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The Ultimate Guide to Financial Due Diligence

Financial due diligence is defined as the detailed analysis of a business carried out from a potential buyer’s end before the formal transaction of the business takes place. It is a crucial step for buyers and allows them to learn about the operations and financial proceedings of their future company as much as possible.

In this process, a buyer can find answers to critical business questions and everything associated with it. Therefore, it’s strongly recommended to seek consultancy from financial advisors to ensure that you are not overlooking any peculiar details that can cost you in the long run.

Due diligence can be termed as the process of discernment, and it can involve the following:

  • Verification of information, including financial and operational, provided by the seller.
  • Finding out any other details that weren’t provided by the seller upfront.
  • Analysing the financial track-record and history of the business.

How to begin the process of financial due diligence?

When running financial due diligence for a business, you will have to get the assistance of a specialized team to assess and investigate the following documents:

  • Balance sheets
  • Income statements
  • Annual reports
  • Partnership agreements
  • Tax filings
  • Profit and loss records
  • Operational facilities, practices and policies
  • Existing contracts

How to carry out the due diligence process

Due diligence in mergers and acquisitions can be a long and daunting process. The process involves working with multiple parties through various stages.

The typical steps involved in the due diligence process are discussed as follows:

  • Assess your goals for the project: Just like any other project, your first step should be laying out your corporate goals. It will help you evaluate your resources, understand what’s needed, and help you align your goals to a concrete strategy. This would also involve gaining clarity on what you want to achieve from the investigation.
  • Analysing the financial position of the business: This step is one of the most crucial steps of the whole due diligence process. It would involve running an extensive audit of the financial records of the company. It confirms the credibility of the documents shown in the Confidentiality Information Memorandum (CIM). Moreover, it would also involve the evaluation of the company’s assets, financial stability, performance, and any issues that may have been overlooked.

The documents for inspection in this stage would include:

  • Profit and Loss statement
  • Income statements
  • Revenue reports and forecasts
  • Balance sheets
  • Inventory sheets
  • Tax documents and related banking and accounting information
  • Ratio analysis reports (e.g.- debt equity, interest coverage, stock inventory, accounts receivable)
  • Extensive documents and data inspection: This is also a very important step of the due diligence process, and it initiates a dialogue between the buyer and the seller. The buyer inquires about documents for auditing purposes, conducts interviews of the seller, runs surveys, visits the on-site operations, etc. The expediting of this step mainly relies on the seller’s willingness to assist the buyer. Otherwise, it can become an over-stretched step.

After receiving all the required information, the buyer then evaluates all the data and documents. Business practices and legal peculiarities are thoroughly assessed. It is one of the most critical steps of due diligence because it gives the buyer an overall idea of the business, its functions, and its prospective value.

  • Analysis of business model and plans: In this step, the buyer goes through the company’s model and plan of growth. It gives the buyer a good idea of whether the company’s model aligns with their goals and if it would integrate well with the buyer’s firm.
  • Risk evaluation: In this step, the company is evaluated holistically, and the risk factors associated with the transaction are identified. Tax risks for example are an important factor that should be considered.
  • Calculating the final offer: In this step, the due diligence team shares all their evaluations, findings, documents, and information with each other and combine them. The collected information is then analyzed, and various metrics and evaluation techniques are performed. This helps the buyer calculate how much they are willing to pay as the final offer for the business during negotiations with the seller.

How long does the due diligence process take place?

When you are planning due diligence, the due diligence strategy or approach should be clear, otherwise it might be very difficult to predict how long it will take. This is mainly because the process not only requires prompt action from the buyer, but it also depends on the willingness of the seller to provide information and documentation in time.

However, no matter how arduous, it should not take you longer than 30 to 60 days to finish the due diligence process. With clear aims and plans to identify the value created by the transaction, a team with highly skilled members can work together to perform the various business and evaluation tasks efficiently. Your ultimate goal should be to gain a complete understanding, get cooperation that is productive and ensure the investigative deliverables meet expectations.

You need not overemphasize on uncovering every single detail, as it is just not realistic to perform all sorts of evaluations in a limited time window. Thus, some smaller issues may arise post transaction.

How is due diligence different for private companies?

Due diligence for private companies is different from public companies because private companies are  not traded on the stock market. Additionally, public companies are held to higher standards and stricter accounting practices.

Following are the things to consider while doing due diligence on private companies:

  • Assessing your own financial resources
  • Accounting and financial procedures followed by the company
  • Size of the company
  • Human resources practices implemented by the company
  • Assessing the legality and related issues
  • Valuation of the company
  • The current leadership and management practices of the company
  • The overall business prospects of the company

If you want to perform due diligence on an energy-related business or project that you are considering a transaction or investment for, contact Pangea Strategic Intelligence, the on-demand consulting firm specialising in Energy, Natural Resources and Infrastructure (“ENRI”).

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