How to Conduct Financial Due Diligence for M&A

Before you buy something, you want to make sure it's worth the investment. You start looking at reviews, talking to experts, and testing the product yourself.

Due diligence is similar; you investigate a potential business partner or contractor to gather enough information to help you decide whether to enter into a business relationship with them. 

If you're a seller, you might wonder whether this is meant for the buyer? Why should you even worry about it?

Due diligence benefits both the buyer and the seller.

For the buyer, due diligence is a way to identify potential risks and confirm that a particular business merger or acquisition is a good investment. The due-diligence process can also help the buyer negotiate a better deal. 

For the seller, due diligence involves preparing all the necessary information and documents to provide to the buyer to ensure that the transaction goes smoothly. It's also a way to show the buyer that the business is a sound investment.

What's Financial Due Diligence?

Financial due diligence is the investigation of a company's financial statements and performance to identify potential red flags and assess its suitability as an investment.

It's an essential step in any merger or acquisition. It allows all parties to understand the company's financial health and identify any potential risks.

You can conduct financial due diligence by reviewing the financial statements, interviewing management, or speaking with customers and suppliers.

Conducting financial due diligence can be a complex and time-consuming process, but it's essential to ensure that you have a clear understanding of a company's financial health before moving forward with any merger or acquisition.

Types of Financial Due Diligence

Buy-Side Financial Due Diligence

The potential buyer of a company performs the buy-side financial due diligence to assess the acquisition target's financial viability. The goal of buy-side due diligence is to identify and quantify the risks and opportunities associated with the transaction to help the buyer decide whether to proceed with the acquisition.

It typically includes reviewing the target company's financial statements, accounting practices, tax filings, and other financial information.

The due diligence team also assesses the target company's business model, competitive landscape, and growth prospects. The team performs a detailed review of the target company's key contracts and agreements.

Sell-Side Financial Due Diligence

Sell-side financial due diligence is when the seller of a business or assets provides financial information to a potential buyer to support the sale. While it helps the buyer identify any financial red flags that could make the sale of the company difficult or impossible, the goal for the seller is ultimately to show that the business is on firm financial ground and a good prospect for acquisition.

Sell-side financial due diligence typically includes an analysis of the historical financial statements of the company, as well as a review of the company's current financial position. It verifies that the seller's financial claims are accurate and satisfies the buyer's questions regarding potential red flags.

Due diligence is usually performed before entering into an agreement, but it can also be used as a tool during or after an agreement has been made. 

Why Is Financial Due Diligence Important?

Here are the benefits of financial due diligence:

• It helps both seller and buyer understand a company's financial health and identify potential risks.
• It shows whether a company for sale is a good investment.
• It helps uncover or resolve any potential red flags that could impact the investment decision.
• It detects any fraud or mismanagement.
• It can aid in negotiations, thereby reducing the acquisition cost.
• It helps both buyer and seller make better decisions and avoid future legal issues.

How Do I Conduct Financial Due Diligence as a Buyer?

Conducting financial due diligence begins by requesting and reviewing relevant financial information from the seller. This includes audited financial statements (of the past five years) and the company’s public filings, such as its 10-K filings, 10-Q filings, and proxy filings. 

What the buyer needs to review:

Financial Statements

• Examine earning volatility, which measures how much a company's earnings fluctuate yearly. Volatile earnings can signify financial distress and indicate that a company is not performing well. The buyer needs to understand the reason for volatility.
• Analyze the expenses and check for any irregularities.
• Analyze the quality of revenue. This tells you how robust the company is: is a single big client responsible for most of the revenue, or is it the combined effect of many clients? Will the loss of a single big client cause the business to collapse?
• Discover factors that affect operating income.

Balance Sheets

• Evaluating the company's marketable assets helps identify and value the company’s assets that could be sold in a liquidation scenario. By understanding the company's marketable assets, the buyer can better understand the company's material value.
• Inspect the company's debt-equity ratio and compare it with the industry standards. If this is a merger, the debt-equity ratio should be as low or lower than the buyer's current company.

Cash Flow

• Examine cash flow. Look at both current and projected cash flow. Are there problems lurking around the corner? Is the granularity of cash flow a problem?
• Find out if there are any areas where the cash flow is particularly tight? These are things you'll want to flag for further investigation.
• Conduct a cash flow sensitivity analysis to understand how changes in certain variables will affect the company's cash flow. It'll help you assess the risks of investment and evaluate the potential upside and downside of the investment. How resilient is the cash flow against market changes? Are there new players in the market that could affect cash flow in the short term?

Tax Statements

• Make sure that the company is reporting its income and expenses accurately. Do financial statements align with tax returns?
• Note any possible fraudulent behavior and ask questions regarding anything that comes up. Is the company classifying its income and expenses correctly? If not, is it because of incompetence, sloppiness, or fraud?
• Make sure tax documents are accurate.
• Look for significant changes in the tax profile from one year to the next or any suspicious deductions or credits claimed.
• Make sure there's no history of tax audits or current disputes.

Assets and Liabilities

• Evaluate the seller's assets by looking for items such as cash, accounts receivable, inventory, and property. Also, consider intangible assets such as patents, copyrights, and trademarks.
• Compare the value of these assets to the company's liabilities, including accounts payable, loans, and leases. If the liabilities are more than the assets, it could signify that the company is in financial trouble and is at risk of defaulting.
• Compare the assets and liabilities to the industry norms to get an idea of how the company is performing. If you find any abnormal items, conduct further investigation.

Various Financial Ratios

Analyze the financial statements to evaluate financial ratios.

To help determine the value of acquiring a company, the buyer should look at financial ratios like operating margin, gross margin, interest coverage, profit margin, current ratio, debt ratio, debt to equity ratio, asset turnover, return on assets, and return on equity.

Compare these to industry standards to develop context on the financial health of the seller's company and the viability of the investment.

Projections

• Examine the target company’s quarterly and year-over-year projections. Are the projections realistic? Do they take into account all the relevant factors? Look for areas where the numbers don’t make sense or where there are significant discrepancies. 
• Check whether the company's projections show that it's on track to achieve its long-term goals. This includes both financial goals (such as profitability) and non-financial goals (such as market share). Red flags could be unrealistic assumptions, large swings in revenue or expenses, or a lack of supporting documentation. What's the average market growth for the company's industry? How does the company compare, taking into account its stage of development?

Conclusion

If you're considering acquiring a company, conduct financial due diligence before proceeding with the deal. Due diligence is essential for both the buyer — to help avoid costly surprises down the road — and the seller (to show that the company for sale is a good investment).

Due diligence varies by industry. The type of due diligence required depends on the target company, but financial due diligence is the cornerstone of due diligence and an essential step in any acquisition or merger.