Financial due diligence is a key step in avoiding any last minute surprises that could derail a transaction.
What is financial due diligence?
It’s wise for anyone who is entering an acquisition or agreement to first investigate the other party and its financial, operational and IT records and performance. This voluntary investigation or audit of a prospective business partner is what you call due diligence. Due diligence is a common practice among investors who are interested in acquiring or buying securities from certain companies.
For financial due diligence, CFOs, CPAs and accountants gather and analyze the quality and health of a potential target’s financial position, including earnings, working capital requirements, and free cash flow. In the due diligence should research whether the company has been involved in any lawsuit or corporate scandal. Recorded red flags should be considered by investors before doing any business with a particular company. Investors and advisors can also step up by checking and verifying credentials and background of the company’s management team.
Financial Due Diligence Checklist
The goal of using this checklist is to understand where the Company stands relative to each of the listed areas and items. Many of them will be “N/A” depending on the stage of the Company. These are many of the same issues that will be researched in either banking, equity or M&A due diligence and it’s best to know the answers early on.
For some of these items, the Company will be in good shape. Others may require a level of cost vs risk analysis to determine if it’s worth fixing now, or waiting until the Company is further along. In any event, doing this comprehensive review starts the Company on a path to being “Diligence Ready” and avoiding any last minute surprises that could derail a transaction.
Financial Due Diligence Process
Financial due diligence steps may vary depending on the type of investment and securities one would like to invest in. But in performing financial due diligence, all investors should first and foremost consider their risk tolerance. Below is the list of some of the financial due diligence steps to guide investors.
Analyzing the market capitalization of a company gives investors an idea about a company’s scope of ownership and potential target markets. The stock price of companies with large capitalization tends to be less volatile due to its revenue trend and diverse investors. Meanwhile, companies with small capitalization and limited market share may have a more volatile stock price and revenue growth.
Researching the members of the board and management of a company is a good determinant of investing. Bio and curricula vitae of the board and top management are published on the company’s website. Through this, one can see whether the people behind and running the company have experience and knowledge in the business. Investors might also want to look at the ownership of the corporation. If top officers have high stock shares, they tend to serve and run the company meticulously to serve their interests. They would ensure that the stocks of the company will consistently perform well in the market.
Numbers do not lie. It is preeminent for any investor to utilize the various financial ratios in evaluating a specific company. Below are some of the financial ratios which can help investors before making any investment.
Price-to-Earning (P/E)
Price/Earnings to Growth (PEG)
Price-to-Sales (P/S)
Price-to-Book (P/B)
Due Diligence for Startup Investing
Examine the Balance Sheet
The Balance Sheet Statement shows the assets, liabilities, debts, and available cash of companies. Having a high amount of debts is not a red flag per se. What investors want to see is the amount of cash the company has to pay obligations and give as dividends. If a company has more cash, the more likely the investment will perform well.
Monitor Revenue and Profit Trends
The income statement will show any investor both the revenue and income of any company. Investors and financial advisors are interested in companies with recorded income historically, rather than losses. The monitoring of revenue, expenses, and equity trends of a company is vital before putting any investment in a company.
Determine Business Industries and Competitors
Looking into a company’s internal affairs before making an investment is not enough. An investor or financial advisor has the responsibility to evaluate the external environment of the company as well. It is vital to size up the competitors of a company by comparing its profit margins. This can help any investor determine whether the prospective company is competitive and profitable or not. On the other hand, performing due diligence on the industry will show investors if the business has opportunities for growth.
Research on the Stock Price History and Dilution Possibilities
For public companies, its important to know the short and long-term movements of the stock price. Most investors prefer stocks that have shown a steady price increase over time. Volatile stocks are often viewed as risky investments. Investors must also know if a company plans to issue more or dilute its shares, which may impact the stock price.
Investing in a startup or new company often entails higher risks compared to established corporations. Below are some of the strategies investors might want to consider when investing in a startup.
- Choose a startup with products with a promising return on investment (ROI) within the next five years.
- Evaluate the viability of the business to ensure an acceptable ROI.
- Always have exit and divestment strategies in case the startup fails to ensure the recovery of your funds.
- Consider partnership to split both the capital and risks.
- Be ready to harvest your investment if you find that the business cannot survive new technology, trends, and policies.
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