5 Compelling Reasons Why You Need Financial Due Diligence In M&A

Why you need Financial Due diligence in M&A

This post illustrates why you need Financial Due Diligence in M&A. Financial due diligence (FDD) has become an essential component of the mergers and acquisitions aspect. This piece aims business partners who are contemplating selling their business (or a portion of it) in the following five years to assist them in likely evaluate the readiness of their business through the critical FDD inquiries. A buyer can also apply the corresponding information to recognize red flags in a potential target. FDD is not an audit or pledge commitment and cannot assure complete safeguard toward downright deception and management misrepresentation.
Few critical parameters required to assess the targets’ financials are:

Strong Finance team

An active finance organization confirms sincerity on numbers and beacons the target management’s dedication to the quality of accounts. A lack of sound finance team would result in a great challenge receiving regular sets of data. Lack of data will get illustrated into red flags (e.g., poor quality of data exerts pressure on sellers to uphold up their estimates with legally binding management representations and clawback conditions). When the business gets sold on a strategic basis,  the buyer usually extracts a notable discount.
If the target is tiny and cannot bear the cost of a senior hire at the current state of development, it would serve to at least have somebody on the company with a solid financial knowledge for 2-3 years. The unit can assist in thinking about the sale, enhancing the quality of economic numbers, and preparing for the transaction.

Strength of the underlying financial systems

Lack of quality data will provide buyers negotiation advantage and can even halt the deal. Conversely, good-quality data would confirm the seller’s position. A quality financial system should display a steady, significant, and consistent number in adequate detail, supported by a robust IT system. The financials must explain how the management deals with cost variations or how efficiently they can pass the costs to customers. The numbers should assist buyers in knowing the principal risks.
High-quality data should incorporate specific monthly numbers over the closing three years, audited accounts, complete breakdowns, and exact reconciliation within management accounts and audited accounts. The data should get extracted from an accounting software (vs. spreadsheets), which had tightly fixed access to prevent any unfair manual override and thus assured data accuracy.

Quality of the business earnings

One of the standard valuation methods is buying on a multiple of earnings/ EBITDA/revenue multiple. The closing deal value gets adjusted based on the FDD. A $100,000 decrease in underlying earnings could end in a $1 million price reduction for a deal going at 10x earnings.
High quality of earnings would reflect when revenues and costs that get earned/incurred continuing the defining commercial pursuit of the business are not one-off, link to the right year, and are sustainable.
Companies not valued on earnings or cash need not bother too much about this. This business could include high-tech startups that mainly receive value from their patents. Other possibilities would be web startups valued on impressions/clicks/users, asset-heavy enterprises where assets are more relevant than the income stream, or asset management businesses where assets under management may be significant. The crucial thing to consider is what drives the valuation of the company. If it is not the revenue, cash, or the profit made by the business, it makes limited sense to bother about earnings diligence.
Critical questions asked includes:

1. Is revenue increasing/decreasing? Why?
2. What is the revenue forecast going forward, and why? Do you expect it to keep rising/diminishing?
3. Can we recognize revenue by division/product/geography?
4. Are revenue changes motivated by volume or price?
5. How many revenues was due to the organic growth of the business, and how much due to acquisitions?
6. What is the customer churn/stickiness?
7. How has the profit margin developed in recent years? What were the underlying drivers?
8. How has the product mix shifted, and what influence has it had on profitability?
9. How much of revenue is recurring/supported by agreements?
10.  What were the one time costs and income in the latest three years (think acquisition costs, legal claims, penalties, disputes, discontinued operations, act-of-God damages)?

Net Working Capital Management

A carefully undercapitalized target whose receivables and inventories get run down while creditors spread out would require a meaningful cash injection from the buyer. Any deviations from a “normal” level of working capital would get subtracted from the price.
Deal working capital is distinct from standard working capital and also involves cash. From the deal aspect, working capital usually eliminates all cash-like items and comprises balances directly linked to operating the company. These items include trade debtors and trade creditors. As a rule of thumb, balance sheet items that would free above EBITDA would be deemed NWC in the deals environment.
Usually, there is no escaping NWC entirely. Still, depending on the nature of the business, particular sections could be less crucial than others (e.g., raw material and inventory would not be as critical for a technology business but may be necessary to a manufacturing company).
Key questions include:

1. Monthly figures for NWC line items over the last 12-24 months. If the business is evolving fast, monthly forecasts over the following six months. For small companies, quarterly numbers may serve.
2. Aging analysis of trade debtors, trade creditors, and inventory
3. Provisioning system for debtors and inventory
4. Numbers that get written off in the year for debtors and inventory
5. Breakdowns by essential customers for trade debtors
6. Analysis by outstanding suppliers for trade creditors
7. Balances for any creditors reported to capital expenditure, corporation tax, and debt
8. Daily cash figures over the last year, checking out any payments linked to items that form below EBITDA (e.g., payments for corporation tax).

Net debt calculation

Transactions get evaluated on a debt-free and cash-free basis so that the amount of debt gets eliminated off the closing price, and the amount of cash is totaled. Additionally, it includes any possible off-balance sheet liabilities published by management, tax advisors, legal advisors, pension advisors, and any regulatory bodies. Definition of net debt :

1. Debt that is scheduled in 12 months or less (short-term bank loans, accounts payable, and lease payments) PLUS
2. Loans with a maturity date greater than one year (bonds, lease payments, term loans, notes payable) LESS
3. Cash and liquid instruments that can get quickly converted to cash (certificates of deposit, treasury bills, commercial paper)

In the deals environment, anything trade-dependent will not be in net debt.
Additionally, it would also count any contingent liabilities and any notable cash outflows post-deal date. On the other hand, any cash considered necessary for running the business (rent deposits) may get regarded as working capital. The general rule is that if it will form to stock (out or in) without significant obstacle, it is net debt.
Key questions:

1. A review of outstanding debt ciphering key debt terms including term, interest, currency, break fee, and change of control consequences
2. Itemized covenant requirements and calculations
3. How much of the recorded debt balance get capitalized as debt fee?
4. How much of the loans to shareholders and related parties would get reconciled in cash upon acquisition?
5. Any contingent and off-balance sheet liabilities that the management is aware of, including any legal or tax disputes the business is connected in with an estimation of possible resolution and expected cost to the company
6. How much of the cash would the management recognize trapped or allocated for the daily running of the business
7. Analysis of money by country and currency
8. Breakdown of extraordinary costs