5 Vital Steps in the Financial Due Diligence Process
Learning these steps ensures you have a clear understanding of a company's financial picture before you buy
Key Takeaways
Financial due diligence requires multiple steps
Learning about the most important steps can aid your decision
These steps are vital in helping you make a sound choice
A Quality of Earnings report covers most of these critical aspects
Due diligence is a broad term you may hear in various settings. When buying a business, due diligence typically applies to the financial side of things, as you'll want to be sure you know about the company's finances, assets, and debts before investing your money.
The due diligence process takes some time because it involves digging into multiple aspects of a business and understanding its financial health. This data makes it easier to decide on your next move and helps you determine if the asking price is acceptable.
You don't have to conduct this due diligence alone because resources are available, but learning the stages of the process can help. Here's a look at the five steps you'll need to follow as part of the financial due diligence process.
1. Examine financial trends
The first step in the due diligence process is gaining insight into the company's revenue, profit, and margin. You'll have to look at organizational income statements to gather this information while comparing revenue and operational expenses to determine how much money the business is making.
A business's profit margin is calculated by dividing net income by revenue. You'll want to examine multiple years of profit margin to determine if the company is consistently making money or if the owner is looking to sell because the business suddenly became profitable after several less prosperous years.
The goal is to determine the organization's long-term outlook by looking at how it has performed in the past and where it's trending. This information makes it easier to make an informed decision when buying a company.
2. Complete an industry and competitor analysis
Next, your financial due diligence should evaluate the industry as a whole and analyze the company's competitors. It's more challenging to turn consistent profits if the industry is in a downturn or you have too much competition in your market. Entering a market with several established options can also be problematic, especially if the industry isn't booming.
This step often involves comparing your profit margin against that of your competitors. Learning as much as possible about your competitors also helps shape your business plan. You'll have to identify portions of the market these competitors aren't covering to take this company to the next level if you choose to acquire it.
3. Investigate the price-to-earnings ratio
Learning about ratios can help you assess the organization you're analyzing. A price-to-earnings ratio (also called a P/E ratio) calculates if the asking price is fair based on how much profit you can expect to earn compared to the cost of buying the business.
The ratio you're comfortable with depends on the business. A higher price-to-earnings ratio could be acceptable in a high-growth industry because you can likely expect significant development in the coming years. When buying a company in a more predictable field, you might look for a lower P/E ratio.
This calculation involves dividing the asking price by the company's annual profits. So, let’s say the owner sells the business for $2 million and it makes $250,000 per year. In that case, the P/E ratio is 8.0. You'll have to determine the P/E ratio you're comfortable with before taking the next step in the process. Searching for common price-to-earnings ratios in your industry can point you in the right direction.
4. Look at the balance sheet
The company's balance sheet contains information on its assets and liabilities, which are worth digging into before buying a business. This sheet will also mention the organization's cash on hand.
You'll want to pay particular attention to the business's debt and how it compares to competitors in the field. Debt isn't always negative, as it can drive growth for some companies, but you'll want to examine the sources of this debt. For example, a low-interest loan from a reputable financial institution is usually nothing to worry about, but paying significant amounts of interest monthly and barely breaking even is a concern.
It's also a good idea to analyze the company's debt-to-equity ratio. The more money the business is generating, the better it will typically be as an investment. However, a company drowning in debt and not making much money will be more challenging to turn profitable.
5. Consider the risks
Buying a business is never without risk, but you'll need to identify the industry-wide and company-specific risks that will help you make your decision. Aspects like unresolved regulatory issues, poor management, or legal problems could create an additional risk that might take you out of your comfort zone.
It's also advisable to look at the worst-case scenario and how it could influence your operations. Can you survive if your next product fails? What happens if your main competitor develops a top-rated product? Will rising interest rates sink you?
Answering these questions and determining how you'll handle any issues that arise is a vital part of the due diligence process. Remember that past performance doesn't offer any guarantees, as there's no telling what could happen in the future. All you can do is try your best to weather any storms that arise along the way.
Be more prepared with expert due diligence assistance
Other financial due diligence steps, such as examining the company's market capitalization, researching who owns stock in the organization, and looking for stock dilution, typically don't apply when buying a small business because it probably isn't publicly traded. You might see these terms, but you usually don't have to worry about them. The process can be complex in any event, however, but fortunately, purchasing a due diligence report on a specific business is possible, removing all the guesswork.
Guardian Due Diligence offers Quality of Earnings reports that help self-funded buyers gain as much financial information as possible on a company before purchase. We can assist with your due diligence, ensuring you know what you're getting into before you buy. Contact us to learn more or to download a free due diligence report sample.