    2. Can the company sustain its historical earnings in the future? More importantly, can it grow its earnings in the future?
    3. What level of working capital does the company require to function smoothly? Is it capable to generate this working capital from internal or external sources?
    4. Are there any major or off-balance sheet liabilities in the company’s balance sheet that needs to be considered?
    5. Does the company have any future commitments or scope of contingencies that need to be considered?
  • When done correctly, financial due diligence provides valuable information and insights to come to a fair purchase price for the target company.
  • Financial due diligence also identifies the issues that the buyer and target company must address so as to ensure a smooth and transparent merger/ acquisition.

1.
The Importance of Financial Due Diligence. http://bdo.ca. June 2019. [Source]
Last updated on : August 29th, 2019
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