Financial Due Diligence

FINANCIAL DUE DILIGENCE

Category: Compliance Services
Written by Reyhan Adam Himawan on 14/03/2024
The author’s views are entirely their own and may not always reflect the views of Putranto Alliance.

Financial Due Diligence is an important part of mergers and acquisitions when the acquiring party is permitted to investigate the operational situation of the target firm. It is a necessary part of the Merger and Acquisition process. It involves a financial professional investigating the target entity’s financial circumstances and various other related factors.

This article will discuss how it works, what benefit you could get, and the steps needed to conduct Financial Due Diligence. 

What is Financial Due Diligence?

Financial Due Diligence can be interpreted as a comprehensive evaluation of an entity’s financial health when a buyer wants to acquire an entity. Financial due diligence is not only related to proposed acquisitions or mergers, but can also be directed against joint ventures, financing or other deals and transactions. The most important usage of financial due diligence is to realize the following functions: to sufficiently reveal financial risks, analyze a firm’s past profitability and cash flow, and forecast the firm’s future operational prospects. The financial due diligence activity includes:

Identify the commercial rationality of a transaction or growth agreement;
Distinguish between facts, assumptions, and projections;
Financial facts, assumptions, and projections.

Objective of a Financial Due Diligence

The buyer of a target entity does not have complete information regarding the financial condition of the target entity. With financial due diligence, prospective buyers can confirm assumptions from the financial state of the target entity and conformity with the acquisition strategy used by potential buyers. Based on this, the objectives of this are as follows:

Gain an in-depth understanding of the financial statements of the target entity;
Finding liabilities hidden behind audited financial statements;
Identify potential impairment losses incurred by tangible and intangible assets of the target entity due to the impact of the business environment in which the target entity operates;
External factors that may affect the financial health of the target entity in the future;
Evaluate and identify potential weaknesses of the entity’s control of its environment that may pose a significant risk to the financial situation prospects of the target entity;
Obtain a credible valuation of the target entity based on the quality of the organization’s financial statements;
Identify potential deal breakers relating to target entities that should be flagged for negotiations between the two parties as soon as possible.

Buy-Side Financial Due Diligence

Buy-side due diligence is a comprehensive analysis of the target entity it intends to acquire. In this circumstance, the buyer must gain a comprehensive grasp of the target entity and its current status. A thorough analysis of the target entity is important, buyers must be confident that they have a comprehensive understanding of the target entity and that their assumptions regarding the strategic rationale for acquisition are accurate. Additionally, buyers should be informed of the company’s inherent dangers. The methods that can be used in conducting buyer side financial due diligence include:

Financial Modelling
Financial modeling refers to the practice of creating or employing a financial model for analysis and decision-making. A model is a representation of a process or an investment opportunity.
Financial Statement Analysis
Financial analysis is part of financial due diligence that reviews an entity's statutory financial statements. This investigation aims to develop findings that are both deterministic and predictive for management decision-making.
Business Valuation Method
Business valuation is an investigation carried out to generate an estimate or opinion regarding the fair market worth of a business interest at a specific moment in time.
Risk Analysis
Risk analysis is a process that identifies potential dangers and weak spots in a system, assesses those weaknesses concerning the level of risk they pose, and demonstrates how those dangers can be avoided or their effects be mitigated.
Distress Analysis
Distress analysis is an analysis of the condition of an entity when it cannot pay off its debts. In other words, if the value of assets owned by an entity cannot cover the amount of liabilities of that entity.

Sell-side Financial Due Diligence

Sell-side financial due diligence can be defined as due diligence initiated by the seller to prepare for possible transactions optimally. Sell-side financial due diligence is highly recommended for the seller to know more details about the condition of the entity he is going to sell. In its implementation, the sell side of financial due diligence must pay attention to several things, including:

Highlighting the strength of the product or services;
Reviewing the financial statement from the perspective of uniformity accounting policy;
Evaluating the control of the environment and organizational control;
Reviewing the financial statement for any unrecorded liabilities;
Analyzing entity financial trends for at least three to five years.

Benefits of Financial Due Diligence

Properly conducted financial due diligence can provide several benefits for both the buyer and the seller. Other benefits include:

Convincing roadshow
By conducting financial due diligence, entities become confident in the organization's strengths and weaknesses, which can be mitigated.
Understanding potential liabilities
Financial due diligence can help the management of an entity in the pitfall of potential liabilities. With this due diligence, management can mitigate these liabilities before negotiating.
Enhancing deal value
With the strength of the entity known, management can emphasize this as an increase in the value of the agreement.
Manage buyer expectation
With effective financial due diligence, management can answer questions from potential buyers and provide good impressions for prospective buyers.
Ammunition for negotiation
By conducting financial due diligence, prospective buyers can find out the risks, liabilities, performance, accounting treatment, and prospect forecasts of the target entity, which can be used as consideration for negotiation.

Financial Due Diligence Process

Financial due diligence cannot necessarily be done without a clear strategy and goals. For the financial due diligence to produce the desired results, careful planning, strategy, and steps are needed. Based on this, the stages of financial due diligence are as follows.

Preparation stage
This stage involves drafting an engagement letter with details like scope of work, responsibilities, confidentiality, remuneration, and duration.
Planning Stage
After the engagement letter has been made, the next stage is the planning stage. In this stage, there are several things that need to be considered by consultants before starting financial due diligence. These include:
- Understanding the environment, including industry specifics and required expertise;
- Create a list of information requests, including details of the target company, financial statements and business plans;
- Build a diverse team, including financial, legal, tax, and human resources experts.
Implementation
The investigative content of the implementation of financial due diligence can be, among others:
- Investigating the Overall Financial Data of the Target Company
- Investigation of the Target Entities Specific Financial Condition
  This assessment evaluates the credibility of the target company's financial statements and internal control systems to understand its financial status and profitability.
- Investigation of Special Matters
  This includes examining specific financial commitments, contingent liabilities, post-balance sheet events, related party transactions, and off-book assets and liabilities. Primary source documents are obtained to evaluate their authenticity, and findings are disclosed in the financial due diligence report based on their materiality.
Reporting
Provide a clear and concise final report that summarizes the findings, highlights key issues that will influence the client's decisions, and identifies any missing or unreliable information. The structure and style of the report will depend on the objectives, reader understanding and management preferences.

How We Can Help

Financial Due Diligence is an integral part of the M&A process. It involves investigating financial measures to establish a historical and factual foundation. Financial Due Diligence involves a financial professional investigating the target entity’s financial circumstances and other related factors. Putranto Alliance can help you conduct a sell or buy side financial due diligence. With our expertise and experience in doing financial due diligence, we can provide you with a thorough financial due diligence report so that you can have the proper information for your next M&A step.

References

B.D.Chatterjee. (2021). A Practical Guide to Financial Due Diligence. New Delhi: Bloomsbury Publishing India.

Franssen, M. (2020). A Comparison Between The Audit and Financial Due Diligence Process in Belgium. Belgium: HEC. Liege.

Howson, P. (2003). Due Diligence The Critical Stage in Mergers and Acquisitions. Burlington: Gower Publishing Company.

FAQs

Is financial due diligence required under Indonesian regulations?

Financial due diligence is not required under any other laws or regulations, but it is highly recommended for prospective buyers who will do M&A to carry it out

What are the consequences for the buyer of the entity if they do not conduct financial due diligence?

If the buyer of the entity does not perform financial due diligence, then there is a possibility that the purchased entity has various financial problems or has a value not as assumed by the buyer.

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