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April 21, 2023 5 minute read

How To Go Beyond High-Level Benchmarks in Financial Due Diligence

When conducting financial due diligence in M&A deals, many professionals tend to focus on high-level benchmarks such as revenue growth and profit margins. However, these metrics only scratch the surface of a company’s financial health.

To get a better insight into the potential risks and opportunities of an M&A transaction, you should dig deeper and go beyond the standard benchmarks. True financial due diligence requires a deeper dive into the numbers, careful consideration of industry trends and market shifts, and a willingness to ask tough questions.

How can you achieve this level of depth and insight? Below, you will obtain tips about what financial due diligence entails and learn ways to ensure your financial due diligence process is comprehensive.

What Is Financial Due Diligence?

Financial due diligence involves analysis of the financial health and performance of the company you are targeting during an M&A. The obvious focus is on the target’s financial health and future prospects.

You will need to consider, as a start, the company’s income statement, balance sheet, and cash flow statement. More thorough due diligence can also help you uncover issues that the financial statements may not reveal, such as contingent liabilities.

From a buy-side perspective, financial due diligence helps you ensure that the M&A target is financially healthy enough to meet your expectations. You will get a better view of the target’s market value and growth prospects. 

From a seller’s perspective, the target can use financial due diligence to identify potential issues that could cause delays or problems during the sale process. The due diligence will be like an internal audit to help the target prepare to answer potential questions or objections from buyers ahead of time.

Checklist for Financial Due Diligence

You should have a financial due diligence checklist detailing everything you need to review during an M&A deal. Here are some of the items you should include in your checklist:

Income statements for the past five years

An income statement will help you identify trends in revenue and expenses. Focus on the following when analyzing the income statement:

  • Earning volatility across different periods
  • Expenses (identify cases where they are irregularly high)
  • Earnings quality
  • One-off items that impact the operating income

Cash flow statements for the past five years

The cash flow statement will give you an understanding of where a company is getting its resources and how it is spending them. Look at the following when reviewing the cash flow statement:

  • The total cash generated every year after accounting for expenses
  • The cash flow quality to understand the main source of positive cash flows
  • Operating activities, such as sales and investments
  • Financing activities, such as debt obligations and dividend payments

 Balance sheet items

The balance sheet summarizes the target’s assets and liabilities. Be sure to check the following when reviewing the balance sheet:

  • Working capital, which is the difference between current assets and liabilities
  • The financial leverage ratio, which tells you how much debt the company has
  • Fixed assets that may have been overvalued
  • Long-term liabilities such as loans and other debts
  • Contingent liabilities, such as outstanding lawsuits or tax disputes
  • The value of marketable assets

Other financial information

There are several other things that you should also include in your financial due diligence checklist. Be sure to check:

  • Accounts payable and receivable to identify any payment delinquencies
  • Detailed analysis of customer concentration
  • Assessment of credit risk exposure
  • Financial ratios such as profitability ratios, liquidity ratios, and leverage ratios
  • Capital expenditure history and future plans
  • Tax returns for the past five years
  • The results of all tax audits in the past five years
  • Summary of deferred tax assets 
  • Financial projections to understand the company’s growth potential
  • Operating trends
  • Financial risk identification and mitigation plans
  • Forensic accounting (if applicable)

The list is extensive, but these are the major items that should be on your financial due diligence checklist.

Tips to Ensure You Go Beyond High-Level Benchmarks in Financial Due Diligence

If you want a successful M&A, do not limit your financial due diligence to just the checklist. Instead, go the extra mile to unravel the underlying drivers behind the financials. Here are some tips to ensure you do a comprehensive job:

Understand the company’s industry and market trends

Assess the competitors and the target’s position in its respective industry. You should ask questions to understand the relative attractiveness of the industry and any upcoming market trends.

Analyze these market trends to identify any potential tailwinds or headwinds that may impact the target company’s future performance. For instance, if the company operates in a rapidly changing industry, consider any potential risk of technological disruption or new competition.

Evaluate the company’s management team and their track record

Look into the management team’s track record, including prior successes and failures. Consider the key decisions made in recent years and how they impacted the company’s performance. This helps you determine whether the management team can take the business forward.

You should also consider the incentives of the management team. Do they have skin in the game? Are their interests aligned with yours? These questions will help you determine whether the management team is a long-term partner or just looking for short-term gain.

Conduct a thorough analysis of the company’s financial statements

Take the time to understand each line item and develop a keen understanding of how these financials impact the overall target’s performance. It’s best to compare the financial statements of different periods to see how your target company has been performing over time. The comparison will help you identify potential earnings manipulation or other signs of financial distress.

Examine the company’s historical financial performance

Pay attention to the company’s financial statements over a period of time, typically several years. The goal is to identify patterns, trends, and areas of concern. Analyzing the company’s historical financial performance can reveal its ability to generate revenue and profit, its cash flow situation, and its financial stability.

Review the company’s projections and assumptions

Projections and assumptions reveal the company’s perception of the future. Reviewing them will help you understand how they arrived at their financial forecast and whether those projections are realistic. You should also consider any variances between actual performance and projected results.

Assess the company’s risks and potential liabilities

Legal, cyber, and operational risks could impact the target’s financials in the future. You should take the time to understand these risks and assess their potential impact on the company’s financials. Examine whether the target has internal processes and controls that will allow you to mitigate these risks.

Additionally, look for any potential liabilities for which the company may be responsible. These include tax liabilities, environmental liabilities, and debts owed to creditors.

Consider external factors that may impact the company’s future performance

No company operates in a vacuum, so external factors will most likely impact your target company’s operations. These could include regulatory changes, economic conditions like a recession, political risks, technological disruptions, or new entrants in the industry. Evaluate these factors to determine which ones will have the biggest impact and how they could affect your target company’s financial performance.

Perform Financial Due Diligence Efficiently With Devensoft

Effective financial due diligence during M&A transactions should go beyond the obvious metrics. While performing comprehensive due diligence may sound daunting, leveraging a tool designed to streamline all M&A processes can make the process much easier.

Devensoft is one such tool that can streamline workflows and collaborations with the target during the due diligence process. The software comes with built-in request items that you can use during the due diligence stage, but it also allows you to customize the list. After submitting the requests to the target, you will get real-time responses and updates to streamline the process.

Schedule a free demo today to see how Devensoft will make your due diligence more efficient.

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