What is financial due diligence (FDD)?
Financial due diligence is typically associated with an M&A transaction and involves the investigation of the accounting and financial schedules of the target company. The work is similar to an audit but is more focused on verifying key inputs and assumptions that are used in the buyers’ financial model.
Overall, the buyer will want to understand the overall purchase price they should pay, which is based on enterprise value, debt and cash, and the change in net working capital (NWC):
What is the role of the FDD team?
So now that you understand the three key inputs to purchase price consideration, we can begin to understand the role of financial due diligence (FDD). There are three key schedules that the FDD team typically prepares to analyze each of three components of the purchase price:
Quality of Earnings (QoE) Analysis
The QoE analysis is arguably the most important analysis as it focuses on the amount of earning power the business has (i.e. cash flow it can generate). The QoE focuses on calculating what the appropriate EBITDA figure is the last 2 fiscal years (audited periods) and the last twelve months (“LTM).
The QoE will typically start with reported EBITDA, which is based on the audited financial statements. The Seller will then propose adjustments to increase EBITDA, which can be viewed as Seller adjusted EBITDA. Seller adjustments can include non-recurring/unusual expenses, non-operating expenses, non-cash expenses, accounting errors, accounting policy changes, out-of-period adjustments, and pro forma and run-rate items.
Then, the Buyer and their FDD team will evaluate the Seller adjustments and potentially propose additional QoE adjustments (i.e. diligence adjustments) to increase or decrease EBITDA.
Diligence adjustments can be identified from reviewing the offering memorandum (CIM, OM, etc.), discussions with management, review of information in the dataroom, or review of the company’s public filings (really anywhere!).
Once the Buyer and the FDD team finalize their QoE analysis, diligence adjusted EBITDA is then used in the financial models for the Buyer. Additionally, the Buyer’s banks and lender may use the QoE to identify the best proxy of EBITDA for their financial models.
Debt and Debt-like (DDL) Analysis
The point of a debt and debt-like analysis is to identify items that could represent debt and future cash outflow for the buyer post-transaction. While 3rd party debt is typically extinguished by the seller, there are other debt-like items that may have be negotiated by the buyer. Debt-like items aren’t always that obvious and require some deep digging by the FDD team. These are items that could be off-balance sheet (not recorded on the balance sheet), future liabilities that aren’t yet recorded, or other obligations. This analysis is typically only prepared for the latest balance sheet date.
Net Working Capital (NWC) Analysis
The Buyer needs to understand the working capital requirements of the business under their ownership. However, as part of the transaction, the Buyer also needs to make sure that the Seller delivers adequate working capital to run the business post-transaction. What the FDD team should do is understand what normalized working capital is and set a favorable working capital target. While the working capital target is typically negotiated between the buyer and the seller, the FDD typically helps the Buyer negotiate a working capital target that is as high as possible (reduces the chance of working capital exceeding the target at close).
The schedule below illustrates how adjusted net working capital is calculated. You would start with working capital per the audited balance sheet, remove cash/debt/income taxes, and then propose diligence adjustments.
NWC analysis is typically prepared for the last 18-24 reporting months.
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