Financial due diligence is an integral component of M&A transactions and is required of anyone wishing to sell their business without experiencing unpleasant surprises post-acquisition.
Buyers’ due diligence advisors will thoroughly analyse your financial statements to verify they reflect what was promised. Buyers will promptly change their offer if any fraudulent figures are used to increase valuations.
What is Due Diligence?
Due diligence is an essential concept in business and law. It refers to taking preventive actions that minimise risk. Security brokers, for instance, must disclose information about their securities before auctioning them. M&A deals, real estate purchases, business purchases, or purchases of all kinds often use due diligence when discussing potential deals. It can even play an integral part in our everyday lives, like selecting which credit card to use, choosing the restaurant for Saturday night dinner, or weighing options when setting goals in life.
Financial due diligence (FDD) in mergers and acquisitions involves investigating a company’s finances and history before purchasing. This typically includes reviewing profitability, growth rates, and customer churn rates; additionally, it’s wise to examine industry standards to measure how the company compares to similar businesses.
FDD ensures that any company purchased is an ideal investment. This process entails checking whether there are sufficient cash reserves and whether the company is not over-leveraged, and evaluating any potential issues within operations, such as regulatory changes, labour laws, or economic risks, such as a recession.
Finalising due diligence requires reviewing a company’s tax situation to ascertain if any back taxes are owed to them and what their projected tax bills should look like going forward. Due diligence generally lasts 45-60 days for individual buyers of mid-sized businesses, while it can take much longer for private equity groups and strategic investors. Buyers should take advantage of this essential step, and using an M&A tool can speed up this step to ensure everything is critical during due diligence.
What is FDD?
FDD (Financial Due Diligence) investigates a company’s financial statements, tax records, assets and liabilities, revenue streams, and market position to determine whether its finances are healthy and its business model sound. This process typically involves professional firms, but it can also be conducted independently by buyers or investors.
Performing FDD is paramount to buyers and sellers, ensuring the financials are accurate and verifiable. For buyers, this helps prevent an unpleasant surprise that devalues a company and reduces the expected return on investment. Sellers use FDD to answer all inquiries from potential buyers about their finances while verifying all claims made against their company.
FDDs may vary in scope depending on the industry and size of the target business, but they generally involve conducting an in-depth investigation that covers everything from financial statements and order forecasts to market and industry information, interviews with key employees, and even reviews of confidential documents in a secure virtual data room.
Utilising public web data when conducting your FDD can significantly enhance the accuracy and speed of this process. Public web data allows you to quickly identify any trends or anomalies in a company’s performance that might impede a deal, as well as provide more information about their customer or supplier relationships. This can be particularly useful when entering new markets or expanding overseas.
What are the Benefits of FDD?
- Financial due diligence is critical to any business transaction. It ensures that the numbers you work with are reliable and accurate. This helps minimise surprises post-transaction and allows buyers to better understand a company’s value.
- FDD can assist in identifying potential issues with target companies before beginning the sale process, saving both parties time and money. For instance, significant historical or projected earnings volatility is often an indicator of potential problems later. Furthermore, FDD will uncover any hidden costs or legal or regulatory risks in any deal, potentially saving time and money.
- FDD can also help assess whether target companies’ revenue generation trends are sustainable and identify any gaps or opportunities for growth within them.
- If you are selling your business, the process of conducting FDD may feel like an audit; however, it’s essential to keep in mind that both parties involved in due diligence want the deal to close smoothly by remaining calm and cooperative during this phase of due diligence, it should all run more smoothly for everyone involved.
- Prepare yourself for an exhaustive series of inquiries into your business finances, from revenues and profitability to cash flows and forecast accuracy. Depending on the nature of the audit, questions could include P&L information for the past five years and details regarding each subsidiary’s profitability. You will also need to show why any discrepancies exist within financial statements, providing a sufficient explanation.
What are the Risks of FDD?
- Financial due diligence involves a detailed assessment of the health state, which requires analyzing financial statements and tax records, assets and liabilities, income-earning channels, business model, place in the market, and other factors. As a critical component of any M&A deal, due diligence involves detailed research and evaluation.
