Financial due diligence – the key stages of an analysis during a company acquisition

Due diligence is a procedure used to identify potential risks and verify whether the information provided by the management board of the company which is being acquired is accurate. The scope due diligence is broad and we can distinguish its financial, legal and tax-related aspects.

In the rest of the article, we will focus on the financial aspect that can be divided into the following stages:

Determination of the scope of the analysis

The first step is about defining the scope and main areas of the financial analysis. The investor determines the elements of financial statements and company details that will be subjected to a detailed analysis. Most often it includes the profit and loss account, the balance sheet and the cash flow statement.

Collection and verification of financial documentation

During the next stage, the investor gains access to the detailed financial documentation of the entity subjected to due diligence. It includes, among others:

• The financial statement: reports on the last several years (usually 3-5 years), the audited financial statement, accounting documentation, such as the trial balance and entries from ledgers.
• Financial forecast: projections regarding future revenue, costs and performance of the company.
• Documents regarding debts: credit and loan agreements, terms and conditions of bond issue as well as information as to their repayment.
• Tax liabilities: tax declarations and reports from the conducted tax inspections, if there have been any.
• Source documents for the data from the financial statements: invoices, payrolls, other accounting documents.

At this stage, verification of the authenticity of documents and accuracy of the presented data are of key importance. The investor may also request additional information, if the data in the statements are not detailed enough.

Analysis of historical financial results

This stage involves an in-depth analysis of historical financial results of the company in order to understand its past performance. During the analysis, it is important to identify:

• The revenue tendencies: an analysis of changes in the company’s revenue, whether the revenue was stable, increased or decreased.
• The cost structure: a detailed analysis of operational costs, such as costs of manufacturing, remuneration, marketing costs, etc. Understanding which of those costs have the greatest impact on profitability is of key importance.
• Changes in cash flows: the assessment of the company’s ability to generate cash, especially with regard to indebtedness, investments and payments of dividends.

Analysis of the capital structure and indebtedness

This stage involves analyzing the company’s capital structure, including its debts. The key components include an inspection of the level of indebtedness, credit conditions, creditworthiness and an assessment of the capital structure. Thanks to the analysis, the investor is able to determine the extent to which the company’s financial structure is stable as well as identify the debt risk that may occur after the acquisition.

Analysis of profitability and effectiveness

The next stage involves a thorough assessment of the profitability and effectiveness of company’s operations. The key rates analyzed in this process are:

• Profit margin: gross, operating and net margin which help in assessing the company’s effectiveness to generate profit from every revenue unit.
• Inventory and receivables turnover rates: to measure how effectively operating assets, such as inventories and trade receivables, are managed.
• Debt ratios, such as net debt to EBITDA, thanks to which it is possible to determine the degree of the company’s debt encumbrance in relation to the operating income.

Assessment of financial forecasts

Financial forecasts present the future expectations as to the company’s performance. Their analysis includes assessing the realistic nature of the assumptions used in the forecasts, such as:

• Makro-economic assumptions: e.g. changes in prices of low materials, inflation, interest rates.
• Expected revenue and costs: an assessment of the possibility of the forecast increase in sales and control of costs.
• Growth rates: an assessment of the forecast increase in sales, profitability and potential capital investments.

The investor makes an assessment whether the company’s financial forecasts comply with its current performance and market conditions.

Identification of financial risks

Based on the collected data, financial experts identify the potential risk that may have a negative impact on the future operations of the company. Examples of risks:

• Excessive debts that might encumber the company after the acquisition, especially under difficult market conditions.
• Unrealistic forecasts, if the assumptions concerning the increase of revenue or reduction of costs are too optimistic, which poses a risk that the expected synergies will not be achieved.
• Pension and employee liabilities that may pose an unexpected financial burden in the future.

Preparation of the financial due diligence report

The last stage of the process is the preparation of the financial due diligence report. Its contents depend on the scope of works specified in the agreement. However, every report should include:

• The scope and basis of works
• The aim of the report
• The adopted methodology, including the risk assessment methods
• Risk identification
• The financial analysis and its conclusions
• Identification of key financial risks
• Recommendations concerning reactions to the identified risk e.g., filing accounting documents into the ledgers.

Author: Weronika Komorowska, Junior Financial Reporting Specialist at the MDDP Outsourcing office in Warsaw.

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