5 Tips for Writing a Financial Due Diligence Checklist
Author: Elliott Holland
Digging into a company’s finances before purchasing it gives you a greater chance of success
Key Takeaways
Financial due diligence is a vital part of any acquisition
Creating a checklist can help ensure you don’t overlook any aspects
The goal is to dig into the company’s finances as much as possible
Following a few tips can make the due diligence process far easier
Conducting financial due diligence is vital before acquiring a company because it helps you better understand the business’s financial performance and what’s driving its numbers. Without this process, you’d be taking the numbers at face value and could be in for a surprise in the future.
Financial due diligence involves doing an investigative analysis of an organization’s performance in the market. It helps ensure you know as much as possible about the company’s finances and projections so you can decide whether to purchase the business.
Knowing what to look for while conducting financial due diligence makes it easier to uncover potential issues. Here are five tips to follow when creating a Quality of Earnings checklist during the due diligence process.
1. Look at five years of income statements
Examining the last couple years of income statements isn’t enough, as you’ll want to analyze at least five years’ worth of documents. These statements could include 10-K, 10-Q, and proxy filings in the United States.
These income statements help make sure you’re aware of volatility across various earning periods and provide insight into areas where expenses seem irregularly high. Analyzing these statements also allows you to see if a single large client or a complete portfolio drives revenue. In turn, that provides an in-depth picture of the business’s long-term outlook.
Finally, looking at five years of statements allows you to pick out exceptional items that could significantly influence operating income. If these items only appear once in the five-year period, it’s up to you to determine if it’ll be a recurring theme or a one-off that never happens again.
2. Don’t forget the balance sheets
There’s more to a successful business than income, so you’ll also want to analyze five years of balance sheets, too. These documents include information on the company’s marketable assets, which you can liquidate if necessary. The goal is to determine if you can sell these assets for more or less than the value they carry on the balance sheet.
Your balance sheet examination will also look at assets not used in day-to-day operations, such as static properties and patents, to see if they have the potential to generate value. For example, an empty property in a bustling area could create significant income for the company even though it’s not realized on the income statements.
It’s advisable to pay close attention to the debt-equity ratio during this step, too (more on this in a moment), by comparing it to the industry at large. Ideally, the company you’re acquiring should have less debt than others in the industry.
3. Pay attention to cash statements
Five years of cash flow statements are another element worth examining as you conduct financial due diligence. Start by analyzing the bottom line, which is the cash the business generates annually after accounting for financing and other expenses.
Next, you’ll look at the quality of the company’s cash flows. Positive cash flows are ideal, but understanding why a company has positive cash flows is vital. If the business is only generating positive cash flows because it’s selling off assets, there may be a deeply rooted problem that requires attention.
You’ll also want to conduct a sensitivity analysis, which lets you know what would happen to the company if cash flows suddenly decreased. For example, if the company can’t keep up with interest payments in this scenario, it could spell trouble.
4. Check financial ratios
The business’s financial statements also provide information on its financial ratios. These ratios include operating margin, gross margin, profit margin, and interest coverage. Other elements you’ll want to look at are the current ratio, debt ratio, debt-to-equity ratio, asset turnover, return on assets, and return on equity.
Incorporating five years of financial ratios into your Quality of Earnings checklist ensures you have a broad dashboard of the business’s financial health to consult. You’ll want to compare these numbers to industry standard ratios, too, for insight into its performance.
5. Keep an eye out for fraud
As you go through an organization’s Quality of Earnings, you must watch for potential fraud. You can typically spot possible fraud in a company’s tax documents, as there are some red flags to watch for throughout the process.
Perhaps the most common fraud you’ll encounter is asset misappropriation. This scenario occurs when company employees engage in skimming or false invoicing and keep the money for themselves. Discovering this type of fraud before acquiring a business allows you to make the necessary change up front.
Another fraud type you might come across is financial statement fraud. A manager or owner is usually responsible for this crime, as it involves inflating asset values or understating liabilities. As a buyer, you could find yourself in trouble if you fail to uncover this fraud because the company might not be worth as much as you think.
Finally, your due diligence could uncover corruption. Corruption takes many forms, but red flags sometimes include payments sent to the wrong accounts and vague descriptions of services performed, which could mean specific individuals are stealing from the company. Financial due diligence provides details on potential fraud as you make your decision to acquire an organization.
Take your due diligence to the next level with help from the pros
Financial due diligence is a significant job, especially if you don’t have considerable experience with the subject. The seller could be motivated to keep as much information from you as possible, forcing you to dig deep into the numbers to uncover the truth. Fortunately, assistance is available as you look to purchase a business.
Guardian Due Diligence condenses all the financial data you’ll need into a Quality of Earnings report, providing a clear picture of a company’s finances before you buy. This simplifies the acquisition process for first-time buyers. Contact Guardian Due Diligence to set up a call or download a sample due diligence report.