Due Diligence for Buying a Business 101 – Part 3: Financial Due Diligence

Previously, I wrote about the need for the purchaser of a business to do due diligence on its prospective acquisition target.  As I discussed, due diligence on a business can be split into three sections: legal, financial, and operational.  This post will explore what is involved with the financial portion of due diligence.

The financial portion of due diligence involves ensuring (a) that the financial information used to make the decision to buy the business and to determine the purchase price is accurate; (b) that the buyer has a thorough understanding of the target company’s finances so that it can include future potential contingencies in its projections and financial models; (c) that there are no customer collection or cash flow issues; and (d) that the buyer has a full understanding as to any future unfunded liabilities like pension benefits for current and future retirees and promised bonuses to employees.  Financial due diligence differs from legal due diligence in that it may require a larger team to conduct.  For legal due diligence, the buyer and its attorney(s) are usually the only necessary parties.  Depending on the sophistication of the buyer and the size of the deal, it may be necessary to hire accountants or other financial advisers to assist with the financial portion of due diligence.

Below, I’ve created a non-exhaustive list of the types of documents that a buyer should request as part of the financial portion of due diligence.  Obviously, every deal is different, so there are likely to be additional documents that would be necessary in any particular deal.

1. Audited financial statements for the last three to five fiscal years and any interim unaudited financial statements, if available.
2. Any reports by and correspondence with the company’s accountants, including any management letters to the company.
3. Any financial projections or plans produced internally by the company.
4. Monthly income statements, balance sheets, and cash flow statements for the last twelve months.
5. Trial balance and general ledger statements as of the most recent month’s end.
6. A detailed description of any add-backs that explain the differences between the company’s tax returns and its financial statements.  In general, since businesses try to minimize their taxable income, it is understood that the actual net income used in financial statements may differ from taxable income, but it should also be clear what methodology is being used in calculating those differences.
7. Details on any transactions with related parties (i.e., owners, affiliates, and their immediate families).
8. If the company has multiple lines of revenue, then the revenue and gross profit of each category should be separated out.  This should be done for the last 12 months at least, but preferably over the entire period of financial statements received.
9. Revenue from the 20 largest customers for the past 12 months.
10. Purchases from the 20 largest vendors for the past 12 months.
11. Detailed A/R aging as of the most recent month end.
12. Detailed A/P aging as of the most recent month end.
13. Monthly inventory reports for the most recent month end, if applicable.
14. List of all leases for real property or equipment, together with the basic terms of each lease.
15. The currently used budget for capital expenditures.
16. List of all bank accounts.
17. Monthly bank statements and reconciliations for the past 12-24 months.
18. Current organization chart.
19. A copy of any incentive compensation arrangements for employees, including bonuses and sales commissions, together with a list of employees covered.
20. Description of any retirement plans together with a copy of the plan documents.
21. Copies of the documents related to any stock plans, ESOPs, and other profit-sharing plans, together with a list of employees covered.

As you can see, doing due diligence on a business acquisition involves reviewing a large amount of documentation.  This post, together with my previous post on legal due diligence, discussed the first two-thirds of the process.  In a future post, I’ll discuss the last section: operational due diligence.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.