Financial due diligence is the process of systematically examining the details and history of a business to confirm the value of the business, most often for the purpose of buying it. Financial due diligence focuses on the quality of earnings and future performance in addition to accounting processes and controls, making it different than an audit or review. While it is possible for a prospective buyer to perform the financial due diligence process, the best practice is to hire professionals.
If you are buying a business, establishing your financial due diligence team is a critical step in avoiding pitfalls. Do you know how to assemble your financial team?
What is financial due diligence for M&A?
When buying a company to perform a merger or acquisition (M&A), financial due diligence is a detailed examination of the business financials to verify the sellers’ and measure business risk. A financial due diligence team will:
- Test controls procedures for weakness
- Analyze accounting policies
- Sample supporting documents such as receipts and invoices
- Interview management
- Correct errors in historical financials
- Create a forecast of future financial performance: revenue, earnings, and cash flows
- Calculate a fair working capital target (when applicable)
Upon completing the financial due diligence process, the prospective buyer will receive a due diligence report which includes major risks identified, corrected financials, forward projections, and recommendations to the buyers. This is more than what an audit report provides – including forward-looking projections and management concerns which should inform your strategic business plan. Your financial diligence team should hold a consultation meeting with you to explain their findings in detail and answer your questions.
Why is it important to conduct financial due diligence?
Can you trust the seller’s financial reporting? The due diligence process is an investment in knowledge to validate the seller’s financial information. Think of it like buying an insurance policy: it is a sunk cost that you hope was a waste of money. But in the cases where due diligence finds major issues and you end up renegotiating the deal, you will be grateful you invested in the service. Issues identified during due diligence include:
- Overstatement of profit due to poor bookkeeping
- Overstatement of profit due to fraud or bad management
- Key customer concentration risk
- Overstatement of inventory, receivables, or fixed assets
- Understatement of accounts payable, taxes due, or other balance sheet liabilities
- Lurking revenue declines or imminent cost/expense risk
- Vendor/supply chain risk
- Appraise management’s ability to maintain accurate financials
These factors affect the target company’s valuation as well as your working capital target. An incorrect working capital target, driven by inaccurate financials, can cost the buyer hundreds of thousands or millions of dollars.
Why hire an expert for financial due diligence?
For transactions under $1M, it makes economic sense for a prospective buyer to perform their own financial due diligence. However, for deals over $1M, you will realize significant benefits from hiring a professional, including:
- Close the deal faster. Buyers typically spend the weeks leading up to close securing capital and negotiating a purchase agreement, and do not have time to perform detailed due diligence.
- Give your investors confidence. Hiring unbiased third-party professionals gives your investors confidence.
- Identify negotiation opportunities. A professional quality of earnings report thoroughly identifies risks, allowing you to negotiate better terms with the seller.
- Cut through deceptive financial statements. Professionals familiar with deceptive accounting can quickly and easily identify misstatements.
Professionals use their expert judgement, sophisticated analysis, and a comprehensive due diligence checklist to ensure no stone is left unturned.
How much should I pay for financial due diligence?
As a rule of thumb, your financial diligence expense should not exceed 1% of total transaction value – for example, $50k on a $5M deal – with complex deals requiring enhanced due diligence with higher costs. On the other hand, you should be wary of anyone charging less than $10k for financial due diligence services, as it will not be thorough or high quality. A good advisory service will adjust their due diligence checklist to avoid unnecessary costs without cutting corners.
When should I start financial due diligence?
Financial due diligence begins after completing a letter of intent (LOI) with the seller. Normally the process to take 4-6 weeks to complete, but it can take longer depending on the quality of financials and support prepared by the seller.
Are you planning an acquisition or ready to hire financial professionals for diligence? Our M&A business services team will sit down to learn about your transaction and discuss the process in detail. Book your free consultation now to get started.