Financial Due Diligence

Financial Due Diligence: Taking the Financial Pulse of the Target Company

Financial Due Diligence (FDD) is a key component in the comprehensive examination of a company prior to its purchase or sale. It focuses on the financial condition and outlook of the target company, providing valuable insights for price determination and post-merger integration.

Objectives and Tasks of Financial Due Diligence

The overarching goal of FDD is to provide the prospective buyer with as complete and transparent a picture as possible of the target company’s financial situation and development. This involves not only presenting the current status but also delivering a well-founded assessment of future earnings and financial conditions.

Core tasks of FDD include:

• Validation of Financial Figures: The financial data presented in the annual financial statements and management reports are examined for accuracy and consistency. This also involves uncovering any "skeletons in the closet," i.e., previously undisclosed financial risks.

• Analysis of Asset, Financial, and Earnings Position: FDD scrutinizes key balance sheet ratios, from equity ratio and leverage to liquidity and working capital. The income statement is also analyzed, especially with regard to revenue trends, margins, and cost structures.

• Identification of Value Drivers and Risks: Essential value drivers of the company are derived from the financial data, such as profitable product segments or key customers. At the same time, financial risks are identified, e.g., dependencies on individual suppliers, impending bad debt losses, or liquidity bottlenecks.

• Preparation of Financial Projections: Based on historical financial data and identified value drivers and risks, financial projections for the company’s future development are prepared. These form an important basis for valuation and price negotiation.

• Identification of Synergy and Optimization Potential: FDD also examines the extent to which financial synergies can be realized through the acquisition, such as economies of scale in production and procurement or consolidation of administrative functions. Additionally, opportunities for process and system optimizations in the finance area are highlighted.

The findings from FDD feed into the overall valuation of the target company and the structuring of the transaction. They provide a fact-based foundation for negotiating purchase price and contract terms (e.g., warranties and indemnities).

Areas and Methods of Financial Due Diligence

Financial Due Diligence typically covers the following areas:

• Accounting and Controlling: The propriety and reliability of bookkeeping, annual financial statements, and internal reporting are examined. The appropriateness of applied accounting and valuation methods is also scrutinized.

• Financing Structure and Instruments: FDD analyzes existing financing sources and conditions, ranging from bank loans and leasing to factoring and equity capital. This includes assessing financing risks and flexibility.

• Assets and Investments: The existence and valuation of fixed and current assets are reviewed, as well as the investment plan and maintenance policy. The goal is to identify necessary replacement and expansion investments as well as any need for write-downs.

• Earnings and Cost Situation: FDD analyzes the composition and development of revenues, costs, and margins. Key earnings drivers and burdens are identified, including benchmarking within the industry.

• Liquidity Planning and Cash Flow: Cash flow statements, liquidity planning, and working capital management are examined. The aim is to identify any liquidity gaps and potential improvements in cash management.

FDD procedures include both document analysis (e.g., financial statements, bookings, contracts, financial projections) and interviews with management and responsible specialists of the target company. Analytical audit techniques such as time series, variance, and benchmark analyses are also applied.

Process and Participants in Financial Due Diligence

Financial Due Diligence is usually conducted by external experts, typically auditors and M&A consultants. The process generally follows these phases:

1. Preparation and Planning: Defining the scope, timeline, and reporting format of the FDD, assembling the audit team, preparing data rooms, and compiling document request lists.

2. Data Collection and Analysis: Reviewing and evaluating the provided documents, preparing data for analysis, identifying audit focus areas and additional information needs.

3. Interviews and On-Site Audits: Conducting interviews with management, controlling, and accounting of the target company, auditing selected matters on-site, and coordinating and validating the findings.

4. Reporting and Presentation: Preparing a written FDD report with key findings, risks, and recommendations, followed by presentation and discussion of results with the client.

The entire FDD process typically takes several weeks to months, depending on the size and complexity of the target company and the scope of the transaction.

Close coordination and collaboration between the FDD auditors and other advisors involved in the transaction (e.g., lawyers, tax experts, strategists) is essential to ensure a consistent overall picture and avoid duplication of efforts.

Challenges and Success Factors

Conducting Financial Due Diligence often involves specific challenges:

• The financial data and documents provided are frequently incomplete, inconsistent, or opaque. Obtaining and validating them requires considerable detective work and persistence.

• Especially in owner-managed mid-sized companies, modern systems and processes in finance are often lacking. Auditors must then sift through mountains of Excel spreadsheets and paper documents.

• The quality of forward-looking financial information (projections, budgets) is often limited. Reviewing and adjusting these requires extensive experience and industry know-how.

• FDD often encounters resistance and blockades from the target company’s management, whether due to fear of transparency or overload of daily business. Diplomatic skill and persuasion are required here.

To overcome these challenges and ensure effective FDD, the following success factors are particularly important:

• Competence and Experience of the FDD Team: Auditors should have broad and deep expertise in accounting, controlling, and corporate finance, combined with industry and transaction know-how.

• Clearly Defined Audit Approach and Efficient Tools: A structured and proven audit approach, supported by powerful analysis and reporting tools, helps accelerate and professionalize the FDD process.

• Close Communication with Management and Seller: Regular and trustful exchange with responsible parties on the seller’s side facilitates access to information and contacts and helps avoid misunderstandings.

• Materiality and Risk Orientation: FDD must focus on purchase price-relevant aspects and avoid getting lost in details. A risk-oriented audit planning and execution helps optimize the use of limited resources.

• Clear and Action-Oriented Reporting: FDD results must be presented in a way that is understandable and decision-relevant for the client. In addition to identifying deficiencies, concrete recommendations for action should always be provided.

A professionally conducted Financial Due Diligence is an indispensable building block for a successful company acquisition. It creates transparency about the financial condition and outlook of the target company and provides valuable arguments for purchase price negotiation and contract drafting.

For the buyer, FDD is an investment that always pays off. It significantly helps to avoid unpleasant financial surprises after closing, identify synergy potentials, and prepare the integration process effectively.

A detailed step-by-step guide to conducting due diligence can be found in the article "Step-by-Step Guide to Conducting Due Diligence".