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The Importance and Purpose of Financial Due Diligence

Due diligence usually refers to within the context of mergers and acquisitions when after reaching an initial agreement of cooperation with the target firm the acquiring party is permitted through mutual agreement to conduct an investigation into the operational situation of the target firm.

Due diligence ordinarily incorporates investigative measures directed against all relevant matters pertaining to merger and acquisition, a series of operations including data analysis and field surveys. One of this operations is Financial Due Diligence, which is determining whether or not company accounts are consistent, evaluating the real situation of assets, liabilities and tax risks.

Financial due diligence refers to financial professionals, according to the acquiring party’s objectives and commissioned scope, conducting investigation into the target firm’s financial circumstances and various other related factors. Financial due diligence ordinarily employs methods such as document review, conducting discussion and interviews with senior management and key employees, comparing historical financial data and trend analysis, and finally the reporting of financial risks along with the actual operational situation of the target firm in written form to the acquiring party.

Conducting financial due diligence is not only related to proposed acquisitions or mergers, it can also be directed against joint ventures, financing or other deals and transactions. Principal work usually centres on people related or interest related business activities and relevant financial data, the ultimate goal being to provide assistance to the acquiring party in eliminating asymmetric information, and allowing the acquiring party to obtain a greater depth of understanding with regards to the target firm.

Due to the differing characteristics of various industries, the knowledge and understanding of a certain industry on the side of an acquiring party might also differ from an equitable level with that of the target firm. Therefore financial due diligence process should be modified or adjusted so as to meet the acquiring party’s specific needs and expectations.

Generally speaking, the most important usage of financial due diligence is to realise the following functions:

1. To sufficiently reveal financial risks.

2. To analyse a firm’s past profitability and cash flow, and according to this forecast the firm’s future operational prospects.

3. To understand the target firm’s assets and liabilities (including contingent liabilities), internal control, and the actual situation of operations management, providing a suitable foundation for follow-up negotiations, strategic investment decisions and the formulation of a post-acquisition business plan and integration program, the target firm’s internal control and actual situation of operational managements must be initially understood.

When compiled with other due diligence results such as legal and operational due diligence, to determine whether the item of investment in question is in keeping with the acquiring party’s general strategic targets and investment principles.

Financial due diligence has the primary objective of establishing and understanding a target firm’s actual financial situation in the recent few years (in most cases around three years), and subsequently forecasting its future financial situation. This is the basis for the acquiring party’s current valuation of the target firm. For strategic investment decisions, as well as for providing a necessary foundation for formulating a post-acquisition business plan and integration program, the target firm’s internal control and actual situation of operational managements must be initially understood.

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