In any M&A deal, it's necessary to carry out a preliminary review in order to analyze the overall situation of the company being acquired.
This preliminary review and investigation is known as due diligence, and it involves reviewing and examining all of the company's information and documentation in full detail to determine whether it complies with all rules and regulations and whether there are any risks to take into account. In short, the goal is for the potential buyer to know and understand in detail what they're going to buy.
There are several types of due diligence (financial, legal, tax, commercial, and environmental, among others), but in this post we'll focus on financial due diligence.
Financial due diligence (FDD)
Financial due diligence is the study of the financial situation of the company being acquired through a review of its annual accounts, audit reports, management reports, and capital structure, among other things. The goal is to determine whether there are any contingencies related to the company's financial data.
This due diligence analysis needs to go hand in hand with other reviews, such as tax, commercial, and legal, since it's the combination of all of them that provides a 360º view of the company.
What is financial due diligence and what is it for?
Financial due diligence allows us to identify the opportunities and risks related to the future performance of the business and the key factors to take into account.
The financial analysis is usually carried out by an external advisor independent of both parties who is completely impartial, and, as a general rule, it takes place once the LOI (letter of intent) has been signed.
Well-executed financial due diligence can significantly increase the deal's chances of success. It also allows all parties involved in the deal to understand the company's real condition and be aware of any risks that may come with acquiring the company.
The objectives of financial due diligence are to:
- Understand precisely the company's condition and its financial performance up to the present date.
- Ensure that the figures presented in the financial statements reflect reality.
- Determine whether there are any risks related to the deal.
- Help investors arrive at a better valuation of the company.
How is financial due diligence carried out?
Financial due diligence, like any other type of due diligence, is divided into different phases that can vary depending on the complexity of the deal. Generally, these are the phases of the financial due diligence process:
1. Planning the process
In this first phase, the client and the external advisor define the scope of the financial due diligence. Once the scope is defined, the work to be carried out is scheduled.
2. Execution
In the execution phase, all the information is gathered and then analyzed. To do this in a structured way, a standard outline is usually followed, which is common to this type of due diligence:
- Business analysis: This first stage aims to understand how the business works in order to analyze its key metrics and see how they've evolved.
- Analysis of results and historical data: This phase analyzes the evolution of the company's sales and expenses, as well as the evolution of its EBITDA, to determine whether the company is profitable.
- Analysis of assets and liabilities: this analysis checks that there are no undervalued or overvalued assets and establishes the company's level of debt.
- Cash flow statement analysis: this phase is very important within the overall analysis process, since it examines the company's ability to generate cash and its level of liquidity. It then determines how much financing the company needs to keep the business running.
- Financial projections: this final stage is carried out to determine whether, once all the documents have been analyzed, the companies' future projections hold up, and to identify the synergies and added value arising from the transaction.
To make the analysis and execution phase more effective, the seller and the target company should set up an online data room (data room), an electronic repository where all the important documents under review should be uploaded.
This tool allows the selling company to provide valuable information in a controlled way while preserving confidentiality. It helps speed up the M&A process by avoiding the need to have the buyer's advisors on site day after day, which would further disrupt the target company's business.
3. Report and closing
The financial due diligence process ends with a comprehensive report setting out the conclusions and risks identified in the analysis. Every due diligence report normally begins with an introduction detailing its purpose. This is followed by an executive summary containing the most relevant facts and potential risks, and it ends with a more detailed, structured analysis along with appendices.
In short, financial due diligence is the analysis carried out at the financial level to ensure there are no contingencies that could derail the deal. Thanks to this type of report, the buyer can understand the company's profitability and its real financial situation, which allows them to make an accurate estimate of the price at which the purchase or investment will be made.
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