In my article on the need for a due diligence, I touched upon the fact that while a client can rely heavily on the preparedness and know-how of the experts involved in a financial due diligence, it is still up to the client to define the scope of work.
I would like to help future clients that have less experience in this area by summarising the activities that are worthwhile carrying out in the course of a financial due diligence.
I analyse four areas in some detail in this article, and will continue with other important areas in subsequent articles of this series.
Assessment of general financial position
During a financial due diligence it is important to be aware of the target company’s history. If we subject the financial statements to a detailed analysis, there is a significant chance we will notice if the seller has massaged its figures to try and make the situation seem better than it actually is. The further we delve back into the past, the easier it becomes to identify trends and cleanse the overall picture of non-recurring effects.
It is also important for us to understand the current financing structure. If we can perhaps provide financing under better terms, then we can take the advantages of this into account during the pricing.
Of course, we also need to know if the current financer will withdraw its financial resources because it does not want to continue supporting the company following a change of owner for example; will we be able to replace the current funding immediately?
Future plans
If the financial due diligence devoted sufficient attention to analysing historical data, we can also easily detect if the future plans are based on financial optimism rather than plain realities. There could be real potential for significant growth or a leap in profits at the target company, and it is not a bad idea if we find tangible indications of this in other ways. If planned incomes rise without any rational explanation, or if planned costs fall in the same manner, we should have no qualms in questioning the reliability of the plans and prepare our own version instead.
Tax returns
During a financial due diligence, reconciling general ledger data with tax returns does not create much added value per se. This is when the person conducting the due diligence can gain assurance that the filed tax returns of the target company were properly accounted for and included in the financial statements. Mistakes can be made here too, but the real problem comes if the target company did not declare tax, or did not declare as much as it should have done.
This is why those carrying out the tax due diligence must be aware of the target company’s operations, they must be able to judge which tax types apply to the company, and assess on this basis if the amount of a tax falls significantly short of the level expected given the company’s size and activity.
Related-party transactions
Related-party transactions can have adverse impacts on the target company not just from a taxation perspective. For instance, if the target company bought a service or product for too much money, or sold something too cheaply, and then failed to make the necessary adjustments when assessing its tax base. The target company may also have received a product or service from a related partner at a favourable price (below market price) and under favourable conditions, which very probably had a benign impact on its ability to generate income. If these sources dry up in the future, and the company can only procure these under normal market conditions after the change in owner, this could result in a significant revision of future plans and return calculations.
RELATED ARTICLES:
Key areas of a financial due diligence – Part 2
