The scope of what will be covered in the final report will be tailored at the outset and may cover a selection or all of the following areas.
Each deal is different and so it is important to ensure that all areas specific to the company are covered at the outset.
Step 1 – A summary of major findings and recommendations
This will often be highlighted at the start of a report and will list everything deemed significant to the deal by the writer. Such recommendations may include potential changes to a deal structure to protect the purchaser or financial covenant suggestions to cover the lender. Often these bullet points will be included in the legal documentation being prepared for the deal.
Please note – Although this is the first thing you’ll usually include in a due diligence report, it will be the last section you put together as it will draw from all of the later sections of the report.
Step 2 – Background and ownership
Each report should include a brief summary of the company, what it does, when it was formed and a reference to financial performance and shareholders.
The report as a whole should be written as if the reader is learning about the company and transaction for the first time, which may well be the case as a deal progresses through credit levels to obtain funding.
Step 3 – Historical trading
This area is often headed by a table summarising the profit and loss accounts of a business for a typical period of three years (the periods will be dependent upon what was agreed in the original scoping letter).
Any quick observations of trends will be commented on and major captions such as turnover, cost of sales and overheads will be reported on in more detail. Typically, revenue streams will be split and annotated as will items such as major customers.
The idea here is to give the reader an understanding of the underlying trends and make up each line in the accounts. For instance it may be significant that 50% of total revenues are generated by just 2 customers which highlights a risk to the business not evident from the face of the profit and loss account.
Step 4 – Balance sheet
This section should include a description of all captions contained on the face of the balance sheet which may include analysis and further discussion in each area.
Topics covered may include the average aged debtor collection days of the business and the overall recoverability of debts. A growing trend in debtor days may mark a recommendation to implement a better credit chasing system following completion in order to aide working capital.
Step 5 – Review of financial projections
Whilst the historical data of the company is of interest to an acquiring entity, the future performance is paramount as it is the profitability of the projected period that will determine the success of a transaction.
This section should concentrate on the basis of assumptions used in preparing the financial projections and comments as to their reasonableness giving due regard to the data uncovered historically.
In reviewing the financial projections, a report may also address ‘what if?’ scenarios to look at the effects on cash and profitability of changing key assumptions such as turnover or gross margin. This is common place and may highlight areas of mild concern or areas upon which particular emphasis needs to be placed to maintain future liquidity.
Step 6 – Adequacy of working capital
This area looks at historical and future cash flows which importantly will include an overview of deal costs and financing arrangements.
This should look to highlight any periods of concern in relation to working capital or cash shortages due to one off costs or seasonal downturns in trade.
The idea here is to avoid any surprises following completion.
Step 7 – Other key areas
Aside from the main areas covered above, a due diligence report will often contain sections on other non-financial areas including but not limited to:
- Management and employees;
- Internal control and systems;
- Insurance; and
- Health and safety record.