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How to Conduct Financial Due Diligence + Checklist

Kison Patel
CEO and Founder of DealRoom
Kison Patel
CEO and Founder of DealRoom

Hundreds of investment bankers, law firms, and M&A brokers turn to DealRoom when conducting due diligence.

The feedback provided by these M&A practitioners is that, more often than not, financial due diligence is the area of due diligence that requires most attention.

Understanding the financial performance of a business and what’s really driving the numbers is what will make or break a deal.

In this article, we look at how to conduct financial due diligence, as well as providing a checklist of the items that require attention to ensure this part of your company’s due diligence process passes successfully.

What is Financial due diligence?

Financial due diligence is an investigative analysis of the financial performance of a company. Similar to 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.

Buy-side financial due diligence

When we think of financial due diligence in an M&A transaction, we’re typically thinking about due diligence from the buy-side perspective.

Indeed, that is the focus of this article and the checklist below. The aim of financial due diligence on the buy-side, as mentioned elsewhere, is to ensure that the target company’s financial situation is as healthy and prospective as you would want it to be as an acquirer.

Read more:
How to Efficiently Conduct Buy-Side Due Diligence

Sell-side financial due diligence

Despite the tendency to think of financial due diligence as a buy-side practice, there is also a need for the sell-side in a transaction to conduct its own financial due diligence.

This is ostensibly the same work, just conducted from a different perspective. The sell-side should be asking itself: “what would the buy side want to see here?”

Financial due diligence can also serve as a form of internal audit, helping to uncover issues that would otherwise have gone unchecked.

Read also:
How to Efficiently Conduct Sell-Side Due Diligence

Understanding the importance of financial due diligence

Financial due diligence should be at the core of the due diligence process, because every other element of the business you’re analyzing will affect financial due diligence in some way.

Need investment in operations? That will affect financials.

The company is facing an upcoming legal dispute? That’s likely to cost you.

The target needs new management? Looks like you’re going to be paying redundancy soon.

Thus, whether the due diligence you’re undertaking is operational, legal or human resources, as in the cases above, or any other area of due diligence, it pays to keep costs in mind.

And while the checklist we provide below is strictly concerned with the explicit financial elements of the target company, every kind of due diligence is in some way financial.

The question, ‘what are the hidden costs here?’ is the essence of what the process is all about.

The financial due diligence checklist

In conducting financial due diligence, you and your team should look to take on the role of an audit committee.

The process begins by analyzing 5 years of financial statements (in the US, this means 10-K filings, 10-Q filings, and proxy filings).

1. Income Statement (past five years)

  1. Check for 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 into the future.
  2. Closely examine expenses and 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
  3. Understand the quality of earnings. Are headline revenue figures being driven by one big client or a number of 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?
  4. Look for exceptional items. Sellers often draw attention to one-off items that affect operating income. For example, a strike leading to a factory shutdown for two weeks. Ask yourself: Is this really an extraordinary item or one that can be expected in the course of 5 years of operating?

2. Balance Sheets (past five years)

  1. 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.
  2. 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.
  3. 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 of your own.

3. Cash Flow Statements (past five years)

  1. 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.
  2. 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?
  3. 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 mimimum, this should include:

  1. Operating margin
  2. Gross margin
  3. Interest coverage
  4. Profit margin
  5. Current ratio
  6. Debt ratio
  7. Debt to equity ratio
  8. Asset turnover
  9. Return on assets
  10. Return on equity

Here, it’s also important to industry standard ratios as a benchmark for the target company 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. 

5. Management Discussion and Analysis

These filings refer to the quality of the financial statements and may answer some of the questions that arise - or lead to you asking new ones. 

6. Tax Due Diligence

A crucial component of financial due diligence that warrants a checklist all of its own. DealRoom provides this checklist to everyone conducting M&A due diligence.

All of this should be conducted while keeping an eye out for fraud. Broadly speaking, there are three types of financial fraud:

  1. Asset misappropriation, the most common kind, involves any measure (e.g. false invoicing, skimming, etc.) used by the company’s employees for personal enrichment.
  2. Financial statement fraud. The most common cases of this are inflating assets and understating (or hiding) liabilities. This isn’t so easy if the financial statements have been audited by a reputable auditor.
  3. Corruption. This could be an article in itself. Red flags include everything from vague descriptions of transactions to payment descriptions being misaligned with the corresponding accounts.

It will pay in the long-run to go into forensic detail with your financial due diligence. At all times, be careful and don’t be afraid to ask questions. Ask target company management about:

  • The nature of all business arrangements, particularly any complex ones that exist
  • End-of-quarter transactions
  • Changes in auditors 
  • Significant growth in a short period of time and what drove it
  • Non-intuitive changes such as receivables growing faster than revenue
  • Changes in accounting practices
  • Insider sales of stock
financial due diligence checklist

Conducting financial due diligence with DealRoom

With a track record as the virtual data room of choice in hundreds of M&A transactions, DealRoom has been able to put together a template for financial due diligence that addresses everything required on both the buy-side and the sell-side.

due diligence templates

Users can avail of DealRoom’s unique requests feature, allowing people to request and fulfill tasks and provide relevant documents in a structured and orderly fashion. 

due diligence requests lists

Importantly, DealRoom aims to be one of the most secure virtual data room on the market, so nobody has to worry about the integrity of the documents and information provided during their financial due diligence process.

data room documents

Conclusion

The scope of due diligence changes depending on your industry.

By way of a simple example, a manufacturing company will invest more time on operational due diligence, while a technology company will spend more time on technology due diligence. All companies, regardless of their industry, need to focus on financial due diligence.

