Due Diligence

Carrying Out Financial Due Diligence: Process, Scope & Limitations

Financial due diligence is an important step for a business. Businesses need to engage in the process of mergers and acquisitions actively; therefore, the role of financial due diligence becomes an indispensable part. A deal can only be completed by conducting proper due diligence, and it is worth knowing that the financial aspect of the said process is the most time-consuming. The method of diligence includes enormous scrutiny of areas connected to financial, legal, HR, and tax compliance domains. Let’s have an in-depth understanding of financial due diligence.

Meaning of Financial Due Diligence (FDD)

The process of FDD includes an enquiry into the company’s financial matters. It involves an analysis of the company’s historical and forecasted trends to understand its relevance and veracity.

It is a crucial process to assess the financial health of the company. Investors, acquirers, etc. rely on this process as a standard of care during mergers and acquisitions. It can help in reviewing a potential deal and investment opportunity through which relevant facts and financial information can be confirmed.

Scope

The Scope of this process differs as per the industry, the business’s scale, and the company’s magnitude. The prime area of focus of FDD is to analyse revenue generation and assess the quality of cash flows and earnings. It also focuses on revenue sustainability by relying upon factors such as working capital, taxes, financial debts and liabilities, and forecasted financial figures.

The scope of FDD also covers the identification process of potential liabilities and commitments. Through this process, various other crucial business variables can also be reviewed. Thus, its scope is not limited but exhaustive.

Why is Financial Due Diligence crucial?

The FDD process provides you with an understanding of the company’s financial performance and the company’s ability to generate future profits.

The process of FDD is important because it allows you to know the strengths and weaknesses of the company. Once you know the company’s strengths and weaknesses, you will be able to make better decisions for the company. You will be able to perceive the exact amount that you need to invest to buy a company. It also provides a clear picture of the return that you should expect from the investment.

Additionally, FDD is required to ensure better negotiation and it helps to reduce acquisition costs. By knowing the company better, the chances of overpaying for the company also reduce considerably.

The process of FDD helps to know various factors about the Company.

• The process of FDD tells you about the profitability of the company. It tells you the amount of profit a company makes at a particular time.
• The process of FDD also helps you to know the amount of debt that a company owes. It tells you how a company plans to repay its debt.
• Another factor known through this process is the company’s growth strategy. It shows how a company will raise its profits in the short term and the long run.
• It also tells you the financial health of the company. The process of financial due diligence provides a company’s debt-to-equity ratio and much more, revealing the company’s true financial health.
• The growth prospects of the company are also revealed in this process. It shows the growth prospects or growth trends of the company.
• This process also reveals the requirements of working capital. The process of FDD evaluates the requirements of working capital in the future.
• It also reveals the net assets of the company. It provides an adjusted figure of net assets. It is done after the business review and determining the company’s net assets in the context of a deal.
• This process also shows how a business generates revenue. It considers various aspects, including a breakdown of customers, product mixes, location, and much more elements. It provides an adjusted revenue or an EBIDTA after reviewing the findings.

Benefits of FDD

There are several benefits of carrying out due diligence. Some of the crucial benefits have been discussed below-

• Identify risks

By carrying out the process of FDD, you can uncover the potential risks associated with the target company. Knowing the risks is critical, especially in the initial stages, or it can cause significant losses in the future. Through this process, you can be cautioned about the potential risks that can screw up your business. Thus, identifying the stakes at the initial stages will help you to make informed choices.

• Perceive the viability of the acquisition

By undertaking the process of FDD, one can determine the viability of the acquisition. It will help you to know whether the entire acquisition process is feasible. Thus, help you to make a wise business decision.

• Know the value of the target company

With this process, you can know the actual value of the target company. Knowing the target company’s value is essential for the success of the acquisition process. Therefore, undertaking the FDD process can be helpful in having a complete understanding of the actual value.

