How do you conduct a thorough financial due diligence on a target company?

1 Historical analysis

The first aspect of financial due diligence is to review the historical financial statements of the target company, including income statements, balance sheets, cash flow statements, and notes. You want to understand how the business generates revenue, what are its main costs and margins, how it manages its assets and liabilities, and how it generates and uses cash. You also want to identify any significant trends, fluctuations, or anomalies in the financial performance and position of the business, and the reasons behind them. This will help you evaluate the historical profitability, growth, and stability of the target company, as well as its accounting policies and practices.

2 Quality of earnings

The second aspect of financial due diligence is to assess the quality of earnings of the target company, which refers to how sustainable, predictable, and reliable its earnings are. You want to adjust the reported earnings for any non-recurring, exceptional, or discretionary items, such as one-off gains or losses, restructuring costs, impairments, or management bonuses. You also want to normalize the earnings for any non-operational or non-market factors, such as changes in accounting standards, exchange rates, or inflation. This will help you determine the normalized or adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) of the target company, which is a common metric for valuation and comparison purposes.

3 Working capital

The third aspect of financial due diligence is to analyze the working capital of the target company, which refers to the difference between its current assets and current liabilities. You want to understand how the business manages its inventory, receivables, payables, and other short-term items, and how they affect its cash flow and liquidity. You also want to calculate the net working capital (NWC) of the target company, which is the amount of working capital required to run the business on a normal basis. This will help you estimate the working capital adjustment that may be required at closing, depending on the agreed NWC level between the buyer and the seller.

4 Debt and liabilities

The fourth aspect of financial due diligence is to examine the debt and liabilities of the target company, which refers to the obligations that it owes to its creditors, lenders, suppliers, employees, and other parties. You want to identify and quantify all the debt and liabilities of the business, including bank loans, bonds, leases, pensions, deferred taxes, provisions, contingencies, and guarantees. You also want to evaluate the terms, conditions, and covenants of the debt and liabilities, and how they affect the solvency and leverage of the business. This will help you determine the net debt (or net cash) of the target company, which is the difference between its debt and cash, and which affects the enterprise value (EV) of the business.

6 Tax and legal issues

The sixth aspect of financial due diligence is to investigate the tax and legal issues of the target company, which refers to the implications and risks that may arise from its tax status, structure, and compliance, as well as its contracts, litigation, and regulation. You want to understand how the business is taxed, what are its tax liabilities and exposures, and how they may change after the deal. You also want to identify and assess any material contracts, disputes, claims, or regulatory matters that may affect the rights, obligations, or liabilities of the business. This will help you mitigate any tax or legal risks or costs that may impact the deal value or structure.