Financial due diligence is an investigative analysis of a company's financial performance. Like an audit, financial due diligence is conducted by outsiders looking to gain a better understanding of the financial situation that the company finds itself in, and its prospects for the future. Financial due diligence also sets out to uncover issues that might not be readily apparent in the financial statements.
After discovering the incentive of the seller, go ahead and get all the financial details on the table, so that you can start working with the vendor to create a business that meets their most important needs and has an equitable profit for you.
The process begins by analyzing 5 years of financial statements.
1. Income Statement (past five years)
Check for the volatility of earnings across periods. If earnings are volatile, be sure to establish exactly what’s driving that volatility and whether it’s likely to continue.
Closely examine expenses, see if there are areas where expenses seem irregularly high, and investigate why this is the case. Examples could be salaries growing faster than overall revenue, marketing expenses that aren’t reflected in growing revenues
Understand the quality of earnings. Are headline revenue figures being driven by one big client or several clients? If one client were to leave the stable of clients, would revenue collapse? Or are more clients being added all the time and staying for longer?
Look for exceptional items. Sellers often draw attention to one-off items that affect operating income. For example, a strike led to a factory shutdown for two weeks. Ask yourself: Is this an extraordinary item or one that can be expected over 5 years of operating?
2. Balance Sheets (past five years)
Evaluate the target’s marketable assets (i.e. those that can be liquidated). Assess whether these assets could be sold for considerably more/less than the carrying value on the balance sheet. Evaluate other potentially marketable assets not used in day-to-day operations, such as patents and unused property. These also have the potential to generate hidden value in the transaction. Pay particular attention to the debt-equity ratio, checking how it stands up against your own firm’s ratio and that of the industry at large. As a rule of thumb, there should be less debt in the target company’s make-up than that in your own.
3. Cash Flow Statements (past five years)
Pay attention to the bottom line here - how much cash is being generated every year after all financing and investing expenses have been taken care of. If this is even close to zero on an ongoing basis, you need to ask why. Check the quality of cash flows. If cash flows are positive, understand the reason behind this - is it because operational cash flows are growing or because the company is selling off assets every year? Use sensitivity analysis with the cash flows. If operating cash flow were to fall 30% (for example, because one of the big clients stopped bringing in business), would the company still be able to pay the interest on its loans?
4. Use the financial statements to check financial ratios over five years, to allow you to generate a dashboard of the target company’s financial health.
At a minimum, this should include:
Operating margin
Gross margin
Interest coverage
Profit margin
Current ratio
Debt ratio
Debt to equity ratio
Asset turnover
Return on assets
Return on equity
Here, it’s also important to industry standard ratios as a benchmark for the target company's performance. To take one example, if the operating margin for the target company is well below the industry average, the likelihood is that there’s something amiss in the company’s operations.
Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment decisions
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