• Track and sort the issues before making a final decision

With the help of due diligence, a company can identify some of the critical issues. Thereby, it will allow you to address the issue before the final decision is made and before the agreement is signed.

• Reduce Acquisition Costs and Legal Costs

A proper due diligence process can reduce the overall costs related to the acquisition. Not only that, any chances of future legal fees can be minimised. Thus, it can save you from incurring a deep hole in your pocket.

• Avoid post-acquisition dangers

The FDD process helps you to avoid post-acquisition conundrums. There are a lot of issues that can prop up after the acquisition process is completed. There may be some risks that you may face in case you fail to do the due diligence exercise. Therefore, in order to avoid such scenarios, consider conducting financial due diligence for a safe and secure tomorrow.

Process of Financial Due Diligence

The FDD process comprises different stages. It can be classified into four different stages. First is the preparation stage, followed by the research stage, then the verification stage, and finally the analysis stage. Let us discuss each of them.

Preparation Stage

Before the FDD process is initiated, one must know whether the company is worth investing in. Determine whether the company satisfies the criteria set by you. This may include knowing whether the company meets your growth parameters and whether it fits within your industry. Further, understand whether there is enough market demand for the product or service provided by the company.

Research Stage

The research stage can be entered into when you have finalised to go ahead with the FDD process and identified the target company. In this stage, you need to do the research work. During the research, you will have to gather all the relevant information regarding the company. The research work can include a variety of things such as communicating with the decision makers of the target company, reviewing essential documents like annual reports, press releases, etc., availing some internal documents such as the minutes of the board meeting, balance sheets, and also obtaining the audits carried out by the third party of the financial statements of the company.

Verification Stage

Once the research stage is over, verify the information that has been gathered during the earlier process. It will require you to compare the results obtained from the research with the real data available on the company. You need to define the scope of the complete due diligence process. You must identify the needed details and analyse past financial data. You need to discuss the key findings with some senior people in the organisation and understand the implications of the results that have been collated. After discussing it with the organisation’s senior management, prepare the final report.

Analysis Stage

When all the crucial information and data have been determined, you need to analyse them thoroughly. A broader analysis of the data should be carried out during this stage. This includes analysing the historical trends of the revenue and expenses of the company. You may have to compare the company’s revenue with the expense and revenue of similar companies. In this stage, you will have to analyse the cash flow statements^[1] and the working capital. Further, the balance sheet should be analysed to know whether there are any signs of mismanagement or risks.

Moreover, the assets, liabilities, and long-term debt should be analysed. You should be aware of the contracts or any agreements made with the company’s suppliers or customers. It is equally crucial to carry out a market analysis to know whether the industry is highly competitive. This is also where weaknesses and shortcomings in the company’s operations are identified.

Thereafter, analysing the product and service of the target company and auditing the company’s books and records is equally crucial. You may also consider scrutinising the management of the company.

Difference between financial due diligence and audit

It is crucial to know that financial due diligence and audit are different from each other. A financial audit involves the assessment of the present financial status of the company based on its past financial statements. On the other hand, FDD involves an in-depth analysis of the reasons behind historical and forecasted trends and examines whether the trends have any relevance to the buyer.

Further, FDD allows the acquirer to know the financial health of the target company, whereas auditing gives assurance about the target company’s financial statements.

Limitations of Financial Due Diligence

The FDD process has certain limitations. It is not similar to an audit carried out as per the generally accepted auditing standards, also known as GAAS. It needs to assure you regarding future performance. Thus, it cannot take the position of an independent audit.

Additionally, FDD is not adequate for small businesses or start-ups as they need complete financial data access.

Conclusion

Comprehensive Financial Due Diligence is crucial for any business to make informed decisions. It ensures that the parties to the transaction resolve issues and execute a successful transaction. Therefore, conducting a complete process of due diligence is critical for any business. In case you are considering entering into a transaction, consult a financial professional who can guide you through the entire FDD process.

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