Due Diligence

Financial Due Diligence Checklist

The FDD means to conduct an investigation into the company’s financial status and how the company has been operating in the past. Suppose the company is paying the taxes on time or not. It includes many areas like domains of legal, human resources, tax, etc. When most of the businesses progress, they tend to engage in the Mergers and Acquisition (M&A). The due diligence process is a time-consuming but important part of the game. The financial discrepancies indicate a lack of transparency in the company, intentional deception, illegal compliance with the deal, etc.

Types of Financial Due Diligence

 Financial due diligence is of two types, namely-

Buy-side Due Diligence and the Sell-Side (Vendor) Due Diligence

Buy-Side Due Diligence

The buyer performs the buy-side due diligence or the acquirer who intends to buy the company. These buyers could be strategic investors, family offices, sovereign wealth funds, pension funds, private equity firms, etc. This type of due diligence mainly focuses on the health of the target company. Information is gathered relating to the company’s expenses—revenues, creditors, debtors, etc.

Sell-side Due Diligence

This type of due diligence is performed by the vendor or seller who is selling the business. It focuses on the acquirers’ interest so that the transaction’s hiccups can be avoided. It helps the seller, through internal audit, to uncover the issues that would have otherwise gone unchecked.

Steps for Conducting Financial Due Diligence

There are four stages for conducting the financial due diligence. These stages are the preparation stage, research stage, verification stage and the analysis stage. All the four stages are defined below-

1. Preparation Stage

First, it is to be examined whether the company is worth investing in or not. The company needs to meet the criteria like whether it meets the growth objectives and whether it fits well or not within the industry if sufficient market demand is there for the products/services offered by the company.

2. Research Stage

It involves gathering information from the decision-makers in the company. Certain basic research is required on press releases, annual reports, SEC filings, etc. Regular visits to the company are also essential. One can also request internal documents like meeting agendas, minutes of the board meetings, balance sheets, etc.

3. Verification Stage

The information is verified at the verification stage, which we have gathered in the research mentioned above. This process can be conducted in different stages as follows-

• Expounding the FDD scope
• To analyze the financial data of the company from the past till date.
• Discuss the findings with the valuable people of the organization
• To analyze the implications of these findings.
• Preparation of the final report.

4. Analysis Stage

It refers to the in-depth or broader analysis of the data which is collected. A thorough analysis of the company’s management is done at this stage. To analyze the company’s books and records. Figuring out the weaknesses in the operation of the company. The long-term debt analysis of the company. To check the existence of any agreements or contracts between the company and customers or suppliers. A market analysis can also be performed to check the competitiveness of the company.

Difference between Financial Due Diligence (FDD) and Audit

FDD is different from financial audits. Although the line of difference is very thin between the two there are differences between the two processes.

Financial Due Diligence (FDD)	Audit
The procedure and scope are defined and agreed upon with the vendors	Whereas in the audits, the procedure and scope  are defined by the rules and regulations of the country
It does not verify the accuracy of the information that is available	The information accuracy is verified
It considers the future projections	It looks primarily at the historical data
It analyses the quality of the earnings	It analyses the balance sheets

Checklist of the Financial Due Diligence

The checklist for the financial due diligence shall include (but is not limited to) the following-

Income Statements

If the expenses seem irregularly high, then an investigation is to be conducted as to why this is the case. For instance, if the salaries are higher than the revenue, etc. What is the volatility of earnings across the periods, and is it likely to continue in the future? The income statements of the past five years are mainly seen.

The client base of the company is to be analyzed. For if the revenue is generated from one or two big clients of the company or there are multiple clients. How long do the clients stay true to the company? And if one client leaves, does it have any effect on the revenue of the company? The exceptional items are to be identified, for example, a strike in the company and if this strike affects the operating income of the company.

Balance Sheets

In this, the target’s marketable assets are evaluated. Some infamous assets like unused property or patents can also be used to generate potential revenue. These are the assets that are not used on a day-to-day basis, but they can also give good hidden results.

Cash flow statements

After all financing and investing expenses, how much cash is generated every year is to be seen. The quality of the cash flows is also to be evaluated and analyzed. There are different reasons for the same; for example, the company is selling off the assets yearly or because of the operational cash flows.

Company’s Financial health status

We can also create a dashboard of the target company’s financial health. It shall include interest coverage, gross margin, return on assets, and equity.

