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Decoding financial due diligence

9th March 2020, 6:00 pm

Due diligence is a complex and critical component of every investment transaction, whether your company is seeking a new round of venture capital, a private equity cash infusion, or positioning itself for an acquisition. The due diligence process is important to investors, because it equips them with the information necessary to determine a realistic valuation for their business, and potentially avoid leaving money on the table. It’s an extensive process and in order to achieve the most favourable results, you need to be prepared.

The due diligence process can be viewed as an investigation into a Target prior to acquisition, investment, refinancing, restructuring, public listing (IPO) or a similar transaction.

Due diligence helps to understand how the business of the Target is conducted and how

it may be able to be integrated into an existing group of companies. A tailored piece of due diligence may also provide assurance on the investor’s existing understanding of the opportunity and challenge the commercial or financial assumptions.

It generally forms part of the investor’s overall commercial, legal and financial DD.

Financial due diligence (FDD) is the most common due diligence a buyer or funder may undertake. The tips below will help any business prepare for such an undertaking and make the process as efficient and effective as possible:

Understanding of the business

A FDD will generally involve obtaining an overview of the business operations including but not limited to:

  • Establishing how the company has grown and evolved;
  • How management manage and monitor their time
  • Understanding the strategies and objective of the business;
  • Profiling the key members of management;
  • Gathering insights into the customer base including customer contracts, terms of trade, customer attrition and concentration;
  • Routes to market and types of agreement;
  • Understanding any fluctuations in revenue and a company’s revenue recognition policies;
  • Pricing strategies;
  • Cost profiles;
  • Staff costs and organisation structure;
  • Inventory management; and
  • Accounting methods.

Targets should be prepared to answer questions and evidence this information by way of walkthroughs and supporting documents. This responsiveness will allow the target to gain credibility and provide the investor with additional comfort regarding the quality of the business they are investing in.

Essential to understand how quickly profit turns to cash and the key components of cash generation. Cash is the lifeblood of a business.

Audited financial statements

Many small businesses carry out financial reporting solely for the purpose of filing the annual accounts and tax returns. While a financial audit may seem like a disproportionate and cumbersome exercise, it can raise the standard of the financial information and raise the investor’s confidence.

Cash versus accrual basis

Some businesses, especially some early stage fast growing technology businesses may use a cash basis of accounting, whereby revenue is recognised when payments are received and expenses are recorded when paid. Investors, however, want financial statements where revenue is recognised when earned and expenses accrued when obligations are incurred. The accruals basis of accounting gives the buyer a clearer picture of the earnings of the business. A good accountant will ensure that company’s financial reports present potential investors with a clear story.

Get organised

Information request lists for FDD processes can be comprehensive and thorough. Advisers performing due diligence will generally request three to four years of information organised on a monthly basis. Reports typically requested include:

  • Statutory and monthly management accounts
  • Integrated forecast models
  • Customer sales data
  • Aged debtor and creditor lists
  • Inventory records
  • Payroll records

Being prepared and responsive will help the target provide third parties with the information necessary to complete due diligence in a timely fashion and provides comfort for an investor. It will thus help a company position itself for higher valuations, stronger negotiations, and better outcomes.

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