Conducted properly, it may tell the buyer as much about the target company as all the other sections of due diligence combined.

request a demo

Hundreds of investment bankers, law firms, and M&A brokers turn to DealRoom when conducting due diligence.

The feedback provided by these M&A practitioners is that, more often than not, financial due diligence is the area of due diligence that requires most attention.

Understanding the financial performance of a business and what’s really driving the numbers is what will make or break a deal.

In this article, we look at how to conduct financial due diligence, as well as providing a checklist of the items that require attention to ensure this part of your company’s due diligence process passes successfully.

What is Financial due diligence?

Financial due diligence is an investigative analysis of the financial performance of a company. Similar to 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.

Buy-side financial due diligence

When we think of financial due diligence in an M&A transaction, we’re typically thinking about due diligence from the buy-side perspective.

Indeed, that is the focus of this article and the checklist below. The aim of financial due diligence on the buy-side, as mentioned elsewhere, is to ensure that the target company’s financial situation is as healthy and prospective as you would want it to be as an acquirer.

Read more:
How to Efficiently Conduct Buy-Side Due Diligence

Sell-side financial due diligence

Despite the tendency to think of financial due diligence as a buy-side practice, there is also a need for the sell-side in a transaction to conduct its own financial due diligence.

This is ostensibly the same work, just conducted from a different perspective. The sell-side should be asking itself: “what would the buy side want to see here?”

Financial due diligence can also serve as a form of internal audit, helping to uncover issues that would otherwise have gone unchecked.

Read also:
How to Efficiently Conduct Sell-Side Due Diligence

Understanding the importance of financial due diligence

Financial due diligence should be at the core of the due diligence process, because every other element of the business you’re analyzing will affect financial due diligence in some way.

Need investment in operations? That will affect financials.

The company is facing an upcoming legal dispute? That’s likely to cost you.

The target needs new management? Looks like you’re going to be paying redundancy soon.

Thus, whether the due diligence you’re undertaking is operational, legal or human resources, as in the cases above, or any other area of due diligence, it pays to keep costs in mind.

And while the checklist we provide below is strictly concerned with the explicit financial elements of the target company, every kind of due diligence is in some way financial.

The question, ‘what are the hidden costs here?’ is the essence of what the process is all about.

The financial due diligence checklist

In conducting financial due diligence, you and your team should look to take on the role of an audit committee.

The process begins by analyzing 5 years of financial statements (in the US, this means 10-K filings, 10-Q filings, and proxy filings).

1. Income Statement (past five years)

  1. Check for 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 into the future.
  2. Closely examine expenses and 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
  3. Understand the quality of earnings. Are headline revenue figures being driven by one big client or a number of 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?
  4. Look for exceptional items. Sellers often draw attention to one-off items that affect operating income. For example, a strike leading to a factory shutdown for two weeks. Ask yourself: Is this really an extraordinary item or one that can be expected in the course of 5 years of operating?

2. Balance Sheets (past five years)

  1. 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.
  2. 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.
  3. 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 of your own.

3. Cash Flow Statements (past five years)

  1. 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.
  2. 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?
  3. 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 mimimum, this should include:

  1. Operating margin
  2. Gross margin
  3. Interest coverage
  4. Profit margin
  5. Current ratio
  6. Debt ratio
  7. Debt to equity ratio
  8. Asset turnover
  9. Return on assets
  10. Return on equity

Here, it’s also important to industry standard ratios as a benchmark for the target company 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. 

5. Management Discussion and Analysis

These filings refer to the quality of the financial statements and may answer some of the questions that arise - or lead to you asking new ones. 

6. Tax Due Diligence

A crucial component of financial due diligence that warrants a checklist all of its own. DealRoom provides this checklist to everyone conducting M&A due diligence.

All of this should be conducted while keeping an eye out for fraud. Broadly speaking, there are three types of financial fraud:

  1. Asset misappropriation, the most common kind, involves any measure (e.g. false invoicing, skimming, etc.) used by the company’s employees for personal enrichment.
  2. Financial statement fraud. The most common cases of this are inflating assets and understating (or hiding) liabilities. This isn’t so easy if the financial statements have been audited by a reputable auditor.
  3. Corruption. This could be an article in itself. Red flags include everything from vague descriptions of transactions to payment descriptions being misaligned with the corresponding accounts.

It will pay in the long-run to go into forensic detail with your financial due diligence. At all times, be careful and don’t be afraid to ask questions. Ask target company management about:

  • The nature of all business arrangements, particularly any complex ones that exist
  • End-of-quarter transactions
  • Changes in auditors 
  • Significant growth in a short period of time and what drove it
  • Non-intuitive changes such as receivables growing faster than revenue
  • Changes in accounting practices
  • Insider sales of stock
financial due diligence checklist

Conducting financial due diligence with DealRoom

With a track record as the virtual data room of choice in hundreds of M&A transactions, DealRoom has been able to put together a template for financial due diligence that addresses everything required on both the buy-side and the sell-side.

due diligence templates

Users can avail of DealRoom’s unique requests feature, allowing people to request and fulfill tasks and provide relevant documents in a structured and orderly fashion. 

due diligence requests lists

Importantly, DealRoom aims to be one of the most secure virtual data room on the market, so nobody has to worry about the integrity of the documents and information provided during their financial due diligence process.

data room documents

Conclusion

The scope of due diligence changes depending on your industry.

By way of a simple example, a manufacturing company will invest more time on operational due diligence, while a technology company will spend more time on technology due diligence. All companies, regardless of their industry, need to focus on financial due diligence.

Conducted properly, it may tell the buyer as much about the target company as all the other sections of due diligence combined.

request a demo

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