Financial due diligence (financial DD)

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 are 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 various types of due diligence (DD). Sometimes it is an owner or business person, who spends a few days individually investigating the financial books of the company. With larger transactions we often see a Big Four 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 hundred thousand euros.

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 numerous 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 accuracy 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 (share purchase agreement) 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 (letter of intent) 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 including the 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 advisers 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 that 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 kinds 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 (CAPEX), and operating expenditures (OPEX) for the last calendar year(s) and a check on forecasted CAPEX
Cash flow analysis (CAPEX, OPEX and further required capital)
Assessment of future management forecasts

Information about the process of financial due diligence

Contact us for a free-of-charge brainstorming session and feedback on your financial due diligence plans. We can discuss how the financial due diligence process can best be organized. We are open to giving you candid feedback about how to structure your financial due diligence process in your industry or country of choice.