Exploring financial due diligence: Key stages, financial red flags + checklist
Mergers and acquisition (M&A) deals typically involve expectations of growth and synergy. But what if the promised financial performance has actually been inflated by misleading accounting?
Take Hewlett-Packard’s financial loss after its acquisition of Autonomy in 2011. In 2012 it took a $8.8bn write-down ($5bn of which was linked to accounting improprieties at Autonomy), almost as much as the $10bn deal itself and effectively wiped out the former’s profits for the quarter.
To avoid a similar fate, buyers should perform rigorous financial due diligence. It can be the buyer’s most powerful tool for revealing the acquisition’s hidden risks. This article explores the main stages of financial due diligence, the most impactful financial red flags, and effective ways to address financial concerns.
What is financial due diligence?
Financial due diligence (FDD) examines a company’s financial aspects, typically as part of M&A transactions and negotiations with potential investors. It goes beyond verifying financial statements, delving into a company’s future potential, sustainability, cost structure, hidden risks, and overall financial health. This process differentiates FDD from a formal financial audit, which verifies the accuracy of financial statements.
However, a financial audit can be part of the broader financial due diligence process being conducted by either the buyer or seller. When conducted by the buyer to evaluate the target company, it’s called buy-side financial due diligence. When performed by the seller to prepare the company for the sale, it’s called sell-side financial due diligence.
Why is financial due diligence critical?
Financial due diligence is critical for informed investment decisions. A lack of financial investigation may lead to unmet expectations. A notable example is Caterpillar’s acquisition of ERA, which included ERA’s subsidiary Siwei.
One year after the acquisition, Caterpillar’s internal investigation revealed multi-year accounting misconduct at Siwei, which led to a non-cash goodwill impairment charge of approximately $580 million.
The four key stages of financial due diligence for buyers
The financial due diligence process can take several weeks or months, depending on the target’s complexity, and involves several stages:
Preparation
During the preparation stage, an acquiring company usually conducts preliminary due diligence — collecting publicly available data on a target company without approaching it directly. The acquiring company defines the extent of the necessary in-depth due diligence, estimates the purchase price, and prepares a financial due diligence checklist.
Research
The research phase usually begins when both parties sign a confidentiality agreement. The buyer’s due diligence team collects detailed financial information from the target company, including its financial statements, historical financial records, and asset lists, to understand its fair market value and mitigate financial risks.
Verification
During the verification phase, the acquiring company confirms the target company’s financial information, including balance sheets, historical records, and annual reports. As part of the financial due diligence process, an acquiring company may have the target’s financial statements audited for accuracy and compliance, often with the help of a dedicated accounting firm. The acquiring company usually conducts further analysis of the target’s audited financial statements to spot any discrepancies and irregularities.
Assessment
During the assessment phase, the acquiring company analyzes the due diligence findings and deepens its understanding of the target’s financial health and any financial implications of the transaction process. The buyer may renegotiate the deal price to account for any issues that have arisen.
Financial due diligence checklist
The financial due diligence checklist usually covers financial statements, taxes, earnings quality, capital structures, financial reporting, and financial risks involved in the transaction. Here is an example of an FDD checklist. Please note that the quantity of checklist items should be adjusted to match the specific transaction.
| FDD category | Checklist item |
| Audited financial statements | Balance sheets Income statements Cash flow statements Classification of assets and liabilities Accounts receivable and accounts payable Off-balance sheet items Operating expenses Retained earnings |
| Taxes | Tax returns Tax filings Tax credits and carryforwards Tax liabilities |
| Earnings quality | Earnings before interest, taxes, depreciation, and amortization (EBITDA) Gross margin Net profit margin Revenue growth rate Key business drivers Free cash flows Earnings per share (EPS) Cash flow reports and forecasts Financial ratios Working capital |
| Capital structure | Equity ownership structure Share issuance Securities Debt covenants Debt repayment schedules Interest rates History of dividend payments |
| Financial reporting | Consistency with general accepted accounting principles (GAAP) Accuracy of budget analyses over the past five years Internal controls Revenue recognition practices Cost capitalization practices Accounting policies and reporting policies |
| Financial risks | Lawsuits Insurance claims Key contacts (customers, suppliers, distributors) Related-party transactions |
Important red flags in financial due diligence
There are several possible red flags that may indicate issues with the transaction:
- Inconsistent financial statements
There may be irregularities, discrepancies, and inconsistencies in accounting practices. Possible interpretations could be unreliable financial reporting or accounting misconduct. - Aggressive revenue recognition
Revenue that is recognized before the actual delivery of goods and services. It may indicate financial manipulation, over-reporting, or a lack of financial controls. - Aging accounts receivable
A large portion of accounts receivable is slow-moving or past due. It may indicate inefficient cash collection and possible liquidity issues. - Revenue concentration
A large portion of revenue comes from a small number of customers. A company may face operational disruption if key customers depart. - Overstated assets
The book value of assets is considerably higher than market comparables and actual value. Overstated assets may lead to post-acquisition write-downs. - Excessive executive compensation
The company’s management is excessive compared to profits. Possible interpretations include conflict of interest, corporate misconduct, and personal gain at the expense of shareholders. - Tax issues
Discrepancies in tax filings or ongoing tax disputes may lead to unforeseen tax obligations and legal compliance issues after the acquisition. - Suspicious related-party transactions
Transactions between subsidiaries, affiliates, and related-parties made at prices that don’t match usual market rates, with little to no actual benefit. Possible interpretations include deliberate revenue inflation in pursuit of higher valuations, inconsistency with shareholder interests, or misconduct. - Lack of financial transparency
A company’s reluctance to provide essential financial statements, like tax returns and debt arrangements, is a red flag that may indicate critical underlying issues.
