Financial Due Diligence for Mergers and Acquisitions

By James DeLeo, MBA, CPA/MST & Richard Frizzell, CPA, MSA
Gray, Gray & Gray, LLP

Mergers and acquisitions (M&A) come with inherent risks. To mitigate these risks, comprehensive due diligence is essential. Due diligence is the process of investigating a target company to assess its financial health, business operations, and legal compliance. Financial due diligence is a critical component of the overall due diligence process, as it evaluates key metrics which are used to value the target company and provides insights into its financial statements, and potential financial risks and opportunities.

Procedures in Financial Due Diligence

The specific procedures used in financial due diligence will vary depending on the size and complexity of the transaction, as well as the industry of the target company. However, some common procedures include:

• Calculate EBITDA: It is common for the purchase price to be based on a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). Accordingly, at their core, the procedures in financial due diligence are designed to evaluate the target company’s EBITDA. This will typically include vetting adjustments (addbacks) proposed by the target company and making diligence adjustments based on the due diligence team’s findings.
• Calculate NWC target: Transactions are often completed with an expectation that a normal level of net working capital (NWC) will be delivered at close. The due diligence team will calculate a NWC target and identify any debt-like items which should be excluded.
• Financial statement analysis: The due diligence team will review the target company’s historical financial statements and assess whether they are prepared in accordance with generally accepted accounting standards (GAAP). Typically, a revenue proof will be prepared as a means to be sure that all revenue was deposited into the bank. Reserves and accruals will be reviewed to ensure they are adequate based on current operating performance. Additionally, the diligence team will gain an understanding of trends in the target company’s historical financial statements including revenues, gross profit, and operating expenses.
• Inquiries of management: The due diligence team will interview the target company’s management team to gain a better understanding of the business and its financial reporting practices. This may include inquiries about accounting policies, estimates, and off-balance sheet liabilities.

Reporting

The findings of the financial due diligence process are typically documented in a report which in turn is supported by a data book which includes the underlying financial statements and data used within the report.

This report is provided to the management team of the acquiring company to help them make an informed decision about the cash flows of the business to assist with valuation and transaction structure. The due diligence report shows all material risks and opportunities that were identified during the due diligence process.

Challenges and Opportunities

There are challenges that can arise during the financial due diligence process. These challenges include:

• Limited access to information: The target company may not be willing or are unable to provide the due diligence team with all the information they need to complete their analysis.
• Time pressure: Due diligence often needs to be completed in a short timeframe, as it is typically the first step in the diligence process and many other procedures cannot take place until financial diligence has been completed which can make it difficult to fully assess all the risks and opportunities.

Despite these challenges, there are also opportunities associated with financial due diligence. These opportunities include:

• The due diligence process can help to identify weaknesses in the target company’s financial reporting practices. This can provide the acquiring company with an opportunity to improve the target company’s financial reporting after the transaction closes.

Financial due diligence is a critical component on both the buy and sell-side of the M&A process. On the buy-side it can help to identify potential risks and opportunities, and it can provide valuable insights into the target company’s financial health. On the sell-side it can help facilitate buy-side diligence to allow for a faster time to close. By conducting due diligence that is thorough and comprehensive, companies can increase their chances of closing successful M&A transactions.