How to evaluate financial due diligence

348

Acquisition and expansion are essential stages in the growth of a business. With the intent of increasing the profits to multi-folds, companies venture out by either expanding into their verticals or buying other successful companies. But, how to be sure that the business is thriving and not just a projection of success? The answer is to evaluate its due diligence.

What is due diligence?

It is the process of verifying, investigating, or auditing a possible transaction or investment opportunity to validate all essential facts and financial information, as well as anything else mentioned throughout the M&A deal or investment process. Before a transaction closes, diligence is done to ensure that the buyer knows exactly what they’re buying.

Every crucial aspect of the firm or product is curbed and evaluated during the diligence assessment, such as profitability, financial concerns, legal difficulties. These fundamental values are the potential deal-breakers. Both past data and forecasts for the future are significant in assessing the organization’s or product’s profitability and risks.

Why is it important?

A transaction that has been scrutinized under diligence has a better probability of succeeding. It helps decision-makers make better judgments by improving the quality of information accessible to them. The buyer has peace of mind that their expectations for the acquisition are accurate. The assessment is valuable for the seller. Going through a thorough financial investigation may disclose that the fair market worth of the seller’s firm is higher than previously assumed. It assists investors and businesses in determining the risks involved and if the transaction is a good match for their portfolio. As a result, many sellers autonomically create their due diligence studies before possible deals.

Evaluating due diligence

The process of evaluation of diligence of a firm or product includes multiple checkpoints. Hence, a comprehensive checklist has been designed to ease out the process of assessment.

The checklist can be roughly classified into five groups.

Financial 

Key checkpoints are-

  •   Review of financial statements like balance sheets, income, and cash flow statements, and tax details.
  •   Review of sales and gross profits
  •   Assessing accounts receivables
  •   Assessing inventory of the business
  •   Evaluating real estate properties and their net value
  •   Examining previous forecasts and actual outcomes.
  •   Reading the owner’s future predictions, including quarterly and annual data
  •   Assessing current debts and their conditions

Operational

Key checkpoints are-

  •   Identifying consumer trends and purchase patterns
  •   Comparing first-time purchasers to repeat consumers
  •   Discover what the most popular products or services are
  •   Examine the company’s marketing strategy
  •   Examine marketing strategies from the past and present
  •   Examine the company’s prior sales and discounts, as well as how successful the promotions were
  •   Calculate the return on investment (ROI) through marketing spends
  •   Examine the outcomes of previous marketing campaigns
  •   Make a market assessment
  •   Investigate the surrounding area’s demographics as well as the business’s target market
  •   Examine the economic prospects for each region
  •   Identifying company’s rivals

Legal

Key checkpoints are-

  •   Examine all contract copies, including leases, purchase contracts, agreements on distribution, contracts of sale, agreements between employees and contractors
  •   Trademarks, copyrights, trade secrets, and patents
  •   Incorporation documents
  •   Documents of registering the business

Workforce capital

Key checkpoints are-

  •   Obtain a chart of the organization
  •   Listing of existing workers, including their titles, pay, abilities, and credentials
  •   Determine how employee pay compares to the income of individuals in similar jobs in the same sector and location
  •   Obtain a summary of the company’s benefit schemes
  •   Learn about the company’s vacation policy
  •   Obtain projections for the company’s future personnel requirements

Product

Key checkpoints are-

  •   List of all the available items.
  •   Find out how much each product costs to make
  •   Calculate the profitability of each product
  •   Examine historical and predicted growth rates
  •   Examine what improvements have been made to items and what improvements could be made in the future

Conclusion

Purchasing a firm without conducting the diligence assessment significantly raises the risk to the buyer in mergers and acquisitions (M&A).

The risks of losing money on the new business or product due to a poor investment are potentially high. It’s possible that the company or product has to be completely revamped. Additionally, without due diligence assessment, the buyer may end up inheriting an unpaid debt or a lawsuit. It is essentially conducting extensive research on a possible purchase and is critical to make educated investing decisions.