How to address financial due diligence red flags?
Red flags may not necessarily signal the end of the transaction but they do allow for valuation adjustments and strategic reassessments. Here are a few possible ways to address them:
Renegotiate the deal price
When financial due diligence reveals that the target company’s financial health is not as strong as initially perceived, it’s crucial to adjust the deal price accordingly. Deal price adjustments are common during mergers and acquisitions. Recent M&A reports show that pro-buyer net working capital (NWC) price adjustments are present in 55% of private M&A deals.
Address red flags contractually
When the deal’s strategic value outweighs potential financial issues, acquiring companies may address any red flags contractually. This typically involves adding risk-prevention clauses to deal terms:
- Earnout provisions
An earnout is a payment structure in which a seller receives a portion of the purchase price when the target company meets specific post-acquisition milestones. Earnouts can represent as much as 25% of the purchase price. This structure reduces the overpayment risks when the target company’s financial performance is uncertain. - Specific warranties
Buyers may request sellers to provide specific warranties and representations, such as the accuracy of financial statements and the absence of accounting misconduct. Warranties and representations provide legal safeguards for buyers and ensure protection in case of legal disputes and material damages. - Escrow arrangements
An escrow involves setting aside a portion of the purchase price in a third-party account (typically between 10% and 25%) for an agreed time after the transaction. Escrows protect buyers against breaches of warranties and representations, hidden liabilities, or financial underperformance.
Terminate the translation
Sometimes, FDD detects critical issues that lead to deal termination, such as deliberate and substantial revenue inflation, accounting misconduct, or severe financial instability.
Conduct financial due diligence with Ideals
Ideals provides a virtual data room (VDR) solution designed to efficiently and securely facilitate financial due diligence. Here are several advantages of conducting due diligence with Ideals data rooms:
- FDD checklist integration
Streamline due diligence workflows by collaborating on integrated checklists with sell-side participants and advisors in real time. All checklist actions are recorded to ensure transparency. - Question-and-answer (Q&A) workflows
Optimize information exchange with role-based, automated Q&A workflows, enabling seamless communication between buy-side, sell-side, and advisory teams. Manage queries and follow-ups with Q&A threads and FAQ sections. - Full audit trail
Keep structured and transparent records with a full audit trail that tracks over 70 data room actions. Enhance data traceability with the history of file uploads and versions in a scheduled due diligence report. - Granular access permissions
Enhance control of the information flow with eight levels of access permissions. Keep critical information accessible to authorized parties only. - Information rights management (IRM) encryption
Ensure that documents remain secure after being downloaded. Documents retain access permissions and can be remotely controlled by project administrators. - Security compliance
Ideals VDR is SOC 1/2/3 certified and complies with ISO 27001, PCI DSS, HIPAA, and GDPR, offering a secure and compliant environment for FDD across various industries.
Image: Ideals’ due diligence checklist feature
The bottom line
- Financial due diligence (FDD) evaluates a company’s financial health and helps M&A buyers make informed decisions in mergers, acquisitions, and investments.
- The four stages of financial due diligence include preparation, research, verification, and assessment. FDD reviews the accuracy of financial statements, the consistency of financial reporting, and the level of financial performance.
- Ideals virtual data room (VDR) enhances the financial due diligence process with integrated checklist functionality, automated Q&A workflows, and fortress-level security.
FAQ
A financial audit verifies the accuracy of a company’s financial statements and compliance with accounting standards. Financial due diligence aims to carefully evaluate a company’s financial performance in the context of mergers, acquisitions, and investments.
The main stages of financial due diligence include preparation, research, verification, and assessment. The FDD stages encompass information gathering, in-depth investigation, cross-checking, and analysis.
Financial due diligence red flags include inconsistent financial statements, aggressive revenue recognition, aging accounts receivable, revenue concentration, overstated assets, disproportionate CEO pay, tax issues, suspicious related-party transactions, and lack of transparency.
Buy-side due diligence is when the buyer in the M&A transaction evaluates the seller, whereas sell-side due diligence is when the seller prepares their company for sale.
Ideals VDR helps companies enhance the security and efficiency of due diligence processes with features like integrated DD checklists, automated Q&A workflows, audit trails, granular access permissions, and IRM security.
Ideals VDR offers an encrypted, audited, certified, and fortified environment. Ideals is ISO 27001, GDPR, HIPAA, PCI DSS compliant, and SOC 1/2/3 certified.