Financial Due Diligence

A Brief Explanation Of Financial Due Diligence

The term Financial Due Diligence first came in to being as a defensive measure equity brokers could turn to if accused of inadequate disclosure of information to investors. The defense the brokers could turn to was proof that they had exercised due diligence in examining the finances of the company or companies whose equities they were selling.

Financial due diligence has since come to mean the conducting of an exercise with the objective of finding out all relevant financial information regarding a company or business one may be considering purchasing. Financial due diligence can involve going down a lengthy checklist, figuratively leaving no stone unturned, in uncovering not only the past financial activities of the business in question, but the current status, and any proposed future actions as well. By exercising financial due diligence, the buyer not only is in a better position to make an assessment as to whether a deal is to be closed or not, but is given some protection from lawsuits in the future should it be determined that some of the information provided buy the seller turned out to be false, and the buyer, having practiced financial due diligence, could not be found at fault.

What are some of the items one might include in a financial due diligence checklist?  As mentioned previously, the list could be very long, but here are some good examples of the information one might attempt to gather.

Typical Financial Due Diligence Information - Financial information from recent years. In most cases annual and quarterly reports for the past three to five years would be asked for. If any such reports were not readily accessible or were lacking in detail, red flags should immediately go up. These reports would include as a minimum, planned versus actual results, a breakdown in sales and gross profits, current inventory or backlogs, and accounts receivable.

Financial projections should be on the list. Usually a company or business should be expected to have financial projections documented for at least one year and preferably three. Numbers for periods longer than three years tend to become less meaningful but still can be of some value. Any lack of documented financial projections would be another red flag warning.

Financial due diligence documentation normally takes in to account a business's capital structure, including the number of shares outstanding if publicly traded, along with an identification of the shareholders. Any outstanding warrants, notes, or stock options need to be provided. All debts, liabilities, as well as lines of credit need to be made available. Tax information is of course all-important, not only regarding what taxes have been paid but clear indications of those tax liabilities planned for or anticipated.

The list includes agreements, past and pending, it includes the record the financial holdings of company by company officers, it includes minutes of Board of Directors' meetings, as well as documents pertaining to decisions made by the Board. Insurance polices, both covering the company and the company's employees have to be made known, as well as any contracts made with employees, other companies, or other entities. A list of property held by the company, including intellectual properties and copyrights or patents is almost always required information.

Summary - The list can go on and on, and anything relating to a company's financial situation is fair game as far as a requirement for information is concerned. As should be apparent, a financial due diligence document is not an executive summary, though there my be one appended to the information documented, nor is it really a summary of any kind. A financial due diligence document is a detailed statement of facts, and financial due diligence, as an activity, is nothing short of a full scale, in-depth investigation, be it of a company or of a specific transaction.