When an investor plans to merge his business with yours or wishes to acquire your business, he will use audited financial records and statements as a basis. However, making an investment based on an audited financial report of a firm may sometimes prove to be a blunder for the investor.
Why Due diligence
An audited financial report does not throw light on some crucial business matters related to finance, IT, legal, operations, and marketing. Financial due diligence furnishes these missing details about your business to potential investors. It provides information about your business’s revenues over some time, trends in sales and operating costs, need for working capital over a specific time, period, management forecast process, and firm’s information systems.
Focus area of Financial Due diligence
Here are some focus areas of financial due diligence, which gives it an edge over financial audit for an investor.
- Sustainable earnings
An investor wants an unbiased and accurate valuation of the firm. Business valuation is mostly on EBI TDA where
EBI = earnings before interest
T = taxes,
D = depreciation
A = Amortization.
Sustainable earning indicates a company’s firm policy and operational measures. It depends upon the pattern of irregular in-flows and out-flows of cash, the way the firm states its assets and liabilities, changes in its post-closing cost structure, and the way it applies principles of accounting. A financial audit report fails to reflect these.
- Analysis of trends
A financial audit uses tools to analyze and explain different patterns in business activities like profit, loss, debt, etc. but fails to elaborate on the market variables which control these trends. One of the major thrust areas of financial due diligence is examination and understanding essential market drivers, customer relationships, sales policy, and efficiency of the operations.
- Working capital
At the time of mergers or acquisitions, an amount of working capital is fixed and delivered to close the deal. This amount is negotiable and depends on the last year’s average working capital. Due diligence considers aspects like the recent trend in business growth, condition of the industry, the operational time of the business (seasonal or annual), and the working capital balances. An audit report does not suggest any of these aspects.
Audits reports generally take into account the financial statements of previous years. It does not indicate a firm’s strength and strength to sustain and increase earnings over time. For such a forecast, company management uses some fundamental assumptions. Financial due diligence analyzes these forecasts and takes into account these key assumptions to help the investor.
Some Qualitative observations
Financial due diligence provides critical qualitative views to investors after an in-depth discussion with the company management. It includes the structure of internal control, the details of the management and accounting team, and system of accounting information.
Both audit and due diligence are essential for a business, but the latter provides more details to the investor at the time of merger or acquisition, and hence, it is better than the former.