Financial Due Diligence Explained
Financial due diligence is an integral part of every merger & acquisition transaction, alongside commercial due diligence.
We already were speaking about what is due diligence: types, meaning & purpose in our blog. So, today we would like to take a closer look at financial due diligence and describe its procedure.
- 1 When does financial due diligence take place?
- 2 What is Financial Due Diligence?
- 3 What is the procedure for financial due diligence?
When does financial due diligence take place?
Depending on whether you are acting as a seller or a buyer, financial due diligence can take place at different times.
Typically, due diligence is part of the merger & acquisition process as follows:
Market screening (creation of a “long” and “shortlist”)
Submission of indicative purchase price offer
Purchase price negotiations
For the seller, it usually makes sense to prepare initial due diligence in preparation for the company exposé (preparation). On the one hand, this is to work out many of the questions that need to be answered during the preparation of the prospectus (especially the questions and findings of the commercial due diligence).
On the other hand, however, also to identify any errors in the company figures and corporate planning and to correct them before they are made available in a data room. Often, financial due diligence also involves the first intensive preparation of corporate planning.
For the buyer, the financial due diligence will follow at the latest after the submission of the indicative purchase price offer. Finally, this offers the opportunity to delve deeper into the business model and the corresponding figures to identify opportunities and, above all, risks.
The findings from this serve both the purchase price negotiation and the recording of risks, which are recorded in the guarantee catalogue for the seller.
If the due diligence on the seller’s side starts even earlier, there are also opportunities to positively influence the value of the company.
What is Financial Due Diligence?
Financial due diligence essentially consists of three parts:
- Analysis of past events;
- Analysis of corporate planning;
- Revised planning based on own due diligence findings.
Analysis of the past events
Even in the case of smaller-company transactions, the analysis of the past will always be part of the scope of the audit.
A potential buyer will never buy a pig in a poke. He will at least look at the financial statements and other financial documents for the last three years.
This historical data is checked within the framework of financial due diligence for:
- Exercise of valuation options and discretionary decisions,
- Influence of one-off effects
What does that mean in concrete terms?
If an auditor has not audited the annual accounts, special attention must be paid to the accuracy of the figures.
The biggest mistakes in practice are:
- Missing or incorrect accruals and deferrals, especially in sales revenue, work in progress, other assets, accruals and deferrals.
- Missing or too low-value adjustments on assets. In particular, intangible assets, receivables and inventories.
- Unreconciled accounts and accounting differences.
- Interlocking relationships between the company and the shareholder and related parties.
This point is the most difficult to assess, as one has to rely on the information provided by the shareholders and the management of the company to be audited. Facts that are not communicated can lead to serious financial damage.
Therefore, one should always get a written assurance of completeness to have at least a right of recourse in case a “surprise” “pops up” after the purchase.
In practice, one mainly finds restitution-relevant facts that have been disregarded so far.
These include, for example:
- Failure to disclose related parties and transactions with them, which may not be in line with the market.
- Contracts not contractually documented
- Warranties that have been indicated by customers or are pending
- Kick-back and rebate obligations that have not yet been called by the client but are not yet time-barred
- Suspected or known contamination on company property
- Pending or threatened litigation
- Known violations of legal regulations that are not known to the public, e.g. corruption transactions
Valuation options and discretionary decisions
In the case of valuation options, one must first ask which type of accounting standard the company to be audited follows and which one the potential buyer follows. Under certain circumstances, there may be significant differences in the presentation here. In practice, however, this point is usually negligible.
The point of discretionary decisions has more practical relevance. How does management assess the outcome of a pending case? How likely is it that a warranty claim will be made? This can lead to very significant valuation differences that have an influence on the past and/or future company results.
Influence of one-off effects
Finding and eliminating one-off effects is particularly important concerning business planning.
An insurance refund, compensation for damages in the context of a long-standing legal dispute or the sale of a company building can be such effects, which usually do not recur.
In planning, however, these can be carried forward (usually unintentionally) if they have not been identified beforehand.
In the vast majority of corporate transactions, corporate planning is also the subject of financial due diligence.
It is essential to compare the planning provided by the company with one’s own due diligence findings.
The planning premises and forecasts set by the company are checked “heart and kidneys”.
Data analyses for the turnover side should already be available in the context of commercial due diligence. In particular, the development of the:
- Market growth
- Customer growth
- Sales volume
Based on ratios and key performance indicators, the cost side can then also be plausibilised based on past data (e.g. ratio of manufacturing costs/turnover).
Revised corporate planning
The findings of your analysis are used to produce the revised planning. This can also contain different scenarios.
- worst case –
- best case – or
- middle case – consideration
This revised business plan now forms the basis for the business valuation and subsequent purchase price negotiations.
What is the procedure for financial due diligence?
This financial due diligence checklist can help you better to understand the financial due diligence process.
First information gathering
At the very beginning, before the actual audit begins, it is important to understand the target company.
The focus here will be on understanding the business model in particular. The focus is then on the risks to which the business model is exposed (market, competitors, financing, etc.).
Possible sources for reviewing the initial information are:
- the client itself (talks with the potential buyer or seller)
- Website of the target company
- Insight into published figures of the company register
- Consultation of the commercial register on the shareholding structure
- Internet research on press releases, markets, competitors, industry associations, etc.
However, the central point will always be the discussion with the client. Here the scope of the due diligence is often defined and the expectations of the due diligence are set.
A central point here is the identification of risks and, if necessary, for the person carrying out the due diligence, that the limits of the financial due diligence are shown so as not to raise false expectations (see e.g. “completeness”).
Preparation of the due diligence by the target company
As a rule, the target company will provide a so-called “data room” in which all relevant documents are deposited. The main task of a data room is to keep all data complete and safe from unauthorised access and/or copying.
Whereas in the past this data was often made available under the highest security precautions in screened rooms and paper form, in the vast majority of cases there has now been a move to virtual data rooms. In these, the data is protected by logging the time of access and watermarks on the documents.
With the help of these security measures, unauthorised copying of the data can then be assigned.
In preparation, a financial due diligence checklist is often worked through and systematically filed in the data room.
If necessary, the data is provided with authorisations so that only certain groups have access to the (previously defined) areas.
- Financial due diligence – auditors
- Legal due diligence – lawyers
- Tax due diligence – tax consultants
- Commercial due diligence – consultants
Composition of the due diligence team
The due diligence team should consist of employees of the potential buyer, seller and external experts.
All employees will have to sign confidentiality agreements in advance.
Conducting the due diligence itself
After the team has been assembled, it begins to work on the respective audit fields and to identify potential and existing risks.
Definition of a “Question and Answers” (Q&A) process
A so-called “Question and Answer” process must be defined for questions that arise in the course of due diligence.
This includes, above all, the definition of
- Who answers the questions?
- In what timeframe will the answers be given?
It makes sense to define a central contact person in the target company for the questions that arise, who collects the enquiries and forwards them to the responsible departments in the company and records the status.
If you have any questions regarding the financial due diligence procedure, please contact our tax advisors in Barcelona by telephone or email.