Businesses undertake due diligence for a number of reasons. Primarily these are to assess risks, verify financial health, and ensure regulatory compliance before making critical decisions such as mergers, acquisitions or investments.
Here we’ll answer some common questions that will help guide you through the due diligence process.
What is financial due diligence?
Financial due diligence (FDD) provides insights into a target company’s operations, assets and liabilities, helping to ensure accurate valuation and smooth integration.
Ultimately, due diligence protects a business from costly mistakes and enhances negotiation leverage, ensuring informed, strategic decisions.
Why is financial due diligence important in the small and medium-sized enterprise market?
Financial reporting is less rigorous for businesses in the small and medium-sized enterprise (SME) sector than larger companies. Their accounting practices may differ from Australian Accounting Standards (AASB) which may lead to differences in how revenues, expenses, assets and liabilities are reported.
While discrepancies aren’t necessarily a sign of poor management, as a buyer, it’s essential to verify and validate the seller’s financial information.
Undertaking FDD, you can minimise the chances of encountering unpleasant surprises or hidden risks post-transaction.
When should I conduct financial due diligence?
Financial due diligence can be done at various stages of a business transaction, (depending on the specific circumstances), however it is most often done after signing a Letter of Intent or a term sheet with the vendor, during a period of exclusivity.
This timing ensures that both parties are aligned on key terms, allowing the buyer to review and assess the quality of the company’s financial before the deal is completed.
What does financial due diligence involve?
Step 1: Information request
The initial step is to determine a transaction schedule and request the financial and operational information from the seller, these typically include:
- Historical financial statements – e.g., balance sheets, income statements
- Monthly management accounts – for seasonality and trend analysis
- Any forecasting – to assess future performance
- Aged debtors, inventory and creditors listings – to assess working capital requirements
- Annual leave and long service leave schedules – to identify any unrecognised liabilities
- Asset listings – to identify whether additional capital expenditures are required.
Step 2: Investigate and analyse
A more in-depth examination of the financial and operational information will likely be necessary This assists buyers to pinpoint any potential risks and uncover opportunities within the target company.
Key areas of focus can include:
- Reconciliation of management accounts: Compare the monthly management accounts to the statutory financial statements. Discrepancies may arise due to timing, accounting practices, or other factors. These should be thoroughly investigated to assess the quality and reliability of the company’s financial reporting.
- Key drivers: Examine how revenue translates into gross margin, operating margin, and net profit. This analysis will help you identify the primary factors influencing profitability, synergies between the two companies, and areas where operational efficiency can be improved after the acquisition.
- Abnormal movements: Look for unusual fluctuations in the financials. Identifying whether these are one-off or recurring issues will help you gauge the sustainability of the business’s financial performance.
Note – Additional analysis may be needed depending on the business’s specific situation.
Step 3: Summarise
This financial analysis report should highlight:
- Any areas of concern or things that may lead to a decline in the business performance.
- Opportunities or synergies between the two businesses.
- Strategies to address risks.
- Any suggested adjustments to the purchase price (if necessary).
It’s important to discuss any concerns with the seller before closing the deal and ensure that any material risks are clearly outlined and addressed in the final purchase agreement.
Should I use an external adviser?
If your business has an experienced mergers and acquisitions team, you may be able to conduct financial due diligence in-house, at least in the early stages.
However, if your team lacks the expertise or you prefer to focus attention on your core operations during the acquisition process, engaging an external adviser can provide significant benefits.
An independent adviser provides an objective perspective, using their experience and industry knowledge.
This helps to guarantee that no details are overlooked during the process, ensuring a comprehensive and thorough evaluation.
When should I engage an external adviser?
It’s best to engage external advisers as early as possible—ideally before entering into an Letter of Intent, or at the very least, before signing a binding offer.
This provides enough time for the adviser time to conduct a thorough due diligence review, and ultimately to prevent costly mistakes down the line.
How HLB can help
We’ve conducted many due diligence reviews and have the skills and expertise to identify potential risks and opportunities, helping you make informed decisions.
By working with us, we can help answer critical questions that are essential for making well-informed decisions, such as:
- Is the financial information provided by the seller true and fair?
- Is the company’s past performance likely to continue in the future?
- Where can I improve profit margins in the target business?
- What synergies I could unlock post-acquisition?
- What risk mitigation strategies should I implement post-acquisition?
- Is the purchase price reasonable?
- Does the transaction structure maximise my desired outcomes?
Our expertise ensures you enter the transaction with clarity, confidence, and a well-rounded understanding of the financial performance and position of your target company.
If you want to learn more about financial due diligence, please check out our podcast series ‘Talking Advisory & Client Solutions’ Episode 4 – Buying – Due Diligence here.