FINANCIAL DUE DILIGENCE

Since the decision to purchase the business and the price to be paid for it are highly dependent upon the forecast levels of sustainable profit, financial due diligence has long been used to underpin the purchaser’s confidence in the figures being talked about. Financial due diligence tends to be historic in focus and is looking at checking underlying performance in the past as a basis for drawing conclusions about the likely achievability of the forecast future performance, together with the current position as regards assets and liabilities.

Accounts, policies, systems and management information

The basic areas that will be reviewed are the company’s procedures, systems and policies. Since a company’s results are materially affected by the accounting policies adopted, the starting point for most reviews will be the policies to ensure that they meet current generally accepted accounting practice (GAAP). The accountants will be looking to see whether policies adopted appear reasonable in respect of the business (for example depreciating assets such as computers over a sensible lifetime of say three years, calculating the value of stock in an appropriate way, providing for bad and doubtful debts and slow moving stock at appropriate levels given the company’s experience, and not anticipating profits before they are earned). In doing so, they will be looking to compare your accounting policies with those generally used in your industry.

They will view the general basis on which your accounts are prepared and how your systems operate in much the same way as will be done during a normal audit to prepare a set of audited financial accounts.

They will want to review the adequacy of the financial information produced and used by the company and you may therefore expect to be asked to produce management accounts, stock reports, aged debtor reports and so on, and to discuss how they are used in the business.

They will therefore be interested in establishing:

• Is the accounting information adequate to control the business and can the business, for example, demonstrate that it knows the gross margin on a product by product basis or the profitability and cash profile of particular contracts?
• Do management demonstrate that they use financial information when making decisions such as investment in plant and equipment or in managing the business?
• How widespread is ‘financial literacy’ within the business?
• How integrated is the finance team with operations and sales or does finance appear to operate in isolation?

Profit and loss

Having looked at the systems which produce financial information, they will want to look at detailed trading results on a business unit by business unit basis to review trends in terms of sales, growth margin and overheads to see the degree to which these vary, are seasonal, or differ from the industry average. You will need to be prepared to answer questions about this historic performance as an aid to them in understanding the basis on which future performance is being forecast and how reasonable this appears in the light of prior trading. A forecast going forwards that is broadly in line with past trading trends is going to appear much more reasonable than a forecast that suddenly shows a 50% increase in sales and a 50% increase in gross margin for the same or less level of overhead.

As has already been discussed, this process will be easier if any clutter of non-performing or non-core business has already been disposed of. The due diligence team will be looking to see:

• Are there any exceptional items or significant changes or events over the last say three years, which have had an impact on the financial performance of the company? If so what are they? Could they repeat themselves?
• Has all the income and expenditure been correctly allocated to the right year, or do the accounts give signs of having been manipulated to show a particular position or trend?
• Do the company’s contractual relationships seem to make commercial sense in that they are designed to make the company profits based on the costs of its services or products and the risks associated with the contract?

Cash generation

Looking beyond the profit and loss results over the last three years they will look to see what has been the business’s ability to generate cash over this period. A statement and source of application of funds can be used to demonstrate where the money has come from and gone to (now known as a cashflow statement). See the example in Figure 8.

• Does the company undertake regular cashflow forecasting exercises and does it actively manage its liquidity and effectively chase its debtors?

Overall review of forecasts

They will be asking themselves:

• Are the forecast results ‘reasonable’ based on past performance?
• Do the forecast cashflow, profit and loss, balance sheet, and ratios all appear to flow smoothly on from existing trading results, or are there significant changes which require explanation and substantiation?

Assets and liabilities

The current level of assets and particularly liabilities will be reviewed in detail, including:

• Land and buildings: are these incorporated at cost or at some later valuation? If so, was this a professional valuation or that of the directors?
• Plant and machinery and other fixed assets: how old is plant and machinery? What outstanding hire purchase, finance or operating leases exist? What period are assets being depreciated over (and is this appropriate)? Is the plant and machinery in good condition? How does the estimated value of plant and machinery match up to the book value? There may be need to have an independent valuation of all plant and machinery and property as part of the process.
• Investments: does the business have any interest in other businesses? If so, what is the nature of the investment and its current value?
• Debtors: what is the current pattern of aged debtors? What is the history of provision for bad and doubtful debt? Does the company have a significant level of old or disputed debts? Does the company collect in its own debts, or are they collected by a finance house under a factoring arrangement? Does the company appear to have adequate backup in terms of customer orders, copy invoices and proofs of delivery in order to be able to collect old debts?
• Stock and work in progress: what level of stock is the company holding? How does it divide between raw material stock, work in progress and finished goods stock? How many days/weeks/ months of turnover does the stockholding represent? Does any of the stock appear to be significantly slow moving or obsolete? If so, has it been provided for? On what basis has the stock been valued and does this appear reasonable in relation to the information in the company’s accounting system?
• Cash: they will need a list of all bank accounts held by the company together with the relevant balances, and will review the cashbooks and bank statements for each account over a period for evidence of other bank accounts and for any unusually large transactions that need to be investigated. They will need a file giving lists of the signatories on each account together with the copies of the facility letter, with copies of any security given in respect of borrowings, and details of any balances that have been personally guaranteed by the directors or owners.
• Having obtained an aged credit listing they will look to identify the key suppliers, to check that supplier statements have been reconciled, and investigate any unreconciled or disputed items. They will review the process for accruing for expenses where invoices have not been received, and will check the adequacy of the accrual against recent goods received notes and stock records, as well as the level of accruals being carried in respect of utilities and other such overheads.
• They will need to obtain a schedule setting out all leases and hire purchase agreements held by the company and showing the balance due and payment schedules. They will also need a list of all potential contingent liabilities from both you and your solicitors which will need to include a list of all outstanding claims and litigation, and they will need to discuss the results with you in some detail.

Obviously in many areas the team undertaking financial due diligence will liaise with the team doing legal and commercial due diligence, for example in the areas of pensions and insurance.

IT

The business’s IT systems will be reviewed (both financial and operational) to consider a variety of legal, financial and operational issues, such as:

• Is there a disaster recovery plan in place?
• Does the company have adequate backup security and antivirus protection, and is it licensed to use all its software?
• Is all of the company’s data under its own control or does it use third party supplies or outsourcing agreements?
• Does the company’s IT infrastructure adequately support the business now and into the future with information and controls or will further investment be required?

Taxation

Past tax computations will be reviewed in detail (together with correspondence with Inland Revenue) to ensure that all tax due has been properly accounted for and dealt with. Treatment of deferred tax will be reviewed and the status of the company as a group or close company will be checked.

If the company has tax losses, the effect of the proposed sale and any changes in the business’s ownership and nature of trade will need to be reviewed to see whether these losses can be carried forward and used or will be lost. As part of this review of taxation, the financial due diligence team will be looking to see whether there are any potential tax liabilities which were not otherwise apparent in the accounts.

In addition, compliance with PAYE and VAT regulations and liabilities will be reviewed in detail, checking for any disputes or correspondence with the relevant authorities, filing of returns by the required due dates and absence of any penalties, surcharges or interest.

Sample document – due diligence questionnaire

The following is an example of a standard financial due diligence checklist supplied by Howarth Corporate Finance showing the extent of information and documentation that will typically be requested from the company for sale (the target) at the outset of a due diligence process.

Use this and the legal due diligence questionnaire earlier in the chapter as your checklists in advance of any due diligence investigation that you may be subject to in order to ensure that you have everything needed to hand.