Mergers and acquisitions – Financial due diligence

This article was originally published 31 March 2016.

Challenge area

In the context of mergers and acquisitions the due diligence process covers a wide range of areas including operations, legal and financial matters. The extent of procedures required under each area is dependent upon the nature of the actual transaction.

So what needs to be done, why, when and how?

Due diligence is not an audit

What is a financial due diligence review? Financial due diligence is not an audit. An audit is concerned with historical financial statements only and provides an opinion as to whether the financial statements represent a ‘true and fair’ view of the company's operations. A financial due diligence, on the other hand, would incorporate a greater scope.

A financial due diligence review would not only look at the historical financial performance of a business but also consider the forecast financial performance for the company under the current business plan and consider the reasonableness of such forecasts.

Another major difference between an audit and a financial due diligence review is that, where an audit reports only on the truth and fairness of the financial results, a financial due diligence review will investigate reasons for the trends observed in operational results of the company over a relevant time period and report on this in terms of relevancy for the proposed transaction.

Clearly, the scope of each financial due diligence will be unique depending upon the nature of the transaction and the size of the company or business operations being acquired. In general a financial due diligence would typically involve a review of the following areas: historical financial results, current financial position, forecast financial results, working capital requirements, employee entitlements provisions, valuation implications, risks and opportunities, and taxation implications.

The key to determining an appropriate scope for financial due diligence is clear identification of the risks surrounding the potential acquisition.

When do I need a financial due diligence review?

Financial due diligence should be undertaken whenever a company is considering acquiring a new business (whether it be by acquiring share capital of an existing company or purchasing the business operations and assets only).

However the benefits of financial due diligence reviews are not limited to merger and acquisition decisions. They can also be useful in assessing the merits of disposing of certain existing business divisions within an organisation. A financial due diligence review is also an essential component of assessing investment requirements for venture capital arrangements.

Who can I instruct?

A financial due diligence review can be conducted either internally, by the acquirer’s own accounting and finance function, or by external independent due diligence experts.

The benefit of using external advisers is that the review is based on an independent viewpoint from a party who has no direct interest in the outcome of the proposed transaction.

Further, by outsourcing the financial due diligence review, internal resource time can be dedicated to consideration of operational due diligence procedures such as the logistics of merging the policies and procedures of both the acquirer and target in an efficient and effective manner.

When should I instruct them?

Ideally, the financial due diligence process should commence as soon as practical when negotiating to acquire a company or business.

Generally once a heads of agreement has been drafted setting out the structure for the deal, then financial due diligence should begin. Importantly, sufficient time should be allocated to the financial due diligence process, as the outcome of the review may provide valuable information required to ensure a fair purchase price is agreed upon and, where necessary, the appropriate guarantees and provisos are put in place.

What information will they need?

The information required to complete a financial due diligence review is dictated by the agreed-upon scope as well as the reporting capabilities of the target company. The main sources of information for a financial due diligence review include:

  • Historical financial data including statutory accounts, detailed management accounts and reports and income tax returns. Where statutory accounts have been audited, access to audit work papers may also aid the financial due diligence process
  • Current financial data such as year-to-date management accounts
  • Business plans and forecast financial information (including budgets and cash flow forecasts)
  • Minutes of Directors' Meetings and Management Meetings.

What will I get out of a financial due diligence review?

Depending upon the scope of the procedures conducted, a financial due diligence review should provide answers to the following questions:

  • Is the information provided by the target/vendor reliable?
  • Are the historical earnings of the company sustainable?
  • What are the potential future earnings of the company, including the impact of new accounting standards on those earnings?
  • What are the possible synergies associated with the proposed acquisition?
  • What are the immediate and future tax consequences of the proposed acquisition?
  • What plans need to be put in place for the post-merger implementation process?
  • Is the purchase price fair given the results of the due diligence process?
  • Based on the outcome of the due diligence are there any potential deal breakers?
  • Is the structure of the acquisition appropriate and should any issues such as guarantees be included in the purchase documentation?

The way forward

The due diligence process is not simply following through a standard checklist of procedures in order to provide a 'tick' for a proposed acquisition. When done properly a financial due diligence review provides valuable information to support the proposed acquisition and identify early the issues that you need to address to combine companies and businesses successfully. There have been numerous high profile examples that have proven the cost of performing expert financial due diligence far outweighs the cost of a bad acquisition.