Due diligence is an integral part of M&A transactions. Due diligence investigation helps an acquirer assess the investment capabilities of a target company before an acquisition.
However, the best way to reduce potential risks is to conduct a financial due diligence process. Many deals fail because of poorly audited financial statements.
Continue reading to learn more about financial due diligence and to understand why a financial due diligence checklist is important in deal-making.
What is financial due diligence?
Financial due diligence is a part of the due diligence process for transactions like M&A. It’s an independent audit of the target’s financial health aimed at confirming a company’s investment potential by means of reviewing historical financial statements and other essential finance-related documents.
The financial due diligence process verifies a company’s financial performance before buyers decide on whether to acquire it. This gives the acquirer a thorough understanding of whether a company is worth the investment.
Financial due diligence parties
There are always two parties involved in any financial due diligence — sell-side and buy-side.
Let’s briefly review the objectives and responsibilities of each side during financial due diligence.
Buy-side due diligence
The buy-side is the buyer, or acquirer, who considers investing in or buying a company.
The objective of buy-side financial due diligence is to assess the target company’s financial performance to ensure that it’s worth the investment and reduce possible risks. To make an informed decision, the buy-side reviews cash flow statements, marketing data, balance sheets, and tax returns. The buy-side due diligence also often involves discussions with the company’s management.
Sell-side due diligence
Despite the tendency to view due diligence as a solely buy-side practice, sell-side financial due diligence is yet another important part of mergers and acquisitions.
Sell-side is a target company that seeks investment or selling opportunities.
The sell-side’s financial due diligence objective is to make sure all the financial documents are in order for the buyer. This way, a target company enhances the chances of successfully closing the deal.
Additionally, financial due diligence helps the sell-side to calculate the cost of the deal. Often, target companies realize that their true value is higher after conducting financial due diligence.
Financial due diligence as a risk management strategy
Proper financial due diligence is also an excellent tool for risk management.
The buyer’s intent to conduct financial due diligence helps potential investors discover hidden costs and avoid extra spending. To do so, the acquirer inspects the company’s annual reports, performs cash flow and market analysis, and reviews all the essential financial information that might influence the deal.
On the other hand, financial due diligence lets the sell-side perform an internal audit of the finances before the buy-side and, thus, avoid any unpleasant surprises.
Financial due diligence checklist
A financial due diligence checklist states what documents to review during the investigation process.
Obviously, the list may be different depending on the buyer’s interest. However, the company’s financial performance is organized and easiest to comprehend in its quarterly and annual reports.
Below are the primary components of financial due diligence.
It’s essential to check whether the target company has any partnerships or joint ventures. Doing that can provide assurance to the buyer that there are no hidden costs in the potential deal.
Moreover, hidden partnerships can significantly influence the final company’s value and future financial performance. So it’s in the best acquirer’s interest to conduct a thorough investigation.
Tax due diligence is an integral part of financial due diligence.
The buy-side reviews the target company’s tax liabilities to see how they influence the company’s revenue. Additionally, it’s important to check whether the company’s tax policy is according to the law and if there’s no financial fraud.
It’s recommended to review the target company’s income statement for each of the previous five years.
- Volatility in earnings across the period. Investigate the reason for volatility and help ensure the trend won’t continue in the future.
- Quality of earnings. Check whether the company’s earnings come from one big client or multiple customers and whether new clients stay for the long term. Additionally, investigate how the company’s earnings will be affected if one big client leaves.
- Irregularly high expenses. Ensure the company doesn’t have any irregularly high expenses. If they are proportionally higher than the industry average, find out why and if there’s a solution.
- Extraordinary drivers. Ensure that there are no extraordinary factors that influence the company’s income. In case there are any (like strikes or factory shutdowns) — investigate what impact they will have on the company’s future operations and income.
It’s best to review balance sheets over the last five years as well:
- Evaluate the company’s assets that can be liquidated. Assess for what price they can be sold — more or less than estimated in the balance sheet.
- Investigate assets that are not used in the company’s everyday operations. Evaluate whether they have the potential to generate higher transaction value.
- Check the debt-equity ratio. Ensure that there is less debt in the target company’s operations than in your own.
Cash flow statement
Just like with the previous components, it’s better to check cash flow statements for the last five years.
By reviewing cash flow statements, auditors can:
- Define how much cash the target company generates every year after all expenses. If it’s far too low, find out why.
- Check the quality of cash flow and determine the growth rate. If the cash flow is positive, look for data to support that.
- Forecast future cash flows. Ensure the company’s performance remains stable even after cash flow drops 20%.
Reviewing financial statements allows for checking the company’s financial ratios for the last five years.
To ensure the company’s operations are in order, check the following:
- Profit margin
- Gross margin
- Operating margin
- Debt ratio
- Asset turnover
- Interest coverage
Using a virtual data room to simplify financial due diligence
Investment bankers, M&A brokers, law firms, and other deal-making sides often use virtual data room software when conducting due diligence.
A virtual data room offers many features that make the due diligence process easier, more automated, and quicker. For example, most vendors provide a due diligence checklist or allow for creating a template. With its help, it’s easier to conduct due diligence since users know what to look for when reviewing a company’s documentation.
Check the top virtual data room providers on our main page to select the one that will fit your needs.
Just like legal, operational, or human resources due diligence, financial due diligence is a chance for the sell-side and buy-side to secure the deal and calculate its true value.
The buy-side’s objective is to ensure the target company is worth the investment and that there are no hidden costs.
The sell-side’s objective of financial due diligence is to determine their true value and to reduce the risk of unpleasant surprises for the buyer.
The main components of the financial due diligence checklist are financial statements, which include cash flow statements, balance sheets, income statements, tax analyses, and a review of the organizational aspects. A virtual data room facilitates and significantly simplifies the financial due diligence process.