A tailor-made approach for financial due diligence
When a potential investor intends to acquire an interest in a target company, it will normally engage an accounting firm to conduct a financial due diligence review of the target. Given the differences in the nature of each deal and the background of investors and target companies, it is crucial for the investor to agree on a tailor-made approach for financial due diligence with the accounting firm to best suit the investor’s needs and requirements.
The business world is very competitive and fast paced, therefore financial due diligence is often performed to a very tight time schedule. In addition, the resources provided by target companies are always limited. A tailor-made approach ensures that the financial due diligence review is performed as efficiently and effectively as possible. See chart below.
A preliminary discussion with clients is normally the starting point for tailor-made planning. It is important to understand the clients’ concerns and expectations before the commencement of an engagement. In this way, the scope of work can be properly planned to address their concerns.
The deal structure is one of the key factors for us to define the priorities for a financial due diligence review. For example, investors in asset deal acquisitions may be more concerned with the valuation of certain assets, whereas investors in share deal acquisitions may concentrate more on the net asset value of the business entity. The interests of financials (e.g. private equity firms) and strategic investors may also be different, as the former may be more concerned with the working capital requirements and cash position, but the latter may take more interest in the industry prospects, operations, internal controls, etc. of the entity.
An overview of the company’s background and business assists us to identify the key commercial risks, and consequently the financial impacts. It is essential to understand the company’s business history, ownership, organizational structure, major products and markets, and business models, etc. These are valuable for the investors and assist the financial due diligence team to customise their working approach.
When we plan our work programmes, we conduct a preliminary review of the financial statements to identify the key potential financial issues. We pay attention to any abnormal gross profit ratios through comparison with industrial averages, as well as any items with material fluctuations over the review period. For example, a significant decrease in payables may indicate better cash flow control but it can also result from certain unrecorded liabilities. This preliminary review enables us to better define the scope of work and focus on high risk areas.
Tailor-made work programmes
As each transaction and their relevant background information differ in nature, there is no standard checklist of procedures to perform a financial due diligence review. Procedures have to be customised for each engagement in order to address the specific risks. A large volume of information requests may not only irritate management but also confuse the analysts. For example, more procedures may be required to assess the adequacy of the provision for the obsolete stock of a pharmaceutical manufacturer than a metal manufacturer.
On day one of most fieldwork, the management team will normally hold meetings with all parties and provide tours of their locations. This gives us an overall feeling for the quality of management and the operations of the company. For instance, we will observe the environment of their warehouse and production lines, office atmosphere, attitude of management, etc. We may be able to identify some apparent risks through these tours. Sometimes a disorderly and sordid warehouse may imply a high risk of slow-moving and obsolete inventories, thus additional procedures may have to be performed to substantiate the adequacy of provision for obsolete inventories.
Due to time limitations or the management’s different priorities, the information available for review is sometimes very limited. Some private enterprises do not even have a set of tidy financial statements. We very often have to adjust our financial due diligence approach based on the limited available information. Where appropriate, the team will give in-depth guidance to management to restructure the information for critical areas. We may also refer to operational data on some occasions.
Regular communication with clients is important during the whole financial due diligence process. We always aim to inform our clients of any unexpected or significant issues as early as possible. In many cases, the scope of work set out at the planning stage may not cover the major deal issues identified when work progresses; accordingly the team has to communicate with their clients in a timely manner to re-focus the direction, adjust the scope of work and stress the key issues.
A tailor-made report should be able to present the most valuable and constructive information to clients. All graph and table analyses presented should be relevant to the industry and business practice. For example, a monthly sales analysis would be useful for target companies which are engaged in the gifts related business with seasonal sales fluctuations. On the other hand, it may be less useful to present it for other industries with stable monthly sales. The business segment analysis would also vary among different industries: it should be presented in a way which highlights the features of the business.
It may be useful for us to edit the complicated and lengthy breakdown of the financial statements from the clients’ point of view. We aim to deliver concise and precise information to our clients by re-organizing, making reference to, and simplifying the raw data received.
As clients normally intend to identify the key deal issues and follow up or make decisions quickly, they usually prefer to receive issue oriented reports. Tedious information is worthless to them and will eat up the resources of all the parties concerned. During our work, we can always identify many issues in the financial, commercial, business or operational perspectives. However, as not all the issues are deal-related, we will scrupulously determine their relevance based on our clear understanding of the nature of the deal.
Our recommendations for identified key deal issues are given to our clients promptly, based on our experience and professional judgment. We may suggest that our clients should consider obtaining warranty and indemnity over certain areas; proposing adjustments to the purchase price, etc. These suggestions can only be beneficial if they are tailor-made for the situation faced by our clients.
We use appropriate industry language in our reports to enable the accurate communication of our sensitive and relevant business analysis. It also facilitates all parties to communicate their ideas of the business plan going forward based on the information contained in our reports.
An efficient and effective financial due diligence review is critical for most transactions, and a tailor-made approach can make it happen easily, effectively and efficiently.
Author: Yvonne Ye and Gloria Leung, August 08 (Grant Thornton Hong Kong)
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