Michael’s M&A Playbook: 5 Tips for A Successful Financial Due Diligence
Financial due diligence is one element of the overall due diligence during an M&A process. The main focus is on the facets of the accounting approach (i.e., accounting standards and policies), cash management (treasury), and the financial performance of the company. The tax due diligence is a separate topic. The financial due diligence is only one tool in a toolset because you need to combine it with the analysis of the business model, market position, go-to-market strategy, development of products and services, operational delivery and customer service, and other administrative processes of the company. Here are some tips to help you in your next M&A deal.
Tips to Make the Financial Due Diligence Process Work
Use an external accounting firm - I have seen, especially with smaller companies, that they want to perform the financial due diligence by themselves. I strongly recommend using an accounting firm because a due diligence is very different from the regular financial analysis of your business. The finance topics can be complex, and you can get easily lost in all the details in a data room. For example, if you are in an international M&A transaction, the accounting topics with different local standards can become complicated without external advisors. When you hire an accounting firm, include a quality of earnings (QoE) report in the scope. A QoE analysis normalizes the reported numbers, i.e., excludes one-time effects and includes topics that should be there but are not included (e.g., stand-alone costs in a company where the parent company provides services). External accounting firms will also summarize their findings in a financial due diligence report.
Understand first the business model, then the numbers - One of my fundamental rules in the pre-closing period of an M&A transaction is to understand first how the target company makes or loses money. Don’t just follow financial due diligence checklists. What is the unique selling proposition (USP), the go-to-market approach, and the operational implementation? Include those topics in your financial due diligence questions. Only after a good understanding of the business model do you know what to focus on in the financial performance analysis. I have seen due diligence teams jumping on the numbers in the data room without understanding the basics of the business of the target company, and it has resulted in a focus on the wrong details. If the target company is in the same industry, use your key performance indicators in the analysis. For target companies in other industries, use market benchmarks and industry-specific performance indicators. Accounting firms and investment banks/advisors can help you to get this information.
Focus first on the cash flow, then the income statement and balance sheet - Cash is king; that's an old and essential rule in finance management. I always try first to analyze the cash flow statement to see where the money comes in and for what the target company uses it. As a second step, I focus on how this shows up in the income statement and the balance sheet. Remember one basic rule: The difference in cash flow and income statement is (over the long run) only timing. It's easy to see this in a project analysis; it's more complicated when you analyze this for a company. However, when you see significant differences between the operational cash flows and EBITDA over many years, start digging. It's a red flag.
Think what is missing in the numbers - This is a lesson learned from my M&A transactions. Everyone starts with the analysis of the data that is available. However, you also need to think about what should be there but is not. For example, I have seen target companies excluding some costs from their management reporting but don't mention it in their notes. Some of those adjustments were significant. Understanding the target's business model will help you with this aspect of the analysis.
Don’t assume compliance with accounting rules - It may sound simple, but ensure that the target company complies with accounting rules. I have been in transactions where smaller target companies didn’t pass audits because of significant issues in the accounting policies and procedures. You would think that this is different for big companies, but it isn’t. I have seen international companies that have been part of big groups struggling with accounting audits. Analyze in detail audit reports and findings. If possible, talk with the auditors of the target company. Sometimes, you need to restructure accounting after the purchase. In such a case, include those restructuring costs in the business case.
Don't Solve Everything by Yourself
The financial due diligence process can be complicated because it includes many different aspects. When you work on an international M&A transaction, the local accounting standards make the analysis complicated. I always found that combining your best internal employees with external experts is the best approach to make it work. When you finalize your financial due diligence report, include both the internal and external findings and assessments.
Feel free to contact me to discuss specific mergers and acquisitions examples.