Tax Due Diligence

The financial frauds are to be detected under this head. Broadly, there are three types of financial fraud-

1. Financial Statement Fraud– It refers to the hidden liabilities. However, if the auditor is reputable, this can be detected extremely fast, and this type of fraud can very well be avoided.
2. Misappropriation of the Assets- The employees of the company might use fake invoicing, etc., for their personal gains. This type of fraud is known as the misappropriation of assets.
3. Corruption- How can we forget this name, which quite occurs in every domain of our living, sadly? Here, it refers to the vague description of transactions, etc.

Case Law– In the case of Nirma Industries and Anr. Vs Securities Exchange Board of India, the Supreme Court of India held that it is the duty of an investor company to conduct proper due diligence on the targeted company before making any investment, which is required as per Regulation 27(d) of the Securities and Exchange Board of India, 1997 SEBI Regulations. In this case, Nirma Industries, which was the investor company, failed to do the proper due diligence and went ahead by investing money despite being aware of the multiple legal proceedings. The Court further held that the companies could not plead ignorance as an excuse when they were rightly fully aware of the ongoing legal proceedings.

Red flags: Non-compliance

• Companies Act, 2013– It can be checked with the charter documents like Articles of Association and minutes of the meeting of the board. All the non-compliances should be assessed.
• Labour Laws– The companies must adhere to the labour laws of the country at all state and central levels. These acts include the Employees State Insurance Act of 1948, the Payment of Gratuity Act of 1972, and the Sexual Harassment of Women at Workplace Act.
• Intellectual Property Rights– IPR is one of the company’s most important assets. So it must be checked from time to time that there are no frauds pertaining to the same.
• Environmental Laws– Compliance with the environment must be there. It is the responsibility of every company to adhere to strict environmental norms. No growth or success of an individual company can be ignorant of our environment and earth.

Company’s Management Team

The track record of the company’s Management team is to be evaluated. The past successes and failures of the company must be checked. It is also the analysis of the company’s key decisions and how they shaped the company’s revenue in the long run. In this way, we can get to know the company’s management team’s performance. The effectiveness of the management team can thus be judged. The assumptions and projections will reveal the company’s perception of the future.

Factors to consider while buying assets

While buying the assets, there are certain important points to take care of, like considering the restrictive covenants, identifying the assets, choosing which employees to keep to draft the sale purchase agreements and making the arrangements with the creditors and debtors.

Advantages of Financial Due Diligence

A lot of benefits are associated with the financial due diligence. Some of them are given as under.

• It identifies the risks that are associated with the target company.
• To understand the real value of the target company.
• To reduce the cost of the acquisition.
• To minimize the legal costs
• To avoid the pitfalls of post-acquisition

Disadvantages of Improper Due Diligence

A German company, Daimler Benz, merged with the Chrysler Group. However, this merger turned out to be unsuccessful. Over a period of time, the value of the Chrysler fell to 7.4 billion. According to many experts, Daimler actually failed to conduct proper due diligence, which resulted in the over-valuation of the target company.

Hewlett Packard, a US-based company, carried out only 6 hours of due diligence, which resulted in a disaster and fraud case. Cathie Lesjak, the former CEO of HP, admitted that she never read the due diligence report properly, which the accounting firm KPMG prepared.

Limitations of the FDD

The FDD cannot provide assurance of future performance, so it cannot replace an independent audit. Financial due diligence is suitable for large-scale businesses. Because small businesses use their own software, it becomes difficult to gather accurate financial data.

Due Diligence under Indian Laws

The dictionary meaning of the term ‘diligence’ is diligent or continuous application. Today, Indian companies have agreed to be bound by certain legislations so as to compete and emerge in the international market. The reasons why companies go through a due diligence process includes joint venture, mergers and acquisition, cross-border transactions, etc. The Ministry of Corporate Affairs has set some guidelines when it comes to inter-company transactions. Indian companies must align with the guidelines of FEMA, MCA and the Securities and Exchange Board of India (SEBI).

Conclusion

Financial due diligence thus becomes a crucial determining factor in checking the success rates of a particular Company. It helps to uncover companies who are engaging in the businesses by the wrong means. The revenue the companies generate should be in proportion to the salaries they offer employees. It is also the responsibility of the companies to pay proper taxes on time and these days to also ensure that the companies having high turnover must necessarily engage in Corporate Social Responsibility. The amended Companies Act requires companies to pay for important social issues like poverty, climate change, environment, children’s studies, etc.

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