Why perform financial due diligence?

Demystifying Valuation, Economic Damages + Forensic Accounting

In basic terms, a financial due diligence (FDD) is a process of gathering information concerning the target company, its source of revenue, the environment in which it operates, its sustainable cash flows, and risk profile. FDD is done to ensure that the prospective buyers and interested stakeholders are able to make an informed investment decision.

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In most cases companies are valued based on a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA) so it makes sense to present the company in the best possible way to increase value. The current trend is for larger companies (> $10 MM in revenue) to perform a sell-side due diligence. A sell-side due diligence will speed up the transaction process and eliminates any surprises found by the buyer.

On the other hand, buyers will perform FDD because management of the selling company wants to present the company in the best possible way to increase value by adjusting historical EBITDA to exclude certain expenses or reverse accruals in anticipation of a sale. A buy-side FDD will test management’s adjustments and report to the buyer its findings.

Both a sell-side and buy-side FDD build procedures to identify risks associated with the following:

  • Concentrations of customers, margins and earnings
  • Related-party issues
  • Change of control issues
  • Non-operating/non-recurring revenue and expenses
  • Supplier concentrations
  • Debt and debt-like items
  • Working capital requirements and standards

In short, a FDD evaluates, interprets and communicates the financial data of the selling company so the client can make an informed investment decision.

If you have any questions on financial due diligence, please contact your Henry+Horne advisor.

Michael R. Metzler, CPA, ABV, CMA, CGMA, ASA