What is financial due diligence? 

Financial due diligence is usually conducted prior to a transaction event such as the acquisition or disposal of a business or in order to support a business re-financing. The purpose of financial due diligence is to assist in understanding the underlying financial position and performance of a business and enable them to understand the risks associated with a potential transaction. It is often used to test and challenge the assumptions that have been made in formulating a valuation of a business that are set out in an offer letter or term sheet.  

The objective of financial due diligence is to assess the risks in a potential transaction and might then extend to how those risks might be managed, mitigated or avoided. Financial due diligence is a process of investigation and analysis of a business usually including analysis of the profit and loss account, balance sheet and cash flows. Financial due diligence might also extend to an assessment of financial projections.  

Work will often extend to considering areas relevant to the offer letter and completion mechanics including the concepts of normalised working capital and pricing adjustments often achieved through the definition of debt. 

What is the purpose of due diligence? 

Due diligence is usually undertaken to mitigate risk. The parties involved will look perform a financial due diligence report to ensure that they are aware of all the details of a transaction before they agree to it. The specifics of the deal always determine the scope of financial due diligence. However, the process typically includes:  

  • An in-depth analysis of underlying historical performance, working capital and cash flows, assets and liabilities 
  • An assessment of the quality of underlying earnings  
  • An identification of items to consider from a pricing perspective  
  • An analysis of the taxation position of the business 

In certain circumstances and jurisdictions, we may also perform a critique of management’s forecasts, including the working capital requirements of the business.  

Where appropriate, our reports will include a summary of the key issues that have been identified by our work and our views on the associated risks and implications for the deal, including integration and other post-deal issues. 

What are the types of due diligence? 

Due diligence can take many different forms depending on what is required. The scope and extent of a due diligence exercise will depend on the nature and size of a potential transaction. However due diligence often comprises of: 

  • Financial due diligence 
  • Legal due diligence 
  • Commercial due diligence 
  • IT / Cyber due diligence 
  • Tax due diligence 
  • Environmental due diligence 

What is a due diligence checklist? 

Checklists will be used in due diligence when analysing a company. Any checklist will include specific matters that need to be addressed and considered to ensure the following are considered: 

Financial performance and underlying trends in financial performance 

  • Quality of earnings 
  • Quality of assets 
  • Working capital and net debt  
  • Debt-like items 
  • Unrecorded liabilities 

What are Enterprise Value and Equity Value? 

The value of a business on a debt free, cash free basis is also known as the Enterprise Value and ensures that the business is valued independently of its capital structure. After the appropriate adjustments for net debt (or net cash) and working capital, the amount the vendor actually receives represents the Equity Value. 

What is a ‘Cash free, debt-free deal’? 

Most private M&A transactions are undertaken on a debt free, cash free basis. 

This means that the final agreed purchase price is the value of the business plus any cash and less any debt and debt-like items at the date of completion.  

What are debt-like items? 

Liabilities at completion (on or off-balance sheet), in addition to financial debt, will be not be funded by working capital. Whilst not technically financial debt, these items will require funding post-completion and represent, in a practical sense, debt or a liability to the new owner. 

Debt-like items can include income tax liabilities, bonus accruals, customer deposits, transaction fees, stretched creditor balances, irrecoverable debtor balances; cash backed deferred revenue etc. 

What are completion accounts? 

Completion accounts are financial accounts prepared at the completion date of a transaction that enable the purchase price to be calculated. The purchase price is adjusted on a dollar-for-dollar basis of actual working capital and net debt at completion. The completion adjustment is effectively a true-up of the consideration at completion to arrive at the agreed purchase price of the business on a debt free, cash free basis. 

It is critical that the sale and purchase agreement is carefully drafted so that each party has a clear understanding of the basis of preparation of the completion accounts and the definition of each component of debt and working capital. 

What is a locked box? 

A locked box transaction uses the historical accounts of the target at a point in time prior to completion as the reference point to calculate the equity value. 

Net debt and working capital items are defined with reference to the historical balance sheet and any resultant adjustment to the purchase price are “set in stone”. This position is then “locked” which effectively means that all economic benefits of the business are for the benefit of the purchaser from the date of the locked box balance sheet. 

For the box to be locked no “leakage” can occur (except for leakage that is expressly agreed, such as a pre-completion dividend). On the completion date, the purchase price is paid by the purchaser to the vendor inclusive of the agreed net debt and working capital adjustment. Other than warranty or indemnity claims, no further adjustment is made to the purchase price. 

Whilst the mechanisms set out above have different advantages and disadvantages, the concept remains the same and a large portion of the purchase price may depend on the final definitions of cash, debt, debt-like items and working capital. 

There are no commonly accepted definitions of these terms and the letter of offer rarely addresses these complexities. Definitions in the sale and purchase agreement will determine the final purchase price and it is this agreement that will be relied upon to resolve any post-completion disputes. 

There can be strong arguments from both the purchaser and vendor as to whether an item represents working capital or is a debt-like or cash like item. The earlier these matters are identified and discussed, the smoother the deal is likely to be. Alternatively, if the issues are deal-breakers, early identification will limit the time, effort and cost incurred on a failed transaction. 

What is normal or working capital? 

Working capital, broadly defined, is the amount of operational assets a business requires to run its day-to-day operations (current assets minus current liabilities). The FDD process, will calculate the normal level of working capital which excludes any non-standard working capital items (such as capital expenditure creditors, stretching of payment terms etc). This normal level will then produce a target working capital at completion.