Financial Crime World

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Financial Due Diligence: A Crucial Step in Mergers and Acquisitions

As hundreds of investment bankers, law firms, and M&A brokers can attest, financial due diligence is a critical component of any merger or acquisition (M&A) transaction. In fact, it’s often the area that requires the most attention from both buy-side and sell-side practitioners.

The Importance of Financial Due Diligence

Financial due diligence should be at the core of any M&A transaction because every other element of the business affects financial due diligence in some way. Operational, legal, and human resources due diligence all have a direct impact on the target company’s financial situation. Therefore, it’s essential to consider costs, revenue growth, and potential risks when evaluating a potential acquisition.

Conducting Financial Due Diligence: A Checklist

When conducting financial due diligence, it’s essential to take on the role of an audit committee and analyze 5 years of financial statements (in the US, this means 10-K filings, 10-Q filings, and proxy filings). The following checklist should be considered:

Income Statement (past five years)

  • Operating margin
  • Gross margin
  • Interest coverage
  • Profit margin
  • Current ratio
  • Debt ratio
  • Debt to equity ratio
  • Asset turnover
  • Return on assets
  • Return on equity

Use of Financial Statements to Check Financial Ratios

  • Sensitivity analysis with cash flows
  • Check the quality of cash flows
  • Understand the reason behind positive or negative cash flow

Management Discussion and Analysis (MD&A)

  • Quality of financial statements
  • Potential risks and challenges faced by the target company

Tax Due Diligence

  • Review of tax liabilities and potential tax savings

Forensic Detail

  • Asset misappropriation, financial statement fraud, and corruption red flags

Interviews with Target Company Management

  • Nature of business arrangements
  • End-of-quarter transactions
  • Changes in auditors
  • Significant growth in a short period of time and what drove it
  • Non-intuitive changes such as receivables growing faster than revenue
  • Changes in accounting practices
  • Insider sales of stock

Conducting Financial Due Diligence with DealRoom

DealRoom has been the virtual data room of choice in hundreds of M&A transactions, providing a template for financial due diligence that addresses everything required on both the buy-side and sell-side. Users can avail of DealRoom’s unique requests feature, allowing people to request and fulfill tasks and provide relevant documents in a structured and orderly fashion.

Conclusion

Financial due diligence is a critical component of any M&A transaction, providing valuable insights into the target company’s financial situation and potential for growth. Conducted properly, it may tell the buyer as much about the target company as all the other sections of due diligence combined. By following this checklist and being thorough in their analysis, buyers can make informed decisions that will ultimately drive success in their M&A transactions.