Author: Devasree Karapurkar
Financial due diligence is a crucial process that is undertaken before any investment, merger or acquisition. It involves a comprehensive examination of the financial statements and other key documents of a company like secretarial records, HR-related documents etc, which may have a financial implication on the transaction.
The objective is to verify the accuracy of the financial information provided by the target company. It also helps to identify and mitigate any potential financial risks that may exist post the transaction.
There are two sides to a transaction: the buyer’s side and the seller’s side. It needs to be performed by both parties. The buyers perform it to understand the potential risks of investing as well as to negotiate the terms of investment for their benefit. The seller needs to perform it to identify any issues that may exist so that gaps can be addressed prior to involving the buyer. It also verifies all claims that shall be made in the sale agreement to ensure that no inadequate disclosures are made. Â
Importance of Financial Due Diligence
Financial due diligence helps make an informed decision on investing in a company and the returns to be expected from the investment. It helps buyer companies evaluate the investee company’s ability to generate future profits by obtaining a clear understanding of the past and current trends in revenues and expenses and helps to identify any potential financial risks associated with the target company. This information is essential for investors to make informed decisions about the acquisition or investment.
It ensures that the financial information provided by the investee company is accurate and reliable. This information is essential for investors to evaluate the financial health of the company. Investors can also identify the potential synergies that may exist between the investee company and their own company. This information is essential for investors to assess the potential benefits of the acquisition.
It provides investors with a better understanding of the financial health of the target company. This information can be used to negotiate the terms of the acquisition. It helps to ensure that the transaction is compliant with regulatory requirements. This information is essential for investors to avoid any legal or regulatory issues.
Performing a Financial Due Diligence
Financial due diligence is a complex process that requires a thorough understanding of financial statements, accounting principles, and business analysis.
The first step is to develop a plan for the process. This plan should include a list of documents that need to be reviewed and the specific areas of the financial statements that need to be analysed.
The next step is to review the financial statements of the target company. This includes the balance sheet, income statement, and cash flow statement. The purpose of this review is to identify any potential liabilities and financial risks and to ensure that the financial information is accurate and reliable.
It includes an analysis of key financial ratios: liquidity ratios, profitability ratios, and debt ratios. It also includes variance analyses and common size statement analyses. This analysis helps to identify trends in revenue and profit growth and to evaluate the financial health of the company.
In the next step of the process, the financial controls of the target company are examined. This includes an evaluation of the company’s accounting policies and procedures, internal controls, and risk management systems.
The tax documents of the target company are reviewed. This includes an evaluation of the company’s tax compliance and any potential tax liabilities.
The whole process may include interviews with key personnel of the target company. These interviews provide investors with additional insights into the financial health of the company.
In conclusion, financial due diligence is a critical process that is essential for investors to make informed decisions about acquisitions or investments. The process involves a comprehensive examination of the financial statements and other financial documents of the investee company. The objective is to verify the accuracy of the financial information provided by the target company and to identify any potential financial risks that may exist. By performing, investors can minimize financial risks, ensure the accuracy of financial information, evaluate potential synergies, negotiate effectively, and ensure compliance with regulatory requirements.
References
https://www.investopedia.com/terms/d/duediligence.asp
https://internationalsales.lexisnexis.com/glossary/compliance/what-is-due-diligence
https://dealroom.net/faq/due-diligence-meaning
https://www.ansarada.com/due-diligence/financial
https://signalx.ai/blog/everything-about-financial-due-diligence/
https://dealroom.net/blog/how-to-conduct-financial-due-diligence
