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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.

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?”

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?

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 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

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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

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.

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