How to Conduct Financial Due Diligence?

Financial due diligence

As part of financial due diligence, a company’s financial performance is investigated. In much the same way as an audit, financial due diligence is conducted by outsiders to gain a better understanding of a company’s finances and prospects for the future. Due diligence also seeks to uncover issues that might not be obvious from the financial statements.

Performing due diligence on the purchase side of a transaction

We are focusing on financial due diligence from the buy-side perspective in an M&A transaction. This ensures that the target company is healthy and is prepared for growth.

Financing due diligence for sell-side companies

Although due diligence is often considered a buy-side practice, the sell-side should also perform it. Asking the buyer what he wants is important for the seller. A different approach to buying, ostensibly. An internal audit through financial due diligence can identify issues that would otherwise go undetected.

Taking due diligence into account when making financial decisions

• In this process, every aspect of the business you’re analyzing affects financial due diligence.
• Investments in operations will affect financials.
• Should the company go to court, you might have to pay.
• You’re going to have to pay redundancies soon, the target needs new management.
• In executing any due diligence exercise, regardless of whether it is operational, legal, or human resources-related, or any other area-keeping costs in mind pays off.
• Every kind of due diligence is financial in some way, even the checklist we provide below.
• This process is all about finding out ‘what are the hidden costs?’

Here is a checklist for conducting financial due diligence

Audit committee roles should be taken on when conducting financial due diligence.

A company’s financial statements are first analyzed (in the US, this means 10-K, 10-Q, and proxy filings).

1.Financial Statements (past five years)

1. Determine what drives earnings volatility and whether that will persist.
2. Investigate expenses closely to see if they are excessive. Examples may include salaries growing faster than revenues, and marketing expenses not reflecting growth.
3. If one large client leaves, or if a number of smaller clients are added, how much revenue would be lost?
4. An unusual item that affects operating income is often highlighted by sellers. Can this item be expected after five years of operation?

2. Last five year’s balance sheet

1. Evaluate the target’s liquid assets and their ability to be sold.
2. Additional hidden value may be found in patents and other unutilized assets.
3. Target companies should be in better financial shape than your own, as long as their debt-to-equity ratio is lower than your own.

3. Statements of Cash Flow (past five years)

1. When all financing and investing expenses have been taken care of, how much cash is generated every year after all those expenses? If it’s near zero, you should ask why.
2. Cash flows should be checked. If they are positive, determine the cause – is it a growing operational cash flow or asset sales?
3. Using sensitivity analysis, determine whether the company can still meet its interest obligations if operating cash flow dropped 30% (for example, because one of the big clients stopped bringing in business)?

4. Create a dashboard of the target company’s financial health using financial ratios over the past five years. At a minimum, this should include:

1. Margin of operation
2. Margin of gross profit
3. Coverage of interest
4. Margin of profit
5. Calculate the current ratio
6. Ratio of debt
7. Ratio between debt and equity
8. Turnover of assets
9. An asset’s return
10. Earnings from investments

As a benchmark, industry standards are also important. The likelihood is that something amiss is happening in the target company if its operating margin is well below the industry average. 

5. Analyses and discussions by management

They may answer your questions or even prompt you to ask new ones regarding the quality of the financial statements.

6. The importance of tax due diligence

The following types of fraud are generally prevalent when it comes to financial due diligence:

1. Using the company’s assets for personal gain is the most common form of asset misappropriation.
2. Inflating assets and understating liabilities are the most common types of financial statement fraud, but it is harder if the financial statements are audited.
3. A whole article on corruption could be written. From vague descriptions of transactions to payment descriptions that aren’t aligned with account names, red flags are everywhere.

Be careful at all times and don’t be afraid to ask questions. At all times, go into forensic detail. Ask target management about:

• A business arrangement, especially one that is complex
• Deals at the end of the quarter
• Auditor changes 
• The driving force behind rapid growth
• Receivables growing faster than revenues are nonintuitive changes
• Audit practices change
• Stock insiders