Conducting financial due diligence is one of the most important activities in the business world. It helps business owners gain a better understanding of their own company or another company that they may be interested in acquiring. Thorough due diligence can help a business owner identify potential opportunities, mitigate risks, and make more informed decisions.
What is Due Diligence?
Due diligence is the assessment of a business’s financial health by examining its financial statements and other documents. The main goal of this process is to see if a company has been profitable in the past and forecast if it will continue to be profitable in the future. Due diligence requires examining the company’s financial statements under a microscope to ensure that all the information is accurate and up-to-date.
Due to the complicated nature of due diligence, it is often advisable to bring on a financial professional to assist with the process. A financial professional can help you understand exactly which financial statements to obtain while addressing potential red flags, inconsistencies, or areas of concern.
When to Perform Due Diligence
Due diligence is most commonly associated with mergers or acquisitions. During a merger or acquisition, the acquiring company conducts due diligence to determine whether it wants to buy the other and how much it is willing to pay. Conducting due diligence during deals like these can help mitigate risks, ensure transparency, and facilitate informed decision-making.
However, due diligence is not reserved for M&A activities. Since due diligence is essentially an audit, you can use it at any time to ensure that your company is financially healthy.
Conducting Due Diligence
To conduct due diligence, you must have access to all of the company’s financial documents. Allowing you to assess things like:
- The company’s historical performance
- Future forecasts of profitability
- Cash flow analysis
- Debt obligations
- Tax compliance
- Legal documentation.
Once you have obtained these documents, experts at Toptal recommend focusing on three key metrics:
- Quality of Earnings: This metric determines whether a revenue stream or expense is from a core principal activity or is just a one-time event. Understanding the difference between these two can help you determine whether a company is highly profitable or just had a good quarter/year.
- Net Debt: This metric determines how well a company can pay all of its debts if they were due immediately. You can calculate it by subtracting a company’s total cash and cash equivalents from its total short-term and long-term debt. Many business owners use this metric to determine a company’s liquidity. If a company isn’t very liquid, it’s at risk of going under if the economy turns south.
- Net Working Capital (NWC): This metric allows you to gauge the short-term health of a company. Net Working Capital is the difference between a company’s current assets (cash, accounts receivable, and inventories) and liabilities (debt, accounts payable). By understanding a company’s assets compared to its liabilities, you can get a sense of whether or not it’s overleveraged.
That said, there are plenty of financial metrics and ratios that you can examine when conducting due diligence. As a general rule of thumb, the more data you have, the better your decision-making will be. However, most modern companies are overflowing with data. To make sense of everything, it’s often best to engage the assistance of financial professionals like accountants, auditors, legal counsel, and financial consultants.
These experts can provide expertise on standard procedures when conducting due diligence, have industry knowledge to help them benchmark, and typically have a detailed understanding of regulatory compliance.
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