- It was crucial to work with an advisor for FDD because the results could lead to hidden issues that would tamper with any deals, resulting in negative impacts. However, the indirect risks are minimized by revealing them during implementation processes and identifying strategies for overcoming such challenges.
- FDD results may also alter the price of any deal since buyers will see how comprehensively FDD has evaluated a company and have a clearer understanding of its worth; as a result, buyers may become less willing to purchase it altogether.
- FDD can be time-consuming and laborious, requiring a comprehensive analysis of your company’s finances, often taking two months or longer. However, using an all-in-one application like SignalX can expedite due diligence processes significantly and reduce the duration by as much as 75%!
- As a seller, you must complete a full FDD before selling your franchise. Doing this will give you all of the information necessary to sell at an equitable price and terms; moreover, an in-depth FDD may reveal issues that might cause buyers to leave a deal altogether. Furthermore, legal advice should be sought before finalising transactions to reduce risk and maximise return.
How to Conduct FDD?
- Financial due diligence (FDD) is an integral component of any M&A deal. It verifies that the company’s numbers match what has been advertised about its story, helps buyers derisk an acquisition, and determines how they will earn a return on their investment. Conducting an FDD can help prevent costly errors like overpaying for an acquisition.
- FDD processes typically begin by determining whether a company’s accounts are set up on either a cash or accrual basis. This is an essential question as it determines how the business records revenue and expenses. It ultimately impacts how much money it has available for investment or financing purposes, along with revealing information such as financing method and debt load.
- After reviewing the company’s historical and forecast performance, all legal liabilities and capital expenditures should also be examined as part of this FDD process. Finally, public web data analysis helps uncover consumer sentiment analysis, assess competitors, and uncover growth opportunities.
- Private equity firms, venture capitalists, strategic investors, investment banks, family offices, sovereign wealth funds, pension funds, and insurance companies usually conduct buy-side financial due diligence (FDD). At the same time, individual investors or broker-dealers may also conduct sell-side FDD.
M&A Checklist for Financial Due Diligence
For any M&A deal to go smoothly, all necessary information must be gathered before proceeding. Financial due diligence involves investigating a company’s finances and verifying their accuracy to help buyers better understand its core performance metrics.
People typically associate M&A due diligence with revenue growth and profit margins. While these metrics are essential, they’re only part of the picture when conducting due diligence. It is also crucial to explore what’s driving these figures and their potential for growth.
Financial due diligence processes are invaluable to preventing costly mistakes that could undermine any deal. By performing a detailed examination of a company’s numbers, you can ensure the agreement serves your best interests without hidden surprises or surprises down the line. Here’s what to look out for when performing due diligence:
1. Income Statements
You should review a company’s three- to five-year history of income statements, balance sheets, cash flow statements, and forecasts for the foreseeable future. Utilising accrual accounting can make spotting discrepancies or inconsistencies easier.
2. Audit Reports
To ensure your company remains compliant and any issues have been adequately addressed, review its audit reports regularly to stay abreast of any updates, review its accounting practices, such as whether cash or accrual-based reporting is used, and understand whether your accounting department uses accrual—or cash-based accounting reporting models.
3. Tax Filings
It is wise for a company to review its tax filings and payments regularly to detect any issues and any ongoing or potential legal disputes that might threaten its financial situation.
4. Customer Reviews
To assess a company’s market standing and reputation concerning new competitors or industry trends, it’s wise to study customer reviews and feedback. It can give a good indication of what it’s like working with this particular business.
5. Intellectual Property Rights
Perform a detailed analysis of their patents, trademarks, and copyrights to ensure you have not violated any intellectual property rights.
Financial due diligence processes help to save time and money and reduce risk for those involved in mergers and acquisitions. These tips will help you promote your M&A due diligence and minimise risks arising from rash decisions.
Conclusion
FDD may be complex, but its effort will pay dividends. FDD reveals hidden costs such as tax risks and quality of profit that reduce the value of businesses and potential opportunities for improvement that accelerate revenue growth. FDD increases the probability of successful M&A transactions by making sure all parties involved work from shared information, thus decreasing risks arising in future deals or investments and improving efficiency overall
