Recognizing financial risks: Scope of financial due diligence

As part of a financial due diligence (FDD), the precise definition of the scope of the analysis and the identification of key areas of analysis are of crucial importance. The analyses of the income statement, balance sheet and cash flow have a significant influence on the transaction decision and the determination of the purchase price. The scope of an FDD is determined by the type and size of the target company/group (“target”), the availability and quality of the relevant data as well as the specific requirements and time frame of the client. The scope of the investigation is defined in the offer and can be adjusted during the process if necessary. A basic understanding of the company structure, the business model and the target's (service) offering is crucial in order to identify relevant risk areas and determine the focus of the analysis. The type of FDD is also defined in close consultation with the client (full scope, selective focus, red flag). The following explanations relate primarily to client relationships and FDD audits in the private equity sector.

Company structure, business activities and accounting
The company structure is presented and the resulting risks are identified. These include, for example, transfer pricing issues, intercompany profits or problems under company law (e.g. limited opportunities to distribute profits abroad to the parent company). Business relationships with shareholders or related parties and companies must also be queried and assessed. The company's business activities are briefly outlined with regard to its range of services and the most important facts. Of particular importance is the precise analysis and description of the accounting and controlling systems, as the results of the FDD also depend on the quality of the data provided. In addition, the analysis also serves to assess any necessary post-merger measures, such as the development of additional resources or integration into the accounting system of an existing group. Any deficiencies in the accounting system identified during the due diligence are presented transparently in this section. 

Quality of Earnings
The examination of the quality of earnings (QoE) is a central component of every FDD, through which the sustainable EBIT(DA) of the last three financial years and the last available month is determined as part of a current trading analysis. Extraordinary business transactions are identified and normalized to derive the sustainable EBIT(DA).

As part of the QoE, selected top-line analyses are included, which usually show the development of sales by business division and region. In addition, the customers with the highest sales are often evaluated to identify possible dependencies and revenue is analyzed during the year to reveal seasonal fluctuations.

Depending on the requirements profile and availability of data, further analyses can also be carried out. These include analyses of contribution margins and gross margins in order to assess the profitability of individual products or services. Analyses of price-volume structures show what the gross profit development is attributable to (price or sales-driven) and where there is potential for optimizing prices and sales volumes. Incoming orders and orders on hand during the year can also be analyzed to gain valuable insights into the target's current economic situation and demand trends. In particular, this helps to verify forecasts and validate developments in current trading. A cohort analysis allows customers to be grouped according to common characteristics such as years and products in order to analyze the behavior and development of existing and new customers during the observation period. In contrast to commercial due diligence, market and competition analyses are generally not part of financial due diligence.

Analyses of the cost of materials sometimes correlate closely with the sales analysis and corresponding contribution margin calculations. In addition, a focus is placed on identifying the largest and most important suppliers in order to identify potential single source risks.

The determination of sustainable personnel expenses shows how salaries of employees (by department, if applicable) and management have developed during the period under review. The subject of further analyses is whether salaries are paid that are not in line with the market (e.g. to related parties or shareholder-managers) or whether extraordinary staff reductions or increases were carried out. In the case of target companies in the legal form of a GmbH & Co. KG, the shareholder/managing director remuneration must be notionally included (adjusted), as the personnel expenses do not generally include this (remuneration via withdrawal).

To analyze QoE, other operating expenses are traditionally broken down into individual cost blocks in more detail and then adjusted for extraordinary business transactions. Other operating income is also analyzed in the same way. In both cases, the aim is to identify extraordinary or non-sustainable expenses or income.

Balance sheet, (trade) working capital, net debt and cash flow
As part of the analysis of the balance sheet items, the balance sheets for the respective reporting dates of the last three financial years and the last available reporting date during the year are prepared and explained. 
The overriding objective is to identify cash and debt-like items in order to determine net debt and to allocate and analyze working capital items to determine the liquidity required for operations.

For this purpose, individual balance sheet items such as other assets, provisions and liabilities are broken down in more detail and classified accordingly as working capital, cash or debt items.

As part of the working capital analysis, inventories, trade receivables and trade payables are examined in particular. Inventories are analyzed with regard to valuation and composition, while trade receivables are examined with regard to their age structure, recoverability and composition. Trade payables can provide information on the payment behavior of the target. They may also include liabilities from the procurement of fixed assets (so-called capex creditors) or extraordinary items, which may need to be deducted directly from the purchase price as debt items.

An essential component of the working capital analysis is the presentation of the development during the year and the derivation of an average level, as the pure reporting date analysis (e.g. as at the balance sheet date) can be heavily influenced by seasonal effects or accounting policies. The calculation of a working capital adjustment (difference between working capital on the reporting date and the average or sustainable level) is therefore an important part of the scope of an FDD.

As part of the determination of the target's net debt (net financial debt), all cash and debt(-like) items are compared. The analysis is relevant in order to provide the input for the equity bridge for the purchase price calculation. In addition to the pure identification of balance sheet items, a more in-depth analysis can be agreed as part of the scope. This includes, for example, the listing of contractual terms of loans (terms, interest, repayment, etc.), in-depth analysis of leasing liabilities or valuation of pension obligations (as the balance sheet presentation does not necessarily correspond to the actual obligation).

The scope of an FDD usually also includes a query of off-balance sheet obligations and the identification of other issues relevant to the purchase price. Potential risks here include cash/bank balances that are not freely available, exit bonus payments that are borne by the target (and therefore ultimately by the buyer) as part of the transaction or taxes that are triggered by the transaction (e.g. land transfer tax). Other examples include the capex backlog, one-off costs for improving accounting/controlling, but also tax assets (e.g. in the case of the KG as a target).

Analyzing the cash flow helps to assess the extent to which the company can meet its repayment obligations (or the repayment of acquisition loans following a transaction) from ongoing operations. Cash flow is therefore broken down into cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. The adjusted free cash flow is usually analyzed in addition to the reported cash flow.

Business plan
The business plan - consisting of the balance sheet, income statement and cash flow statement - is usually prepared by the target and critically scrutinized as part of financial due diligence. In particular, the underlying assumptions are checked to ensure that they are plausible. The findings from the historical analysis are used for this purpose. In addition, corresponding planning models are checked for their mathematical accuracy. As many business plans are planned depending on sales development, a close exchange with other work streams (especially commercial due diligence) is required.

Conclusion
The scope of a financial due diligence is prepared in consultation with the client and depending on the expected risks of a target.

Overriding risks can arise from the business area, the corporate structure and the organization (in particular the quality of the accounting system).  In this context, the scope must specify which analyses are to be carried out. A precisely defined scope that is adapted to the risk areas of the target enables efficient identification and assessment of any financial risks of a planned transaction.

In addition, the scope must be defined in such a way that all parameters required to evaluate the company (e.g. sustainable EBITDA, working capital adjustment, net financial debt) are covered. The specific analysis of the annual financial statements, in particular the balance sheet, income statement and cash flow statement, should enable an assessment of the sustainable earning power and serve to identify further issues relevant to the purchase price. In the event of a positive due diligence result, the findings can be used directly for further purchase price negotiations and as a decision-making aid for further steps in post-merger integration.lfe für weitere Schritte in der Post-Merger Integration herangezogen werden.

With a customized scope, due diligence can be carried out in an efficient and targeted manner and the transaction process can be accelerated. Risks are identified at an early stage and bad investments are avoided.