Updated Dec 19, 2024

A Guide to Conducting Financial Due Diligence During Mergers and Acquisitions

Mergers and acquisitions (M&As) can be exciting opportunities for a company’s growth, but the entire process can be complex and challenging. After all, bringing two existing organizations together involves much more than signing an agreement.

M&As can be delicate, time-consuming processes since there are several steps involved, which include aligning corporate cultures and analyzing legal documents, financial records, and operational details. Regulatory hurdles and employee and stakeholder expectations also add more layers of complication.

Fortunately, you can work with professionals who can help you navigate a merger or acquisition. Providers of transaction advisory services can aid you with conducting due diligence to examine and evaluate financial records, legal contracts, and other relevant documents to uncover risks and opportunities.

Financial advisory services can assist you with valuing business and securing funding. Meanwhile, project management services can help with coordination across teams and timelines to keep the entire process on track.

With the right strategies and help from service providers, you can successfully navigate a merger or acquisition and maximize the benefits of this business strategy.

What is Financial Due Diligence?

In M&As, financial due diligence refers to the process of reviewing and evaluating an organization’s financial health.

The main focus of the process is to assess the target company’s financial statements and other documents pertaining to its assets, cash flow, and projections to determine its current financial condition and predict future performance.

If you’re the acquirer, it can help support your asking price and possible negotiating tactics.

This process can help uncover certain risks you should know about and include in your decision to proceed with or forgo the merger or acquisition.

These risks include:

1. Financial Risks

When done correctly, due diligence can expose financial discrepancies and instability and potential fraud within the target company. Experts can detect these by checking for inconsistent reports, unexplained transactions, and sudden changes in expenses, revenues, and profits.

2. Tax Risks

Through financial due diligence, you can find out if your target company has not complied with tax laws or has unpaid taxes. A thorough check of their tax document can also help you uncover tax planning and payment strategies that authorities may find risky or unconventional.

3. Market Risks

Due diligence can help you study and assess your target company’s position in the market. You’ll be able to find out potential risks, such as declining market share, over-reliance on only one supplier, and increased competition.

4. Legal Risks

Financial issues can arise from lawsuits, non-compliance with laws and environmental regulations, and other legal problems. If you don’t want to lose money from the merger or acquisition, include a legal check in your due diligence.  

Best Practices and Tips for Conducting Financial Due Diligence

Below are the most helpful practices and tips for conducting financial due diligence during a merger or acquisition:

1. Obtain all essential documents from your target company.

Financial due diligence involves checking and evaluating several important documents to understand your target company’s financial health, risks, and potential.

Below are some of the key documents you need to request from your target company:

  • Audited and unaudited financial statements, preferably from the last three to five years
  • Detailed financial schedules
  • Management reports, financial projections, and budgets
  • Tax returns and other records
  • Current contracts or agreements with customers, suppliers, and service providers
  • Intellectual property documents
  • Organizational chart and employee contracts
  • Regulatory documents

Keep in mind that missing information can lead to surprises down the line, which is why you should prioritize obtaining these documents.

2. Set the right metrics for valuation.

Establishing and analyzing specific financial ratios or metrics can help you understand your target company’s true value. These benchmarks are also crucial for performing data-based, unbiased due diligence.

Some of the metrics you can consider are:

  • Profitability ratios. Gross margin, net profit margin, and other profitability ratios can help you see how efficiently your target company can turn revenue into profit.
  • Debt-to-equity ratio. This benchmark reveals how much of the business is financed by debt, which gives you insights into its financial stability.
  • Liquidity metrics. This liquidity ratio shows whether the company can meet short-term obligations or not.
  • Industry-specific metrics. Customer acquisition costs or churn rates can help you understand your target company’s value and competitive positioning.

These metrics help ensure your target company’s performance, efficiency, and profitability align with its valuation.

3. Review all financial statements and tax documents.

Once you have your target company’s financial statements and tax documents, review them thoroughly.

Go over the balance sheet, cash flow statement, income statement, and other financial documents to determine the asset value, outstanding debts, and other important figures. Be on the lookout for potential red flags, such as poor inventory management and bad debt expenses (BDE).

As you review the tax returns and other documents, assess the efficiency of the company’s tax accounting processes and mitigation of tax risks and penalties, if any. Take note of financial synergies or savings they made from their strategies.

4. Evaluate the target company’s current internal controls.

Internal controls refer to the systems and processes the company uses to manage its finances, ensure accurate reporting, and protect their assets.

You can get a clear picture of how effective these internal controls are when you review the target company’s customer, supplier, and lease contracts, organizational chart, and other corporate documents.

Pay attention to how often the financial statements are audited. Also, find out their strategies for preventing unauthorized transactions.

The information you gain from reviewing these documents can help you avoid overvaluing the company and potential legal issues in the future.

5. Assess the target company’s quality of earnings, profit potential, and liabilities.

While reviewing all documents, look for any ongoing, pending, or settled litigation. Make sure the company does not have any issues with intellectual property licenses and property owner rights since both can cause costly problems in the future.

Also, perform a quality of earnings (QoE) analysis since this process can give you insights into the company earnings’ sustainability and reliability.This can help you understand if the majority of their profits are gained from their core operations or one-off major events.

Devote sufficient time to study the company’s profit potential to ensure you are making a smart investment. Check their sales reports and projections and customer contracts. Find out if there are untapped markets or products that could help you bring in additional revenue.

These pieces of information can give you peace of mind that you’re making the right move by merging with or acquiring the target company. 

Conducting financial due diligence requires expertise, attention, and time. Ensure this is done correctly to leverage its benefits by working with business consultants in the UAE who specialize in this niche.

With their help, you can streamline your M&A journey and experience a smooth transition and long-term success.




Author - Suprabha Bhosale
Suprabha Bhosale

Finance Writer

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