A private equity investment involves the allocation of funds in expanding businesses with an expectation of good returns in future. Nevertheless, prior to investing private equity firms need to know the actual financial soundness of the target company. It is at this stage that financial due diligence comes in very handy. It assists the investors to scrutinize the finances of the company with a keen eye with the aim of making the correct choice.
Understanding the Company’s Real Financial Position
Among the initial objectives of financial due diligence is to enable the privately owned equity firms to know the actual financial position of a business. This involves reviewing the revenue, expenses, profits, debt and financial stability of the company.
Investors can have a clear understanding of the performance of the company in the past and its opportunities of future growth by examining financial statements and historical data. This will avoid the possibility of investing in a business that seems to be doing well on the surface but is weak inside.
Evaluating the Quality of Earnings
The interest of the private equity firms is in investing in a business with stable and reliable earnings. Financial due diligence assists in finding out the authenticity of profits of the company as well as their sustainability. It determines whether the earnings are the result of normal business operations or one-off events which might not be replicated in future.
This makes the investors more confident about the performance of the company in the long run and enables them to realize the value that the business would be able to achieve.
Assessing Cash Flow Strength
The success of any business would highly depend on cash flow. A company can only experience profits on paper only to run out of cash to run smoothly. Under financial due diligence, the cash flow statements are studied to determine the amount of money in, out and whether the company can cover its daily and future financial commitments.
Firm cash flow means that investment risk is lower whereas poor cash flow can portend financial strain.
Checking Debt Levels and Liabilities
All the private equity investors will be interested in knowing the amount of debt which the company has, and will it be able to meet the debt in a responsible way. Financial due diligence assists in the evaluation of total liabilities of the firm, the terms of loans, date of repayment and its financial obligations.
This analysis would assist the investors in determining whether the company is able to absorb additional investment or not so that its debt balance renders it to be risky.
Understanding Working Capital Needs
Working capital is needed by a business to run its day-to-day activities including paying suppliers, holding stock and operating costs. Financial due diligence also investigates the working capital cycle in order to find out how effectively the firm uses its resources.
This information assists the private equity investors in strategizing the future funding needs as well as eliminate unexpected difficulties.
Detecting Financial Risks and Irregularities
Shareholders should be informed whether the company has some latent risks or financial irregularities. The concerns that are detected through financial due diligence are a lack of consistency in records, overstated revenues, incorrect valuation of inventory, or even undisclosed liabilities. The ability to identify these concerns early allows the private equity firms to make the wrong investment decisions and save them the losses they will make in future.
Helping Structure the Final Deal
Based on the results of financial due diligence, the deal is structured by the decision of the private equity firms. This can be how much investment or how much performance is expected to be made in the future or what protection is necessary to ensure the interest of the investor is not compromised. Transparency created by due diligence makes both the parties know very well what they are getting and hence they will go into agreement with full confidence.
This content is meant for information only and should not be considered as an advice or legal opinion, or otherwise. AKGVG & Associates does not intend to advertise its services through this.
Also Read: Understanding Financial Due Diligence: Scope and Significance
