What is financial due diligence?
To understand the value of anything, we must look at it closely. Financial due diligence is the process of looking closely at an asset’s finances, considering both potential profit and risk.
Most often, the term financial due diligence (or FDD) is used in the context of a merger or acquisition. The buy-side — the party looking at acquiring the other — will be examining the target company’s balance sheets to try and determine whether the business is profitable and worth going ahead with a deal.
The importance of financial due diligence
Financial due diligence is a fundamental part of the overall due diligence process; it’s where you’ll gain an understanding of how resilient a business is, what are its financial liabilities, and how much risk it could bring you.
It’s surprising, then, that this vital step in M&A often gets undue attention. On average, one out of every two deals fail to go through on account of poor financial due diligence.
This tells us we need to give FDD all the consideration and effort it deserves.
What parties are involved in financial due diligence?
Financial due diligence involves the buying and selling side. That’s because any negotiation is only as good as the data you have to support you.
So the buying side wants to know what it’ll be getting into, while the target company needs to make sure it doesn’t sell itself short, leaving money on the table.
Buy-side financial due diligence
The buy side is above all trying to form a clear picture of the target business.
|Establishing the real value of the business|
|Identifying potential risks and liabilities for an informed decision|
|Accurately comparing with similar companies|
|Strengthening its bargaining hand|
Sell-side due diligence
Although the bulk of FDD is done by the acquiring side, the sell-side also has work to do.
|Identifying underlying issues that could damage bargaining power|
|Ensuring that it is not undervaluing itself|
|Presenting a compelling case for buyers/potential investors|
Financial due diligence checklist
- List of subsidiaries, joint ventures, and partnerships with other organizations
- Organizational chart outlining the corporate structure and key stakeholders
- Shareholder agreements and stock option plans
Tax due diligence
- IRS and state tax exemption letters
- Federal and state tax returns for the last three years (e.g., forms 990, 990-T)
- Additional federal and/or state tax records as agreed upon
- Documentation related to sources of unrelated business income
- Tax-exempt bond financing information
- Property tax exemption certificates
- State sales tax registration and records
Financial and funding
- Audited financial statements for the past three years or year-end statements if no audit is available
- Management letters from the organization’s accountant
- Most current financial statements, including balance sheets and income statements
- Operating and capital budgets for the current year
- Financial institution details (names and addresses)
- Comprehensive list of liabilities and corresponding loan agreements or liens
- Details of other debt financing arrangements, such as purchase agreements or sale and leaseback agreements
- Confirmation of any conflicts of interest regarding assets owned by the corporation
- Overview of current grants and contracts, including terms and conditions
- Description of restrictions, terms, and agreements for all restricted funds, including endowments
- Summary of the fundraising program and any related agreements
- Obligations and terms of gift agreements
- Aging schedules for accounts receivable and accounts payable
- Breakdown of revenues and expenses for each program
- Copies of guarantees by the organization or other parties for obligations
Capital and real estate
- Deeds and title documents for owned properties
- Lease agreements for buildings and equipment
- Mortgage documents for any outstanding loans
- Inventory of significant equipment and vehicles
- Zoning permits and use approvals
- Preliminary title annual reports for each property
- Environmental assessments for owned or leased properties
- Insurance policies related to property and equipment
Main aspects of a financial due diligence checklist
Let’s break down the above list into its main segments.
Here your aim is to understand the financial ramifications of the company’s operations. You’ll want to review and analyze existing partnerships, joint ventures, customer contracts, and other collaborative agreements.
You’ll also want to look at the company’s management and assess things like contractual obligations, consulting agreements, and agreements relating to intellectual property, as well as any risks associated with these arrangements.
Finally, you should evaluate the legal and financial structure of these relationships and their impact on the target’s financial health.
This starts with the basics: examine the target company’s tax returns, provisions, and strategies. If your due diligence team has nobody with an accounting background, this would be a good time to bring an outside consultant for an independent audit of the data.
You’ll need to assess the accuracy and completeness of the tax reporting, and establish whether the company is in full compliance with tax regulations.
