What is Financial Due Diligence and Why It's Important for Investors?

What is Financial Due Diligence and Why It's Important for Investors?

Due diligence is a critical part of investing or an M&A transaction. It’s the process of researching a company or project to give investors the information they need to make an informed decision. Financial due diligence checks a company’s financials, accounting policies, and other factors that could affect its business and investment risk. It’s an essential part of the process, especially for sophisticated investors. It is important to understand what financial due diligence is and why it’s so important?

What is Financial Due Diligence?

Due diligence is the process of investigating a company or project to give investors the information they need to make an informed decision. In short, it’s the process of getting all the facts. Financial due diligence is the process of researching a company’s financials, accounting policies, and other factors that could affect its business and investment risk. While due diligence is necessary for all investors, it’s particularly important for sophisticated ones. These are the people who will be applying the most resources to the investment and who will have the most at stake should the investment go south. For those investors, understanding what due diligence is, why it’s important, and how to do it well is critical.

The goal of financial due diligence is to uncover any potential issues with the company’s finances and operations — and to correct them if possible. Financial due diligence is different from operational due diligence, which looks at the company’s management and how it runs its day-to-day operations.

What type of information does Financial Due Diligence check?

Financial due diligence examines the company’s balance sheet, income statement, and cash flow statement — along with any other relevant financial documents, such as securities filings and contract details. The information gathered during financial due diligence is used to evaluate a company’s financial condition and its ability to repay debts and fund future operations. It’s also used to assess the company’s risk.

Financial due diligence also uses normalization to smooth out any one off events such as sale of an asset, a bonus etc. This leads to a clearer picture from studying the trends of the business directly linked to its trading activity. Any elements that may be considered as a debt or a liability such as advanced revenue collected, lease obligations and accrued interest etc. might also be reclassified as debt. This is done as many deals and investments are done on a cashfree debt free basis.

What can Financial Due Diligence tell you about a company?

Here are some of the things financial due diligence can tell you about a company: - Where the company’s money comes from and goes — financial due diligence reveals where a company gets its money and reveals any potential issues with the company’s cash flow.

• How profitable the company is — financial due diligence shows you how much profit a company made during a specific time frame and how much it spent to make that profit.
• How much debt the company is carrying — financial due diligence shows you how much debt a company has and how it plans to repay that debt.
• The company’s growth strategy — financial due diligence explains how a company plans to increase its revenue and profits in the short and long terms.
• The company’s financial health — financial due diligence shows you a company’s debt to equity ratio, its profitability, its revenue and expenses, and how much profit it’s generated over a specific time frame.
• The company’s growth prospects — financial due diligence shows you how strong the company’s growth prospects are.
• How much working capital is needed—financial dude diligence evaluates the working capital requirements for the coming months and what condition of working capital would the project or business be taken over in by an investor.
• What are the net assets of the company—financial due diligence gives and adjusted figure of net assets after reviewing elements of the business and determining what the real net assets of the company are in the context of the deal
• Quality of earnings- financial due diligence looks into how the revenue of the business is generated by looking at multiple aspects like the breakdown of customers, geographical landscape, product mixes, revenue recognition methods and much more. This process provides an adjusted revenue or EBIDTA based on findings.

Why is Financial Due Diligence important?

The information gathered during financial due diligence can help make an informed investment decision. It can also protect from investing in a company that may overextend itself — or one that’s on the brink of bankruptcy. If a company is close to bankruptcy, it may not be able to repay when investors want to redeem their shares. In that case, an investment could end up being worthless.

Key Takeaway

Financial due diligence is an essential part of investing. It’s the process of researching a company’s financials, accounting policies, and other factors that could affect its business and investment risk. This includes examining a company’s balance sheet, income statement, and cash flow statement — along with any other relevant financial documents, such as securities filings and contract details. The information gathered during financial due diligence is used to evaluate a company’s financial condition and its ability to repay debts and fund future operations. It’s also used to assess the company’s risk.