Financial due diligence can make or break an M&A deal. This guide covers the three pillars of the process – quality of earnings analysis, net working capital levels, and debt/debt-like items identification.
Financial due diligence in M&A is the process of ensuring the price of a business is in line with its operating performance “under the hood.” The three pillars of this process are: the quality of earnings analysis, determination of net working capital levels, and identification of debt and debt-like items.
Recent history provides cautionary tales highlighting the make-or-break importance of financial due diligence. The HP-Autonomy deal in 2012 led to protracted legal battles due to inaccuracies in the former’s income reports, balance sheets, and cash flow statements. And Paulson & Co’s Sino-Forest investment hit the headlines a year earlier in 2011, after a class action lawsuit alleged that the hedge fund had not conducted adequate due diligence into the forestry company’s shaky auditing and finances.
In this guide, Hilton Smythe takes you through how to avoid a due diligence disaster with a walkthrough of best practices – from quality of earnings analysis through to correctly identifying debt and debt-like items.
“What should I be looking at?”
Quality of earnings
A quality of earnings (QofE) analysis is important, because it measures the portion of profits derived from genuine business improvements—increased sales or reduced costs—rather than accounting tricks. These manipulations might include inflating inventory values, altering depreciation, or accrued revenue.
Validating adjusted EBITDA, which is usually used as a proxy for operating cash flow in mid-market M&A, is a key part of the process.
You and your advisory team will want to look at:
