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Why Is It Important To Conduct Financial Due Diligence?

Last updated: 18 Jul, 2023 By | 6 Minutes Read

Any merger and acquisition are conducted after a lot of thought and planning, especially with regards to the health of the company being acquired. The study is based on a large number of parameters. These include financial, human resources, tax, legal and other regulatory and statutory compliances.

Detailed investigation or “due diligence” is made on the historical and forecasted operations and results of the company. However, the focus is generally on financial due diligence and that will be the primary focus of this piece.

Concept specifications

There is a general misconception that since there is an in-depth investigation into the finances of the company being taken over, due diligence is a form of an audit. This is not correct. An audit is basically a certification that the financial statements prepared by the company reflect the true position of the financial health of the company.

However, this activity goes a step beyond the stand of an audit. It seeks to assess reasons of the historical trends and based on it what forecasts can be made of the future performance of the company.

There are no fixed standards of due diligence methodologies which vary between businesses and depend on the scale of the company being purchased. Typically, the emphasis is given on the historical quality of earnings as reflected in past earnings before interest, amortization taxes and depreciation, the worth and value of net assets, debt and liabilities, capital expenditure requirements, working capital requirements and most vitally projected financial results.

After assessing all these variables, a potential purchaser of a company should be able to evaluate and know about any factors that might act as deal breakers or whether the price of the acquired company is appropriate and show the true worth of the company.

The time for financial due diligence

This analysis of the financial position of the company should be taken up whenever a possible buyer is considering an acquisition of a business. Typically, the process should begin as soon as an expression of interest has been placed before the seller or a letter of intent detailing out the terms of the transaction has been agreed upon by both the purchaser and the seller. The process should go on simultaneously along with the negotiations.

Generally, the whole procedure should take between two to four weeks but that depends on the size of the company being acquired and the nature of work that has to be completed.

Who can conduct this activity?

There are a number of options here. The investigations into the financial health may be entrusted to the acquirer’s own team of audit and accounting experts or can be outsourced to an external team of professionals who have a high degree of expertise in this field. Most purchasers opt for external agencies because of some inherent benefits. These include –

  • Getting an independent and unbiased opinion from those who have no stake in the transaction
  • Done by experts who fully understand the intricacies and dynamics of M&A environment
  • Internal resources can be better utilized for the planning of necessary transactions after the deal has gone through.

Information required for evaluation

Here too the reports and documents required for carrying out financial evaluation is not standardized. It is dependent on the abilities of the company being acquired to generate reports accurately.

However, the mandatory reports that form part of the procedure include business plans and budgets, current financial statements, trial balances, general ledger, comprehensive management reports and state of the accounts, latest operating results and projected financial analysis of accounts.

Answers provided by financial due diligence  

The reason for carrying out this process is to get answers to a lot of questions about the financial health of the target company. These include –

  • Checking whether all the records provided by the seller is accurate in all respects
  • Whether the historical revenue and earnings will be sustainable in the future too
  • Whether the company has invested to the maximum extent possible in capital expenditure
  • Checking for any liabilities that should be taken into account but not reported.
  • The potential future earnings of the company warranty
  • The quantum of working capital requirements at transaction closing
  • Whether the company has future commitments and contingencies

All these will enable the purchaser to know whether a fair price is being paid that reflects the true state of the financials of the company. It also helps to determine if the necessary guarantees have been made a part of the final agreement and whether all issues have been addressed and included therein.

Further, in the present business environment of uncertainties that prevails the world over, it is necessary to carry out a detailed analysis before investing in the purchase of a company. The amount invested for financial due diligence far exceeds the ultimate loss that might have to be incurred for a bad acquisition.

Taking help of professional agencies

It is very clear now that financial due diligence plays a very important part in any M&A process and that it should be outsourced to expert and professional services with long years of experience in this field. Only they will be able to carry out a detailed evaluation of the financials of the company, a crucial prerequisite for understanding the state of the finances of the targeted venture.

A leading company in the field of financial due diligence accounting services is Cogneesol. We have been offering top-level accounting services to our clients all over the world and hence our accountants are well conversant with this process. All reports typically required for due diligence are routinely prepared by us on behalf of our clients, most of whom fall in the Fortune 500 category.

Hence we are eminently qualified to offer financial due diligence and accounting services and have done so for many of our valued clients.

To know more about our due diligence accounting services, write to us at [email protected] or call +1-646-688-2821. You will be more than happy with our services.