What You See is Not Always What it Seems: Due Diligence in the Mergers & Acquisitions Process Part II –Financial Due Diligence

Previously, I wrote a blog highlighting a business purchaser’s need to do due diligence on its prospective target company.  As stated, the due diligence process can be split into three parts:  (1) legal; (2) financial; and (3) operational.  I began this series with a blog concerning legal due diligence.  This blog will explore what is involved with the financial part of the due diligence process.

Financial Due Diligence

Financial due diligence involves ensuring:  (1) financial information used to make the decision to purchase the business and the purchase price is accurate; (2) that the buyer has a thorough understanding of the target company’s finances so that it can include future possible contingencies in its forecasts and financial methods; (3) there are no customer collection or cash flow problems; and (4) the buyer has a full understanding as to any future unfunded liabilities such as pension benefits for current and future retirees and promised bonuses to employees.  In contrast to legal due diligence, financial due diligence may necessitate a larger team to complete.  For legal due diligence, the buyer and its attorneys are usually the only required parties.  Depending on the sophistication of the buyer and the magnitude of the deal, it may be essential to hire accountants or other financial advisers to assist with the financial portion of due diligence.

Below you will find a non-exhaustive list of the categories of documents that a purchaser should request as part of financial due diligence.  Every deal is different; thus, there are likely additional documents that would be necessary in any particular deal.

  • Audited financial statements for the last three to five fiscal years and any interim unaudited financial statements, if available;
  • Any reports by and correspondence with the company’s accountants, including any management letters to the company;
  • Any financial projections or plans produced internally by the company;
  • Monthly income statements, balance sheets, and cash flow statements for the last twelve months;
  • Trial balance and general ledger statements as of most recent month’s end;
  • A detailed description of any add-backs that explain the differences between the company’s tax returns and its financial statements;
    – In general, since businesses try to minimize their taxable income, it is understood that the actual net income used in financial statements may differ from taxable income, but it should also be clear what methodology is being used in calculating those differences.
  • Details on any transactions with related parties;
  • If the company has multiple lines of revenue, then the revenue and gross profit of each category should be separated out;
    – This should be done for the last twelve months, but preferably over the entire period of financial statements received.
  • Revenue from the twenty largest customers for the past twelve months;
  • Purchases from the twenty largest vendors for the past twelve months;
  • Monthly inventory reports for the most recent month’s end, if applicable;
  • List of all leases for real property or equipment, together with basic terms of each lease;
  • The currently used budget for capital expenditures;
  • A list of all bank accounts;
  • Monthly bank statements and reconciliations for the past twelve to twenty-four months;
  • A current organizational chart;
  • A copy of any incentive compensation arrangements for employee, including bonuses and sales commissions together with a list of employees covered;
  • A description of any retirement plans together with a copy of the plan documents; and
  • Copies of the documents related to any stock plans, ESOPs (employee stock ownership plan), and other profit-sharing plans together with a list of employees covered;

Conclusion

Due diligence is arguably the most important step in the M&A process for purchasers.  It will aid in verifying the information previously provided by the seller and recovering any information not previously provided by the seller.  Due diligence on a business involves reviewing a large amount of documents.  This post covered merely one third of the process.  Stay tuned for the final installment in this series, covering operational due diligence.

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