Services Overview: What is financial due diligence?

The process and advisors involved in selling a business can be likened to a real estate transaction. Each transaction has a buyer (homebuyer = corporation/investor) and a seller (homeowner = corporation/business owner), an agent marketing the sale and managing the process (real estate agent = investment bankers), financing sources (mortgage provider = commercial bank) and a number of other advisors or stakeholders that assist in the process (home inspector/appraisers = due diligence providers/lawyers).

Financial due diligence is like the home inspection of a real estate transaction. Or if a financial due diligence provider is representing the seller, their role is similar to the house stager/cleaner that’s prepping the business for sale. You would never buy a home without a home inspection, and you would never try to sell your house without tidying up before showing it to potential buyers. So why would you go it alone when buying or selling a business?

Financial due diligence is typically broken down into three main analyses:

Quality of Earnings – What are the normal, recurring, sustainable earnings of the business? A quality of earnings analysis addresses this question through a deep dive into the reported figures to identify nonrecurring income or expenses that may not continue going forward. This is not as simple as reconciling the internal financial results to a tax return or to a set of audited financial statements because these sources may reflect what was recorded in the year but are not representative of normal operating results. For example, what if a company’s largest customer went bankrupt on the last day of the year? The financial statements and tax returns should and would include the revenues earned from that customer in that year, but if you were buying that business, you would not want to count on those revenues continuing going forward. Or what if a company finally received a large insurance settlement related to an incident from years prior? You should not count on that nonoperational income recurring each year.

Debt & Debt-like – Most M&A transactions are structured on a “cash-free, debt-free” basis, meaning the overall purchase price is adjusted dollar-for-dollar upwards for any cash left in the business and downwards for any reported debt left in the business. Debt is typically viewed as borrowings from a financial institution; however, businesses often have liabilities on or even off their books that may feel “debt-like” in nature. These may include items like legal settlement accruals, environmental obligations, unfunded pension plans, etc., that are outside of the day-to-day operations of the business and should be considered in the overall valuation of the business if the buyer is expected to assume these liabilities.

Net Working Capital –The day-to-day operations of a business run on current assets such as accounts receivable, inventories, prepaid expenses, and current liabilities such as accounts payable, accrued expenses, and payroll-related liabilities. These assets and liabilities are transferred to the seller as part of the sale of the business. M&A transactions call for a “normal” level of working capital to be delivered with the business, but as these balances fluctuate on a daily/weekly/monthly basis this is subject to negotiation. The net working capital analysis lays out the historical trends in the balances for purposes of understanding net working capital impact on cash flows and also for purposes of establishing a “normal” level of working capital to be used as a target in the purchase agreement.

The normalized financial performance and balance sheet position of a business are among the main drivers of its value, which is why financial due diligence is a critical part of any M&A transaction. The results of financial due diligence can significantly impact the negotiated value of a business. Having an experienced due diligence provider on your team is critical to ensure no value is left on the table.

The analyses mentioned above are three main analyses that are the output of a detailed dive into the financial results and supporting analyses performed during due diligence. Stay tuned to future blog posts that dive deeper into these analyses and other drivers of a business’s value.

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About the author: Joe Finnerty is the founder and managing principal of Colm Advisory.