When engaged in a complex transaction, such as a merger or acquisition, or when engaged in private equity funding, it’s reasonable to expect that an audit of the target company’s financial statements will take place. The acquiring company or group of investors certainly want the reassurance that the company’s assets and liabilities are properly organized and reported according to generally accepted accounting principles, and reviewed fairly by an unbiased neutral party that does not stand to gain from the transaction.
However, an audit might not be enough to gain an in-depth view of a target company’s financials, including the processes and controls involved in managing capital. The due diligence process, on the other hand, typically covers a wide range of areas, including legal, information technology, operational, marketing, and product or service issues.
Financial due diligence focuses on providing the acquiring company or investors with a more complete understanding of the company, generally in the following areas:
While EBITDA (earnings before interest, taxes, depreciation and amortization) is used to fairly evaluate a company, financial due diligence goes deeper. Financial due diligence focuses on the quality or sustainability of those earnings, including such anomalies as non-recurring income and expenses, variations in the application of accounting rules, or regional or international differences in the treatment of assets and liabilities. All these factors, considered in the light of due diligence, can provide a more complete picture of the sustainability of earnings during a transaction.
Sales and Revenue Trends
Audits can analyze revenues, but unfortunately, not the drivers or underlying strategies used to generate those revenues. Financial due diligence reports include an industry and competitor analysis, in addition to the target company’s sales strategies, existing customer relationships and customer churn, in order to more completely understand whether the trends reflected in the financials might continue moving forward.
Working Capital Needs
While a “target” working capital is negotiated during a transaction — usually based on the average working capital balances over the past twelve months — some buyers and investors lean in more closely. Some companies might be seasonal, or be challenged by an ever-changing legislative or regulatory environment. Others might have a product in development that will not be ready for market until a future date. Such factors can severely affect regular working capital controls. Audit reports do not provide this extra layer of insight, and sophisticated buyers will look at more than just a twelve-month history of working capital as part of their financial due diligence.
Financial due diligence also incorporates the forecasts and assumptions of the management of the target company — something that regular audits do not provide. Audits provide a historical analysis of a company’s financials. While this is certainly important, it is generally accepted that past performance is not necessarily an indicator of future performance, and so acquiring companies and investors are usually interested in what a company’s future plans include. Financial due diligence uncovers the feasibility and validity of the targeted company’s forecasts, including all variables and assumptions.
Human Capital Investments
While usually a current liability according to accounting rules, financial due diligence will go deeper to better understand how the acquiring company unlocks the value in human capital. For example, if the acquiring company spends on training and development, leading to increased productivity and lower turnover, financial due diligence will uncover this. A regular audit would just count the salaries and costs associated with learning platforms as liabilities.
More than just listing the expenses of IT assets, including investments in hardware and software, financial due diligence will go deeper to uncover whether these IT investments yield incremental return on investment (ROI). Perhaps investments in advanced accounting and security software systems were able to save the company a substantial amount of money. This helps the acquiring company and investors understand more about how the target company evaluates and fully utilizes its liabilities for advantage.
It’s important to note that while an audit can provide the checks and balances that assure assets and liabilities are properly reported, an acquiring company or group of investors most likely wants to go deeper. They want a more thorough picture of how revenues are captured and how liabilities arise. Auditors may have specific industry experience, but they are normally not in a position to comment on the areas cited above.
How Financial Due Diligence Differs from an Audit
Though outlined via a few categories above, it’s important to understand how financial due diligence differs from an audit. Below are three key areas:
No Regulatory Requirement
An audit usually must be performed regularly, usually once per year, regardless of whether a company is engaged in an M&A transaction or liquidity event. However, financial due diligence is completely discretionary.
Can Cover Several Prior Years
Whereas an audit will always cover the period of one year of the company’s performance, financial due diligence can investigate performance going back several years.
Wider Range of Parties Involved
Whereas an audit is performed by a public accounting firm, independent of the target company in the transaction, financial due diligence can be performed by a range of accounting, financial, legal and operational professionals. The financial due diligence team can be composed of professionals from both inside and outside the target company, or outsourced to independent advisors or consultants.
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While deals principally seek to create shareholder value, successful mergers can accomplish much more than that.
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Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.