Financial Due Diligence Service

Written by Reyhan Adam Himawan on 16/07/2024
The author’s views are entirely their own and may not always reflect the views of Putranto Alliance.

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Introduction

Financial Due Diligence is a critical component of mergers and acquisitions (M&A), allowing the acquiring party to investigate the operational and financial situation of the target entity. This process is essential for ensuring that the acquisition aligns with the buyer’s strategic goals and financial expectations. This article aims to provide a comprehensive understanding of this due diligence, including its definition, importance, optimal timing, benefits, and process.

Definition

Financial Due Diligence is a thorough evaluation of an entity’s financial health, typically conducted when a buyer intends to acquire another entity. This process is not limited to acquisitions or mergers but can also apply to joint ventures, financing, or other transactions. The primary functions include revealing financial risks, analyzing past profitability and cash flow, and forecasting future operational prospects.

Key activities involved in financial due diligence are:

  1. Identifying the commercial rationality of a transaction or growth agreement.
  2. Distinguishing between facts, assumptions, and projections.
  3. Evaluating financial facts, assumptions, and projections.

The Importance

The buyer of a target entity often lacks complete information regarding the financial condition of the target. Due diligence allows prospective buyers to confirm assumptions about the target entity’s financial state and ensure alignment with their acquisition strategy.

The objectives of due diligence are:

  1. Gaining an in-depth understanding of the target entity’s financial statements.
  2. Identifying liabilities hidden behind audited financial statements.
  3. Recognizing potential impairment losses on tangible and intangible assets due to the business environment.
  4. Assessing external factors that may affect the target entity’s future financial health.
  5. Evaluating potential weaknesses in the entity’s control environment that could pose significant financial risks.
  6. Obtaining a credible valuation of the target entity based on the quality of its financial statements.
  7. Identifying potential deal breakers that should be flagged early in negotiations.

Buy-Side Financial Due Diligence

Buy-side financial due diligence involves a comprehensive analysis of the target entity that the buyer intends to acquire. This process ensures that the buyer gains a thorough understanding of the target entity’s current status and inherent risks. 

The methods used in conducting this process include:

  1. Financial Modelling: Creating or employing a financial model to represent a process or investment opportunity for analysis and decision-making.
  2. Financial Statement Analysis: Reviewing the statutory financial statements of the entity to develop findings that are both deterministic and predictive for management decision-making.
  3. Business Valuation Method: Generating an estimate or opinion regarding the fair market worth of a business interest at a specific moment in time.
  4. Risk Analysis: Identifying potential dangers and weak spots in a system, assessing those weaknesses in relation to the level of risk they pose, and demonstrating how those dangers can be avoided or their effects mitigated.
  5. Distress Analysis: Analyzing the condition of an entity when it cannot pay off its debts, assessing whether the value of assets owned by the entity can cover its liabilities.

Sell-Side Financial Due Diligence

Sell-side financial due diligence is initiated by the seller to optimally prepare for possible transactions. This process allows the seller to gain detailed insights into the condition of the entity being sold. 

Key considerations in this process include:

  1. Highlighting the Strength of the Product or Services: Emphasizing the strengths of the entity’s offerings to potential buyers.
  2. Reviewing Financial Statements for Uniformity in Accounting Policy: Ensuring that financial statements are consistent and adhere to uniform accounting policies.
  3. Evaluating Control of the Environment and Organizational Control: Assessing the entity’s control environment and organizational controls.
  4. Reviewing Financial Statements for Unrecorded Liabilities: Identifying any liabilities that may not be recorded in the financial statements.
  5. Analyzing Financial Trends: Examining the entity’s financial trends over at least three to five years to understand its performance trajectory.

The Best Time To Do

The optimal time to conduct financial due diligence is during the initial stages of the M&A process, before finalizing any agreements. This timing allows the buyer to make informed decisions and negotiate terms based on a comprehensive understanding of the target entity’s financial health.

Early due diligence can also help identify any red flags or deal breakers that could impact the transaction.

Benefits

Properly conducted financial due diligence offers several benefits for both buyers and sellers:

  1. Increasing Confidence: Entities gain confidence in their strengths and can address weaknesses, enhancing their presentation to potential buyers.
  2. Understanding Potential Liabilities: Management can identify and mitigate potential liabilities before negotiations.
  3. Enhancing Deal Value: Knowledge of the entity’s strengths can be used to increase the value of the agreement.
  4. Managing Buyer Expectations: Effective due diligence allows management to answer potential buyers’ questions and make a positive impression.
  5. Ammunition for Negotiation: Buyers can use insights from due diligence to negotiate better terms based on identified risks, liabilities, performance, and prospects.

