Financial due diligence (Buy-side)

Financial due diligence involves an investigative analysis of a business, assessing

the key issues facing the business and the drivers behind maintainable profits and
cash flows, identifying the key financial risks and potential deal breakers of the
transaction.
 
Financial due diligence
On this page, we give information on the subject of financial due diligence.
The subject is enormously broad, and each financial due diligence project
differs from acquisition to acquisition. Financial due diligence is not an audit,
as it incorporates a much larger scope. A financial due diligence review not
only looks at the historical financial performance of a business but also gives
a professional and independent opinion on the future. A financial due
diligence review will explain the trends observed in the operational results of
the company.
Here is an overview of this page:
What is financial due diligence?
The importance
The objectives
The phases of financial due diligence (when to start)
Methods of financial due diligence
Deliverables or reports in financial due diligence

What is financial due diligence?

Financial due diligence is normally performed when a buyer wants to acquire a
company. In this situation, the buyer needs to have certainty about the
company and the financial situation it is in. Hence, financial due diligence can
be described as a project where a detailed investigation and analysis is
performed to assess the key issues facing a target’s financial business. A
clear focus is on the business drivers of its historic and projected profits and
cash flows. Further, the balance sheet and full profit and loss accounts will be
analyzed in detail as well. In practice, we see several types of due diligence
(DD). Sometimes it is an owner or business person, who spends a few days
individually to investigate the financial books of the company. With larger
transactions we often see a ‘big 4’ or a specialized external firm perform an
independent financial due diligence process on behalf of the buyer. A detailed
report is produced that can cost up to several hundreds of thousands in euro.
The importance of financial due diligence
A financial analysis of the target is important. A buyer needs to be assured
and understand which risks exist in the company. An asset (purchase) deal
means that the historic legal responsibility is not transferred to the buyer. This
can mean that the financial due diligence is shorter or less extensive
compared to a transaction where the shares are acquired. However, this
doesn’t necessarily need to be the case in all circumstances. It is also very
important to determine the value drivers of the financial performance and be
assured that the future earnings of the company will be sustainable.

The objectives of financial due diligence

The due diligence process is much more than a standard checklist of
procedures in order to provide approval for a proposed acquisition. When
done properly, a financial due diligence review provides valuable information
to support the proposed acquisition. There have been several examples where
performing expert financial due diligence has saved the cost of a bad
acquisition. Financial due diligence generally has the following objectives:
Get a good understanding of the historic financial situation of the company
and the correctness of the reported numbers
Check that there are no hidden ‘skeletons in the closet’ (reveal financial risks)
Fully understand the target firm’s balance sheet (assets and liabilities
including contingent liabilities)
Fully understand the target firm’s profit and loss (are the historical earnings of
the company sustainable in the future?)
Forecast the target's future financial situation (to ensure a realistic valuation
and a justification of the purchase price)
Determine if the expected synergies can be realized (and further substantiated)
Get an opinion on the purchase price. The DD can also serve as a basis for
further price negotiations (often seen in practice)
See if any material deal breakers come up (identify early the issues that you
need to address to combine businesses successfully)
Get an idea of which guarantees should be requested in the SPA by the buyer
Use the financial due diligence report of an external firm to achieve bank
financing
Use the financial due diligence report to fine-tune the business plan and to
prepare the post-acquisition integration plan

The phases of financial due diligence (when to start)

Given that financial due diligence can be a costly and time-consuming
exercise, it is important to determine when the process should start. On the
page, buying a business (/buy-business/process-buying-company.htm) you
can get a better idea of when the DD is normally conducted. In general, this
happens after the negotiations and an LOI has been provided and signed. For
a buyer, it is important that you know how many companies have performed
financial due diligence. If there are many, you run a substantial risk that you
will not end up as the final buyer and will have wasted your time and
investment during the financial due diligence process. Hence, it is important to
have exclusivity and an agreed LOI with price and other conditions. Currently,
in most M&A projects a VDR (virtual data room) is available. This gives buyers
the opportunity to investigate the company with internal resources before
deciding on costly external financial due diligence. Once an LOI has been
drafted that describes the structure of the deal, financial due diligence should
begin. Ample time and resources should be allocated to the financial due
diligence process, as the outcome of the review can provide valuable
information regarding a realistic purchase price. It can also help to get
appropriate guarantees and provisions in place.

Methods of financial due diligence

Financial due diligence can be performed via a variety of different methods.
The most common methods are to perform an analysis of the financial
statements, interviews with key employees, order forecasts, market and
industry data or analyses for benchmarking among other ways. There is no
ideal case for financial due diligence. It is always a balance between quality,
costs, and the level of desired information. It is important that financial due
diligence is conducted by independent advisors or people that can give an
independent opinion. This is crucial in order to have a financial due diligence
report that gives a fair, open and objective opinion. A financial due diligence
review can be conducted either internally, by the acquirers' own accounting
and finance department, or by external independent due diligence experts. The
benefit of using external advisers is that the review is based on an
independent viewpoint from a party who has no direct interest in the outcome
of the proposed transaction.

Deliverables or reports included in financial due diligence

The deliverables for a financial due diligence project can differ enormously. In
general, it is good to have a report prepared. However, in practice, we see all
kind of activities being performed and reports being produced. Here are some
of the contents of a standard financial due diligence report:
Analysis of the financial situation
Executive summary of key findings
Overview and workings of financial business drivers including possible risks
Purchase price adjustments to the result (EBITDA adjustments)
Analysis of the sales margins in similar industries
Check of financial forecasts and give an opinion on the achievability of these
financials
Audited financial statements for the target company for the last fiscal year(s)
with the auditor’s opinion
Comparison of last year's forecasted budgets compared to the actual
performance
Detail of capital expenditures for the last calendar year(s) and a check on
forecasted CAPEX
Cash flow-analyze (CAPEX, OPEX and further required capital)
Assessment of future management forecasts