Buying a business is a big decision – in this article, we’ll walk through a financial due diligence checklist to help ensure you don’t miss any key items to review.
It’s important to do your due diligence to protect yourself, make sure that the business is a good fit for you and that you’re getting a fair price.
By ensuring that you’ve covered all 17 points on this checklist, you can be confident that you’re making an informed decision when purchasing a business.
As always, rely on your M&A advisors for guidance as you get started with any M&A diligence process.
Financial Due Diligence: Why Does it Matter?
Financial due diligence is the process of gathering and verifying financial information about a target company. It provides an assessment of the financial health of a business and helps uncover any potential risks before you commit to the purchase.
It gives you an in-depth understanding of the company’s finances, helping you to assess whether it’s a good fit for your business goals and whether the price you’re paying is reasonable.
Financial due diligence allows buyers to understand the financial position of the business and assess its potential risks, rewards, and opportunities. By performing rigorous financial analysis, buyers can uncover hidden issues that may not be apparent from an initial cursory review.
Is financial due diligence worth it?
Yes, financial due diligence is absolutely worth it. It can be the difference between a successful acquisition and a complete disaster that could have been avoided. With $2.9 trillion in M&A transactions in 2021, being patient and going through comprehensive due diligence is more important than ever.
With the right information, buyers can make better decisions about whether or not to proceed with the transaction. It also provides you with a greater understanding of the company’s assets and liabilities, enabling you to negotiate from a position of strength.
What is financial due diligence vs. audit?
Financial due diligence and an audit are two very different processes.
An audit entails a deep dive into historical financial statements only, while financial due diligence is a more comprehensive look at the company’s overall financial health.
Financial due diligence goes beyond an audit by taking into account recent events or actions that may have an impact on future performance. It also looks at potential opportunities and risks associated with the acquisition, rather than just assessing past performance.
The scope of each financial due diligence will be unique to the company being acquired and will depend on which areas of the business are most important to you. As you move into the process, think about which risks you’d like to mitigate, what data you’d need in order to make an informed decision and which areas of the business you’d like to better understand.
How Do You Conduct Financial Due Diligence?
Financial due diligence should involve a review of the company’s financial reports and records, as well as interviews with key personnel responsible for managing finances. It’s important to look at the company’s financial statements over a period of time, and consider factors such as revenue trends, profit margins, cash flow, debt levels and liquidity.
Depending on your scope, a financial due diligence should provide answers to the following questions:
- Is the company generating sufficient cash flow?
- What is the company’s current financial position?
- Is the information provided reliable and accurate?
- Are the prior year earnings of the company sustainable?
- Are there any potential liabilities that could impair future performance or increase acquisition costs?
- How well are the current accounting systems and processes performing?
- Are there any unexpected tax implications of the proposed transaction?
- What are the potential synergies within with the proposed acquisition?
- What seasonality in revenue and working capital requirements does the business experience?
- Does the business have adequate working capital to support its operations?
- Do the financial statements accurately reflect the company’s performance?
At the end of the review, you’ll want to get a sense if the purchase price is fair based on the results and get clear on any potential deal breakers.
Financial Due Diligence Checklist
1. Review the last 3+ years of financial statements.
One of the first things you should do when conducting financial due diligence is to review the historical financial statements of the business. Ideally, these statements are audited, meaning they are verified by a qualified accountant.
This will give you a sense for the financial health of the business, profitability by profit line, trends over prior years, and help you identify any red flags.
Make sure you look at at least 3 years of financial statements, and if available, look at the last 5 years. Documents you review should include:
- Income statement
- Balance sheet
- Statement of changes
2. Statement of Cash Flows
Reviewing cash flow will help you understand the company’s ability to sustain its operations and meet its obligations. It’s important to look at cash flows in addition to profitability metrics, as a company may be profitable yet unable to continue operations due to cash flow issues.
A few things to be aware of:
- Make sure you understand if the company is generating enough cash flow to pay for its operational costs and debt obligations.
- Cross-compare cash flow against the income statement to ensure the two align and that there are no discrepancies.
- Assess current liquidity, cash flow projections and solvency ratios over the next 12 months. Look out for any potential working capital issues or debt repayment issues that could cause problems down the road.
It’s also important to ensure there are no potential risk areas that could affect the business’s ability to generate sufficient cash flow.
Get clear on any restrictions on cash flow, such as debt repayment requirements or any other contractual obligations (i.e. restrictive covenants with banks could require certain debt levels).
3. Adjustments
Review any adjustments made to the company’s financial statements.
Keep an eye out for:
- Any one-off or non-recurring expenses that will not likely be repeated in future periods (restructuring costs, one-time sales to large customers, legal fees etc.)
- Inappropriate shifts from operational to non-operational expenses
- Analyzing capital expenditures to operating expenditures
Adjustments can have an impact on a company’s overall financial performance and are important to consider when evaluating a business’s financial health.
