What Does Financial Due Diligence Mean?
Table of contents
- Financial Due Diligence Meaning? What is FDD?
- Different Types of Financial Due Diligence
- The Financial Due Diligence Process
- Key Considerations for Financial Due Diligence
- Common Mistakes to Avoid During Financial Due Diligence
- The Benefits of Financial Due Diligence for Business
- High Level Financial Due Diligence Checklist
- Conclusion: Why Financial Due Diligence Matters
Financial due diligence (also called Accounting Due Diligence, Transaction Advisory or M&A Due Diligence) is a crucial step for any business looking to make an investment or acquire another company. It’s a comprehensive review of the financial statements (down to the transaction level) of a business to ensure historical and projected financial performance is well understood before making an investment decision. In this article, we will explore what financial due diligence means, the different types of due diligence (aside from FDD), the FDD process, the benefits of FDD, and a financial due diligence checklist.
What is Financial Due Diligence? What is the Meaning?
Financial due diligence, also known as FDD, is a process that involves reviewing a company’s financial performance, including accounting records, financial statements, and other relevant financial information. The primary purpose of FDD is to identify financial risks that may exist within a company, and to validate the historical EBITDA and revenue, which is the basis for M&A valuation. Financial due diligence also includes identifying potential liabilities, such as outstanding debt, aged payables, or legal disputes, as well as identifying any areas of the business that may require additional investment (e.g., delayed capex).
The process of financial due diligence is typically undertaken by a team of financial professionals, including accountants (usually certified public accountants) and financial analysts. These FDD professionals review the company’s financial statements at the transaction level (i.e., general ledger), conduct interviews with key personnel, and perform a range of other analyses to gain a comprehensive understanding of the company’s financial performance.
The Different Types of Due Diligence
There are several different types of due diligence that can be performed during an M&A transaction, including Financial/Accounting Due Diligence.
Tax Due Diligence
Tax due diligence involves reviewing a company’s tax returns and other relevant tax documents to identify any potential tax liabilities or issues. This includes reviewing the company’s tax filings, identifying any potential tax deductions, and ensuring that all taxes have been paid on time.
Legal Due Diligence
Legal due diligence is the process in which an attorney reviews a company’s legal documents, such as contracts, leases, and other legal agreements, to identify any potential legal risks or liabilities. This includes identifying any outstanding legal disputes, as well as reviewing the company’s compliance with relevant laws and regulations.
Commercial Due Diligence
Commercial due diligence (or CDD) involves reviewing a company’s market position, competitors, and overall industry trends to identify any potential risks or opportunities. This includes analyzing the company’s customer base, sales channels, and marketing strategies to ensure that the business is well-positioned for long-term success.
The Financial Due Diligence / Transaction Advisory Process
The FDD process typically involves several key steps, including:
Step 1: Pre-Due Diligence Assessment
Before beginning the due diligence process, it is essential to conduct a pre-due diligence assessment to identify any potential red flags or areas of concern. This may include reviewing public information, such as news articles and financial reports, as well as conducting interviews with key personnel. This process also includes getting up to speed with the industry and business model.
Step 2: Planning Stage
Once the pre-due diligence assessment has been completed, the next step is to plan and prepare for the due diligence process. This includes identifying the specific areas of the business that will be reviewed, as well as assembling a team of financial experts to conduct the review. This requires an understanding of the business itself. FDD professionals usually get access to a virtual dataroom where high level data about the company is uploaded, including a CIM (confidential information memorandum)
Step 3: Data Collection
The next step in the financial due diligence process is to prepare a detailed request list based on the data that has already been provided and the specific areas of diligence that were planned during the planning stage. Included in this phase is data aggregation, which involves setting up a basic financial model in excel (also called a “databook”).
Step 4: Analysis and Review
Once all relevant financial data has been collected and aggregated into a databook, the next step is to analyze and review the information. This phase is where FDD professionals earn their worth. A skilled FDD professional is able to quickly analyze the target company’s financial statements and identify areas of concern. This includes reviewing all three financial statements (income statement, balance sheet, and cash flow), identifying any potential liabilities or legal risks, and analyzing the company’s market position and overall performance. This phase also includes a 4-hour long discussion with target company management to answer questions that arise.
Step 5: Reporting and Recommendations
The final step in the financial due diligence process is to prepare a detailed report outlining the findings of the review and providing recommendations for next steps. The FDD report is typically provided to the business investors (i.e., financial due diligence firm clients), who can then use the information to make an informed investment decision.
The Benefits of Financial Due Diligence for Businesses
There are several benefits of financial due diligence for businesses, including:
- Identifying Potential Risks and Issues
One of the primary benefits of financial due diligence is that it identifies any potential risks or issues that may exist within a business. This allows businesses to take proactive steps to address these issues before they become significant problems.
- Providing a Comprehensive Understanding of the Business
Financial due diligence provides a comprehensive understanding of a business’s financial situation, including its strengths, weaknesses, and potential areas for improvement. This information can be used to make informed decisions about the future of the business.
- Enhancing Credibility
Finally, financial due diligence can enhance a business’s credibility, both with investors and other stakeholders. By conducting a thorough and comprehensive review of the business’s financial information, businesses can demonstrate their commitment to transparency and accountability.
High Level Financial Due Diligence Checklist
A financial due diligence checklist can help businesses and investors ensure that they are conducting a thorough and comprehensive financial review. Some key items to include on a financial due diligence checklist include:
- Financial statements for the last 3 years
- Tax returns for the last 2 years
- AR and AP agings
- Company overview (confidential information memorandum)
- Customer and vendor contracts
- Employee list and compensation by emlpoyee
- Customer list and revenue by customer
Conclusion: Why Financial Due Diligence Matters
Financial due diligence is a critical step for any business looking to make an investment or acquire another company. By hiring a great FDD firm to conduct a thorough and comprehensive review of a company’s financial information, investors can identify potential risks and issues and gain a comprehensive understanding of the target business.