What is due diligence

In our earlier article, mergers and acquisitions (M&A) typically involves five distinguish stages of preparation, matching, bid & offer, due diligence and completion.

One of the most important process in a deal transaction is due diligence which is a comprehensive evaluation of a business undertaken by a prospective buyer to establish the accuracy of the target’s financials, obligations and evaluate its commercial potential. This stage is when the buyer confirms that what they are buying as per the representation by the seller and falls within their risk appetite without any major surprises.

The due diligence can be broken down into four key areas being:

1. Financial due diligence
2. Tax due diligence
3. Legal due diligence
4. Commercial due diligence

Many M&A activities and litigation cases have emphasized on the need to conduct a thorough due diligence to identify any red flags in a potential target. This is especially true in private company acquisitions as the seller has not been subject to the scrutiny of the public markets.

Financial due diligence

Financial due diligence is one of the key due diligence areas as the financial information forms the integral and major part of the M&A deal transaction, including influencing the price to pay for the M&A deal. With financial due diligence, the buyer can anticipate issues that might arise and identify risk areas relating to the target company. It can also prepare the seller to negotiate mitigation measures through sales and purchase terms and pricing.

Below are some of the common points of interest when conducting a financial due diligence:

Revenue

When we begin looking at the financial numbers of a company, we always search for the revenue size of the company. Revenue typically reflects the size of a company and the market size of the industry that it has captured.

Topics of inquiry or concern will include the following:

• What is the source of the revenue and how it was derived? Rationale: Understanding of the business model
• Who is the major customer? Corporate or individuals? Local or overseas? Recurring or one-off? Rationale: Customer concentration risk
• Any contractual-based revenue? Rationale: Revenue stability
• What is the revenue trend for the past 3 years? What contributes to the upward or downward trend? Rationale: Revenue growth

Cost of sales

The cost of sales affects the gross profit margin of the company and represents how much a company pays in order to generate the revenue.

Topics of inquiry or concern will include the following:

• Who is the major supplier? Do you have constant and stable supply of materials? Rationale: Supplier concentration risk
• What is the cost to generate revenue other than purchases? Rationale: Cost of sales breakdowns
• What is the gross profit margin trend for the past 3 years? Is the margin reasonable for the industry? Rationale: Gross profit margin growth and stability

Other income and expenses

Other income generally gives the idea of the company’s side source of income besides its main principal activity such as rental income and interest received.

Expenses are recurring fixed costs that are essential to keep the business running although not directly related to revenue generation. For example, staff cost, marketing and distribution cost.

Topics of inquiry or concern will include the following:

• Are the transactions recurring or one-off? Rationale: Potential adjustments to valuation as the transactions only arose during certain circumstances
• (Other income) Is the company relying heavily on other income rather than its main business? Rationale: Profitability based on core business
• (Expenses) Any unusual transactions which does not relates to business activities? For example, overseas travelling, penalties and legal cases. Rationale: Risks and contingent liabilities arising from unusual transactions
• (Expenses) How much is the staff cost? What is the revenue contribution of total staff cost? How many staff is in the company? Rationale: Efficiency and reasonableness of staff remuneration

Assets

Typically, by evaluating the assets of the company, we can check if the company is asset rich (relies heavily on its fixed assets to generate revenue such as manufacturing and logistics) or asset light (has fewer fixed assets and focus on intellectual technology and services).

Topics of inquiry or concern will include the following:

• What are the fixed assets of the company? Are they used for business operation? Rationale: Existence of fixed assets
• Who are the main receivables? Are the trade and non-trade receivables collectible within the payment terms given to them? Rationale: Recoverability and collection control
• Is the amount of inventory accurate? When is the last time a stock count was conducted? Rationale: Inventory control
• How much is the liquid cash in the company? Rationale: Cash flow management
• Is there any amount owing by related parties? Rationale: Related party transactions risk

Liabilities

Reviewing the liabilities gives the buyer the indication how much debts have to be paid in short term (less than a year) and in long term (more than a year).

Topics of inquiry or concern will include the following:

• Who are the main trade and non-trade payables? Is the amount accurately recorded? Rationale: Payment control
• Are there any banking facilities maintained by the company? Are there any collaterals? Rationale: Summary and status of banking facilities
• How much is the short and long term debts? Rationale: Ability to meet debt obligations
• Is there any amount owing to related parties? Rationale: Related party transactions risk
• Is there possibility of contingent liabilities and off-balance sheet obligations? Rationale: Risk of possible liabilities post acquisition

Timeline

A financial due diligence generally takes 4 weeks to 3 months, depending on the complexity of the work, the readiness of the documents and the cooperation of the seller.

All in all, these are the crucial key areas of concerns for a financial due diligence exercise. On top of that, financial due diligence can also give rise to certain indications outside of the financial statements, such as:

• Competency of the finance team
• Effectiveness of the fixed assets injected
• Strength of the financial data and underlying systems
• Potential synergies of the proposed M&A
• Trustworthiness of the seller
• Potential valuation/pricing adjustments

Thinking of acquiring or investing in other companies?

A thorough financial due diligence consumes time, effort and expertise. We always believe that business owners should focus on building value of the company rather than being bogged down with this meticulous exercise.

Leave the hassle to our experienced corporate advisory department. We can assist you in your financial due diligence and help ensure the smoothness of your M&A exercise.

Reach out to us for more information!

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