What is Financial Due Diligence?
Financial due diligence, or financial diligence, is the process of researching a company or individual with the intention of verifying their financial fitness to conduct business. Financial Due Diligence Consultants, Financial discernment is intended to ensure that a company or individual can fulfill its obligations as they become due and are not in danger of insolvency.
Traditionally, due diligence is used as an umbrella term to describe the evaluation of a company’s financial health. The term was originally introduced in a 1990 book by John Z. Reed, “Due Diligence: How to Evaluate a Company Before Buying It” (published by Quill & Brush). The chapter has been excerpted several times, including in its original edition under the same title. The term is also used for any similar process that includes evaluating service providers or other third parties when selecting new candidates for a transaction (as opposed to side-by-side comparison of potential acquirers).
Due diligence encompasses preparing the legal, technical, financial and social context of a transaction. The intention is to make the “transaction” more attractive by enabling the buyer to evaluate better whether its own objectives will be achieved.
Due diligence is an important part of financing a large business deal. It will help determine what asset is most valuable for future growth and might help in making sure that buyer and seller can work together well as business partners. Steps taken in this process are also very important in proving legal integrity of both parties involved.
Why Financial Due Diligence?
In any business-related transaction involving property, goods, services or equity investments it is important to have an understanding of what you are buying before making a decision on whether it’s worth exploring further. For many businesses and individuals due diligence refers back to their own personal rights, including protection from fraud and misrepresentation by others which may lead to liability under criminal laws if something goes wrong.
In financial markets, financial due diligence encompasses a wider range of investigations than civil law. Generally, information about the legal ownership of a company is not readily available for public scrutiny. This is particularly true in developing countries where information about legal owners must be ascertained from the register at the Registrar of Companies. Even in more developed countries like the UK and Canada, information available varies widely and depends on the jurisdiction.
In addition to legal ownership, details of effective control are important factors. They may include beneficial ownership which is confidential in most jurisdictions but may be open in others depending on circumstances.
There are many different types of financial due diligence investigations and may vary depending on which side is initiating a transaction, whether it’s a merger & acquisition (M&A), private equity (PE) investment, public offering of securities to both investors and the general public, etc. A more detailed analysis is conducted by prospective lenders who will seek to ensure that debtors can pay back interest and principal on loans even though it’s primarily more for borrowers to prove their creditworthiness.
As a result of increased risk-aversion following the global financial crisis, companies and individuals are finding it increasingly difficult to obtain credit and this has forced some businesses into bankruptcy. In order to protect themselves, lenders now require far more information about borrowers than they ever did in the past.
Firms conducting a due diligence investigation will consider legal structure and corporate governance, financing (if any), operations, market demand for products or services, systems and controls over those processes, intellectual property and regulatory compliance against local rules and laws. There are many regulatory and legal issues to be considered when conducting a financial due diligence investigation.
In the context of a merger and acquisition, financial due diligence aims to analyze the target company’s situation in order to assess whether it is worth pursuing further. Its purpose is to disclose any material issues related to its performance, with a view towards reaching an informed decision on whether its assets as represented would yield returns sufficient to enable it to fulfill its potential under the new controlling entity. The information gathered could pose a risk to the acquiring company if it is not adequately scrutinized and risks that could arise from further analysis of the target company’s financial situation will also be considered.
Steps in Conducting Financial Due Diligence
There are several steps involved in conducting a financial due diligence report. The first step would be to confer with the potential sponsor. The next step would be to conduct an extensive review of the company’s operations and financial information and any other information that might be relevant to the business, such as intellectual property or patents. Following this phase, a draft report is created that is then sent off to the potential sponsor for review. The potential sponsor will then respond back with any questions he or she has concerning the report.
The final phase of creating a financial due diligence report involves addressing all concerns raised by the potential sponsor. Once all issues have been resolved, a final draft of the report is created and distributed to all parties involved in the business transaction for further review.
