Financial due diligence can be defined as the process of assessing the financial health of a business or corporation after thoroughly examining different financial records. It is carried out to find any irregular processes or errors in financial data recorded. It aids in evaluating the current and historical financial performance of businesses. The forecasting methods used also help to identify any potential risks in the future. The purpose of conducting a financial audit can vary. However, in many cases, companies must mandatorily audited by an external financial auditor. Read on to learn more about financial due diligence.
How to conduct financial due diligence?
Investors must conduct financial due diligence before investing their money in a business. It is done to learn about the potential risks and gains related to the investment. Financial due diligence entails deeply analysing complex financial data to identify patterns, performance, risks and growth prospects. Here is a step-by-step method to conduct financial due diligence precisely.
- Company Capitalisation
Evaluating the prospective company’s market capitalisation will help learn about its size and growth. For publicly listed companies, you can just multiply the outstanding shares with the market value of each share. For other private companies and start-ups, you can use different methods like venture capital valuation, Berkus, cost-to-duplicate, etc. In addition, market capitalisation gives insights related to the volatility of stocks, company size, broadness of ownership, etc. You can also find out about the exchanges on which the shares of a potential company are trading.
- Revenue and profit trends
The next thing to check while conducting financial due diligence on a prospective company is the revenue and profit trends. Revenue is an essential indicator of a business’s financial health. Learning about the profitability trend is equally important. A positive trend in profit indicates the economic well-being of the business. It promises growth and stability and makes the company a good investment prospect. However, a negative trend might exhibit signs of failure and poor management.
- Industry and competitors
Industry and competitor research is another significant evaluation that contributes positively to financial due diligence. Learning about the business’s industry and growth prospects can help make a good decision. Also, it is crucial to research the competition to evaluate a company’s standing and reputation in the market. A highly competitive space might not offer lucrative returns on the investment deal.
- Management and ownership
People run companies, and an able management team can increase the probability of profits and growth. Therefore, inspecting the people in management and assessing the company’s ownership is crucial before investing. Regardless of the business idea, the outcome is contingent on how well the administration and its employees run the business.
- Financial statements
Financial due diligence is incomplete without analysing critical financial statements like the balance sheet, P&L statement, cash flow statement, etc. They offer deep insights related to the financial standing and a comprehensive overview of the company’s assets and liabilities. This will help you find metrics like accounts receivable & payable, net profit, gross profit, short- & long-term debt obligations, tangible & intangible assets, etc. Hiring a due diligence consultant is highly recommended to avoid any complications in the due diligence process.