Requirements

To engage with our FDD services, please provision the following documents:

  1. Financial Documentation:
    • Recent financial statements and reports.
    • Audit reports and related financial assessments.
  2. Legal Documentation:
    • Contracts and agreements related to debts, leases, and business transactions.
    • Tax filings and any correspondence with tax authorities.
  3. Operational Information:
    Details on business operations, including ownership structure and principal agreements.

Duration

The Financial Due Diligence process can vary depending on the complexity of the target entity’s financial situation and data availability. Generally, it entails:

  1. Compiling findings: Approximately 10 working days
  2. Meeting and discussion: 1 working days
  3. Adjustments: 5 working days
  4. Further meeting and discussion: 1 working days
  5. Final adjustments & finalization: 5 working days

How to Prepare A Financial Due Diligence

Financial due diligence requires a clear strategy and well-defined goals. The process involves several stages:

  1. Preparation Stage: Drafting an engagement letter detailing the scope of work, responsibilities, confidentiality, remuneration, and duration.
  2. Planning Stage: Consultants must consider several factors before starting due diligence, including understanding the industry, creating a list of information requests, and building a diverse team of experts.
  3. Implementation: This stage involves investigating the target company’s overall financial data, specific financial conditions, and special matters such as financial commitments and contingent liabilities.
  4. Reporting: Providing a clear and concise final report that summarizes findings, highlights key issues, and identifies any missing or unreliable information.
Steps to Create Financial Due Diligence

How We Can Help

Financial Due Diligence is a crucial part of the M&A process, involving a detailed investigation of the target entity’s financial circumstances. Putranto Alliance can assist in conducting both sell-side and buy-side financial due diligence. With expertise and experience, we provide thorough and comprehensive financial due diligence reports, ensuring that clients have the necessary information for their next M&A step.

Our Services Include:

  1. Budgeting:
    Putranto Alliance will assist entrepreneurs in providing guidance on budgeting and cash flow management as well as ensuring financial sustainability of the company.
  2. Investment:
    Putranto Alliance help clients to optimize their investment portfolios and ensure compliance with tax laws and regulations through strategic tax planning and accounting services.
  3. Tax Due Diligence:
    Putranto Alliance provides a thorough examination of all aspects of a company’s tax situation, including an analysis of how tax reporting methods can impact the company’s operations. We ensure that the company complies with all applicable tax regulations by reviewing previous transactions to ensure that no details are overlooked. This comprehensive review helps identify potential tax risks and opportunities, ensuring the company’s tax position is accurate and optimized.
  4. Tax Accounting:
    Putranto Alliance can assist clients in preparing financial statements in accordance with PSAK (Indonesian Financial Accounting Standards) regulations and in calculating the amount of tax payable by individuals or businesses in accordance with applicable tax laws. We can also help in optimizing financial structures and transactions to minimize the required tax burden legally. This includes preparing and organizing tax documents such as tax reports, analysis, and strategic planning to utilize tax incentives and avoid unwanted tax risks.

FAQs

Financial due diligence is not mandated by Indonesian laws or regulations. However, it is highly recommended for prospective buyers engaging in M&A transactions to conduct thorough due diligence to mitigate risks and ensure informed decision-making.
Failure to conduct financial due diligence exposes the buyer to potential risks and uncertainties regarding the financial health and value of the acquired entity. Without proper due diligence, the buyer may face unexpected financial issues or discrepancies post-acquisition, leading to unfavorable outcomes.
Putranto Alliance guarantees the security and confidentiality of the data provided during and after the financial due diligence process. We adhere to international standards set by ISO 27001 Information Security Management System and its extension ISO 27701 Privacy Information Management System. Our implementation of these frameworks ensures the effective protection of sensitive information through strong security measures and privacy controls.
If significant issues emerge during buyer-side financial due diligence, promptly assess their impact, notify the seller transparently, negotiate remedies, seek legal advice, conduct further investigations, if necessary, consider alternatives, document all communications and decisions, and proceed cautiously to mitigate risks and ensure a successful transaction.

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