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What is Financial Due Diligence, and Why Do You Need to Do It?

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The residential real estate market in Canada has been feverish since the new year. People are eager to make winning offers on homes—tackling their home buying competitors with big offers and speedy transactions. 

Katerina Georgieva of CBC reports that home inspectors are “calling for legislation to regulate their industry to ensure consumers are protected.” 

This increase in buyer eagerness has likewise caused numerous residential buyers to forgo necessary home inspections. Len Inkster, a home inspector out of Ontario, says that approximately “less than 25 percent of all home sales are being inspected.” 

Forgoing inspection is a serious and senseless risk; “it's like playing Russian Roulette with your finances and your home's finances and your family's finances.” Inkster states that “he frequently gets calls from recent home buyers...requesting an inspection after a sale has gone through because they weren't able to get one beforehand…” 

These-post sale inspections often lead to ownership and investment "horror stories."

Due diligence is an essential factor to verify the sensibility of any major investment. 

When it comes to purchasing a pre-existing business, conducting due diligence is like conducting a “home inspection” on your target business. You certainly would never dream of purchasing a business before you had to financially investigate it. 

Buyers of businesses need to be prepared to undergo financial due diligence during the process of acquisition because professionally conducted fiscal due diligence uncovers the reality of your investment and the risk that your acquisition involves. 

As BDO Canada articulates, “financial due diligence is not an audit. An audit provides an opinion on whether the historical financial statements present fairly the financial position of a company. Financial due diligence, on the other hand, goes deeper to understand the reasons for historical and forecasted trends, and reports on the relevancy of these trends to the purchaser.”

The Value of Financial Due Diligence 

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Mackenzie Regent, who is a managing partner and co-founder of a transactions and financial due diligence advisory firm headquartered in Calgary, expresses that financial due diligence is “where deal expertise meets technical accounting.”  

As with many other stages in the acquisition process, it’s beneficial to hire a professional advisor, like a chartered professional accountant who is versed in acquisition and valuation, to aid you through the due diligence process. The BDC backs this statement, saying “attempting to save money by doing your own due diligence could lead you to significantly overpay for a business. Professional fees for due diligence are negligible in comparison.”

A buyer should commence financial due diligence efforts prior to negotiating terms and immediately after an LOI (offer) is positioned. 

“Adequate time should be allocated to the financial due diligence process. Financial due diligence inquiries can range between two to four weeks depending on the size of the target company and scope of the work.” 

Regent states that the following factors are the reasons why conducting financial due diligence during acquisition is important. 

  1. Due diligence enables you to capitalize on the deal opportunities ahead of you. 
  2. Due diligence ensures transaction readiness. It showcases to a seller, who in the early stages of acquisition may be entertaining several buyers at once, that you’re credible and ready to move forward with acquisition. 
  3. Due diligence creates value as it identifies opportunities for valuation or structure improvement.
  4. Due diligence gives a buyer confidence in their investment by properly determining price and deal implications.
  5. Due diligence makes a buyer stand out from the crowd. Bringing independent experts to the table shows a seller that you’re prepared with a track record of experienced individuals by your side.

What Does Financial Due Diligence Ascertain?

Inspecting your target business and its financial records from the inside out helps you solidify your decision to purchase a business. Coincidently, it also helps you  decipher and draft your purchase agreement as well as transition plan. 

Furthermore, a portion of your financial due diligence report will analyze the quality of your target business’ financial statements and archived information. 

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As the BDO argues, financial due diligence helps buyers confirm information about their target, answer questions about their target and discover previously undisclosed concerns about their target. The BDO points out that financial due diligence should answer questions about a target and the viability of an acquisition. Such questions include:

  • Is the information provided by the vendor reliable? 
  • Are the historical earnings of the company sustainable? 
  • What are the potential future earnings of the company? 
  • Are there any on or off balance sheet liabilities that should be considered? 
  • Does the company have any future commitments or contingencies?

While a buyer should have already had a general valuation audit in place prior to offering on a business, financial due diligence is the best way to gather a fair valuation and to determine an accurate purchase price. 

Financial due diligence allows a buyer to:

  • quantify the purchase price of their target business and assess the target’s financial health. 
  • establish the maintainable earnings of their target business.
  • examine the capital required to achieve future earnings.
  • assess the quality of their target business’ financial information. 
  • decipher whether or not an acquisition target is financially worth pursuing. 

Is Your Desired Acquisition a Favourable Financial Investment?

All in all, when you purchase a pre-existing business, you’re not only investing in your future earnings but you also, ultimately, purchase your target business’ future earnings and working capital. 

As Regent expresses, “when you’re buying a business, you’re buying a group of assets that are going to generate that future earnings…” Therefore, by conducting your due diligence, you can make sure that the necessary assets are “left in place to generate that cash flow you’ve paid on.” 

“Buyers need there to be enough operational capital in the business to continue to generate the earnings they paid for in the transaction valuation.

In completing a due diligence review, you can rest with confidence knowing that “the batteries are included,” with your deal. In other words, you know that you’ve acquired everything you need to in order to keep the business running, growing and continually producing advantageous capital. 

Due Diligence is Crucial to Your Journey 

Performing due diligence as a buyer is an act that truly allows you to understand the business that you’re taking over. Acquiring a business is a consequential venture. When a buyer fails to follow through with formal due diligence tasks, both financial and legal, they significantly increase the chance of purchasing a business with imminent and lasting issues.

Village Wellth helps buyers connect with experienced financial advisors. Our network of trustworthy CPAs and due diligence professionals will guide and assist you through the process of acquisition, while also keeping you informed about the status of your target. With assistance and the proper due diligence engagements, you can ensure that your acquisition venture is viable, promising and worthy of your time, effort and money.

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September 13, 2022
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