Financial Due Diligence Overview
If you're contemplating buying or selling a business, or in the process of executing a transaction, performing due diligence is often a key activity in the process. These procedures can vary significantly depending on the size and complexity of the transaction and your ultimate due diligence needs.
Financial due diligence often focuses on providing potential investors with an understanding of a company's:
Sustainable economic earnings
Historical sales and operating expense trends
Historical working capital needs
Net debt and debt-like items
Key assumptions used in management's forecast
Key personnel and accounting information systems
Other important financial or accounting matters
Below are five activities typically performed as part of financial due diligence.
1. Identify Deal Issues
Ultimately, key issues identified in a potential deal is what matters most. You want findings to be transparent and brought to your attention throughout the engagement to ensure there are no surprises.
2. Trend Analysis
A key component of performing financial due diligence is reviewing trends over a historical period, often for the last twelve months and past two fiscal years. This process leads to identification of key market drivers, sales strategies, customer churn, and other factors that may impact earnings in the future. Trend analysis may also incorporate a review of a target's cost structure, vendor usage, and other expense items to identify potential post-transaction synergies.
3. Quality of Earnings
As businesses are often valued based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) or on Discretionary Earnings for smaller businesses, a primary focus of financial due diligence is on the "quality" or sustainability of a target's earnings. Non-recurring or unusual income and expense items, over or understated assets and liabilities, post-closing cost structure changes, and other matters are analyzed to adjust historical EBITDA or Discretionary Earnings to reflect sustainable earnings.
4. Working Capital
As part of a business sale, the buyer and seller typically negotiate a target working capital, often referred to as a working capital "peg", to be delivered at transaction close. This negotiated amount is usually based on the average working capital balances over the last twelve month period, though various factors should be considered by both the buyer and seller. This includes recent business growth trends, industry conditions, seasonality of the business, and other considerations.
5. Net Debt
Net debt and debt-like items are often a negotiating point between the buyer and seller. There may be liabilities a buyer may wish to consider as debt-like, and therefore, either exclude from the deal or seek as a reduction in the purchase price. If debt is to be excluded from the transaction, the buyer should ensure the definition of debt in the SPA (Sale and Purchase Agreement) is sufficient to require a reduction in the purchase price.
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Disclaimer: The information contained in this article is for general guidance only. The information presented should not be acted upon without the advice and guidance of a professional tax, legal, of financial adviser who is familiar with all the relevant facts.