4. Recurring Revenue: MRR and ARR
Get clarity on the company’s recurring revenue streams: recurring revenues provide a more sustainable business model and help to reduce the risks associated with seasonality.
Be sure to understand the total amount of Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR). Also review any customer trends over the past 3 years and get a better understanding of customer churn or attrition.
5. Accounts Receivable
Review the Accounts Receivable (AR) to see if there are any irregularities or patterns that may be a red flag. This includes looking at the age of receivables, credit terms, and collection rate.
6. Accounts Payable
Similarly, review Accounts Payable (AP) to get a sense for any unusual activity that may be a red flag. This includes looking at the age of payables, payment terms, and payment rate.
7. Understand the Customer Mix
Who are the biggest customers and what is the expected lifetime value of a customer?
What is the purchase history and trend of major customers? Are there any customer concentration risks?
Understanding the customer mix will help you get a better understanding of the company’s revenues, sales cycles, and any potential risks.
8. Review Key Contracts
Another key area to focus on during financial due diligence is reviewing any key contracts that the business has in place.
This includes contracts with suppliers, customers, landlords, etc. It is important to understand the terms of these contracts and to assess whether or not they are favorable for the business.
For example, are there any early termination clauses that could be detrimental to the business?
9. Insurance Coverage
Ask for copies of all insurance policies, including property, liability, and workers’ compensation insurance. Make sure coverage is adequate and that there are no lapses in coverage.
10. Review Tax Returns
Reviewing tax returns will give you a good understanding of how the company has been operating in recent years, including its income and expenses. It’s also important to look out for possible red flags such as inconsistencies between reported income and expenses on tax returns compared to audited financial statements.
Have there been any significant changes to taxes or deductions in recent years? If so, what were the reasons for those changes?
Finally, it is important to have a clear understanding of the tax obligations of the business. This includes both federal and state taxes. Speak with an accountant to get a clear picture of what tax liabilities you would be taking on if you were to purchase the business.
11. Review all employee contracts and benefits packages
Review all employee contracts and benefits packages to help you understand what you’re potentially inheriting in terms of costs associated with employees.
Ensure they are up to date, compliant, and get clarity what kind of liabilities might exist if an employee were to leave or be terminated.
12. 3rd Party and Internal References
If possible, you’ll want to review third-party references such as banks, suppliers and customers.
Previous management letters and accountant opinions can also provide valuable insight into the financial health of the business. Additionally, you should speak with current and former employees of the business to get an understanding of the financial processes in place, as well as any potential risks or deal breakers that could impact the future performance.
13. Pricing Models
Analyze the company’s pricing models to understand how it sets prices and determines revenue.
Have they made any changes to prices historically?
It is important to understand any potential pricing pressures or opportunities, as well as any customer segmentation strategies that can help optimize revenue.
Are there opportunities to increase prices or adjust the product offering to maximize profits?
14. Review Inventory Reporting
Make sure you understand what inventory levels are needed to run the business and that there is not too much tied up in inventory that could become obsolete.
This will help you get a better understanding of the company’s cost structure and any potential risks when it comes to excess inventory.
It’s also important to review reports that track inventory turnover and levels, as this will provide insight into the efficacy of the company’s supply chain.
15. Expense Trends and Cost Structure
Understand the cost structure of the company and analyze any expense trends or risks. Look at how the company is funded, what kind of debt is in place and if it affects the current or potential profitability.
The analysis should also identify any unexpected or unusual items that could be impacting profits in a negative way.
- Are expenses increasing faster than revenue?
- How do expenses compare to industry benchmarks?
- Hany any owner personal expenses or loans been restated as expenses?
- Are there any areas that could be optimized?
- Are there any unrecorded liabilities in the business?
- Ensure you review any guarantees that have been given to creditors and assess whether they will affect your proposed transaction.
16. Review of Fixed Assets
Understand the company’s fixed assets, including plant and equipment, land and buildings.
- How does book value compare to fair market value?
- Are there any assets that are not being used efficiently or could be sold?
- What is the maintenance schedule of the machinery or equipment?
- How old are the machines and inventory involved in the business (have they become obsolete?)
It is important to understand the depreciation schedule for any fixed assets as well as the estimated useful life of each asset. This will help you assess the true value of the business.
17. Assess Additional Growth Opportunities
Are there any untapped markets that could be leveraged or new products/services that could be offered?
How easy would it be to expand to other locations? What are the potential growth opportunities? This can help you give you a better understanding of how the company may perform in the future.
Conclusion
Financial due diligence is a critical step in the process of buying a business. By taking the time to review key financial areas, you can avoid some major pitfalls down the road.
Use this checklist as a guide when conducting your own financial due diligence so that you can make an informed decision about whether or not purchasing a particular business is right for you.
As I mentioned above, I recommend you rely on professionals to help navigate the financial due diligence process and ensure you are making an informed decision.