To further prevent any surprises down the line, you’ll want to focus on identifying any potential tax liabilities, risks, or outstanding tax issues.
This is where you’ll analyze the revenue and expense items in the target company’s income statements. Are the target company’s revenue recognition policies accurate and consistent? What goes into operating expenses? What are the most common or recurring expense items?
These and other questions will help you establish how sound the statements are. Besides that, you’ll also want to review profitability trends and key financial performance indicators for the target company’s industry.
Look into the assets, liabilities, and equity components of the balance sheet. Assess the valuation and classification of fixed assets, including property, equipment, inventory, as well as intangible assets.
Once you’re done, review the composition and quality of the target company’s liabilities, such as outstanding debt, loans, accounts payable and accounts receivable.
Finally, check the target company’s equity structure, including shareholders’ equity, reserves, and any outstanding stock options or convertible securities.
Cash flow statement
Cash flow statements let you assess the target company’s ability to generate and manage cash.
This is where you’ll analyze both the sources and uses of cash. For this step, your team should also look into operating activities, the target company’s growth rate, investing activities, and financing activities.
You should also include in your finacial due diligence checklist things like:
- Working capital management
- Target company’s liquidity position
- Fixed and variable expenses
- Market analysis with cash flow trends
Here you’ll review the overall quality and reliability of both the historical financial statements (usually for the past 3-5 years) and the unaudited financial statements for the current fiscal period.
This step will allow you to assess the consistency of the target company’s financial information, alongside issues of compliance with accounting standards and reporting requirements. Keep an eye out for any potential accounting irregularities, omissions, or areas requiring further investigation.
Remember: There’s no such thing as excessive investigation before signing a high-stakes deal.
The role of financial due diligence in risk management
“Risk comes from not knowing what you’re doing.”
This quote by Warren Buffett reminds us of the importance of the financial due diligence process for proper risk management. As seen above, research has repeatedly shown that as many as one in two mergers and acquisitions fail, most often due to a poor understanding of the risks underlying the acquired business.
Among other things, following a proper acquisition due diligence checklist can help you:
- Help lower litigation costs
- Identify areas of potential post-deal loss of reputation
- Prevent damage to the customer base and alienation of other stakeholders
- Conduct better long-term risk assessment and reduce concomitant costs
- Develop a well-informed risk mitigation strategy
Hidden costs do exist and can have a tremendous impact. In fact, a 2001 study found M&A deals caused as much as a staggering $226 billion loss in shareholder value over a span of 20 years.
As of 2023, not only do similar rates of M&A failure remain similar, but recent research puts faulty due diligence as precisely one of the leading causes for deal failure — a stark indicator that we disregard FDD at our own peril.
How to use virtual data rooms to simplify financial due diligence
Digital transformation and the rise in cybersecurity threats have pushed virtual data rooms onto the fore of modern dealmaking. More than just another office tool, data rooms can be a key value driver both in the pre-deal and post-deal environment.
Cloud-based and equipped with a slew of security and collaboration features, data rooms are a godsend to a company’s internal control procedures, providing a platform where companies can share and access sensitive data securely during the due diligence process.
During the due diligence process, data rooms help both parties involved operate with all kinds of confidential company data, including legal documents such as outsourcing agreements, trade secrets, tax settlement documents, and information concerning key employees, including employment agreements and employee benefits.
The reality is simple: Most deals that fail do so because of poor due diligence.
This means if you want to sleep soundly at night knowing your merger or acquisition isn’t about to join that list, you must gain a thorough understanding of the target business. You also need to be able to provide assurance to your company’s stakeholders that your team knows what it’s doing and you won’t be the latest example of acquisition indigestion.
This isn’t easy. It means doing painstaking research hour after hour, file after file.
So put together a good due diligence team, leverage the dealmaking features of a high-level data room, and go through your due diligence checklist point by point. All the time and headache spent now for due diligence will pay handsome rewards in future profitability, stability, and yes — good sleep at night.