Financial due diligence: The key to informed and successful transactions

In the dynamic world of business transactions, certainty is paramount. Financial due diligence (FDD) provides the confidence that the financial data underpinning your decisions is reliable and free from any unknown risks.

In today's challenging deal environment, characterised by volatile interest rates, fluctuating valuations, and varying financial data quality, the importance of FDD is increasing. Whether you are a business owner preparing for an exit, a Chief Financial Officer evaluating an acquisition, or an investor assessing growth opportunities, FDD enables well-informed, strategic decisions.

In our article, we dive into what FDD entails, when it’s essential, why it’s important, and how it can ensure your next transaction realises its full potential.

What is financial due diligence?

FDD is a comprehensive analysis of a company's financial performance and position, examining both historical results and forecasted financial performance under the current business plan, considering the reasonableness of the assumptions adopted. Unlike an audit, which focuses solely on verifying the accuracy and fairness of historical financial results, FDD investigates the reasons behind trends in operational performance over a relevant period and evaluates their relevance to the proposed transaction. The scope of each FDD is tailored to the specific nature of the transaction and the size of the company or business operations being acquired.

A typical FDD engagement encompasses:

• Historical performance: Analysis of revenue trends, earnings quality, margin volatility, and unusual cash flows
• Quality of earnings: Assessment of the sustainability and accuracy of reported earnings, with adjustments for non-recurring items, accounting policies, and management judgement
• Cash flow and working capital: Evaluation of liquidity, sustainability, and operational flexibility
• Balance sheet and net debt: Consideration of liabilities, provisions, and off-balance-sheet exposures
• Forecasts and assumptions: Assessment of whether growth expectations and underlying assumptions are supported
• Customer and product concentration: Examination of revenue sources and potential vulnerabilities
• Capital expenditure requirements: Identification of material future investments that may not be evident from historical accounts
• Normalised working capital and net debt: Considerations for purchase price adjustments at completion.

Ultimately, FDD aims to provide stakeholders with a thorough understanding of the company's financial narrative by evaluating its historical and forecast performance for credibility, completeness, and consistency. While FDD does not offer assurance, it supports informed decision-making by delivering a comprehensive analysis tailored to the transaction's context.

When is financial due diligence needed?

FDD is crucial in most significant corporate transactions, including:

• Buying a business: Whether acquiring shares or assets, buyers must understand the target's financial performance and risk profile to make an informed decision about paying an appropriate price. FDD helps buyers identify potential risks and avoid unforeseen issues
• Investing in a company: Private equity, venture capital, or strategic investors depend on FDD to substantiate revenue models, cost structures, and growth projections. This is especially crucial when value is tied to scale or operational leverage
• Entering a joint venture or partnership: Partners seek comfort that the counterparty is financially stable and commercially viable. FDD fosters transparency and trust
• Selling a business (vendor due diligence): Vendors can proactively conduct their own due diligence to address potential issues, streamline the process, improve deal certainty, and enhance buyer confidence
• Management buy-outs or buy-ins: In these scenarios, FDD assists all parties to understand whether the business can support the required funding and remain viable post-transaction.

Neglecting FDD can lead to significant challenges after a transaction closes, including discovering working capital shortfalls, non-recurring earnings, key customer concentration risk, or unknown liabilities payable. These issues may erode the anticipated value of the deal, create financial strain, or require costly corrective actions, potentially undermining the transaction’s success.

Why financial due diligence matters

FDD is more than just a box-ticking exercise. It creates value in several ways:

• Identifying risks early: FDD identifies issues not evident in standard financial reports, including revenue concentration, pending litigation, underfunded liabilities, or unsustainable cost structures. Proactively addressing these issues minimises surprises during buyer due diligence and can allow active discussions with the seller
• Strengthening valuation: FDD provides a normalised perspective on earnings, net debt, and working capital, creating a clear and defensible financial narrative. This enables buyers to evaluate value confidently and sellers to substantiate their pricing
• Informing deal structure: Insights from FDD inform transaction terms, including warranties, indemnities, earn-outs, or other protective mechanisms, facilitating a balanced agreement and smoother completion
• Promoting transparency and confidence: A comprehensive FDD report demonstrates professionalism and openness, providing buyers, boards, and financiers with the necessary clarity to advance, reducing delays and negotiation friction
• Unlocking hidden value: Beyond risk mitigation, FDD can uncover opportunities for upside, including margin improvements, pricing optimisations, or improved working capital efficiency, thereby increasing the perceived future value of the business.

How BDO can help

At BDO, our deal advisory team collaborates with buyers, sellers, and investors to deliver commercially astute insights that go beyond data. We tailor our FDD approach to your specific context, prioritising the factors most critical to your transaction.

With extensive experience across sectors like healthcare, insurance, resources, technology, retail, and manufacturing, we are adept at navigating common challenges and leveraging key value drivers.

Whether preparing for a transaction or evaluating an opportunity, we assist you in:

• Understanding the financials behind the deal
• Substantiating assumptions that underpin valuation
• Identifying hidden risks and untapped potential
• Structuring the transaction to safeguard your interests.

Contact our financial due diligence experts to learn how we can support your next transaction.