Corporate Finance Explained | Financial Due Diligence
In corporate development and finance, the excitement of an acquisition often masks the underlying risks. Financial Due Diligence (FDD) is the structured investigation into a company’s total financial health. It is the crucial "forensic" step that moves a deal from celebration to investigation, determining whether a transaction is a winning strategy or a multi-billion dollar mistake.
The 5 Pillars of Financial Due Diligence
To assess risk and validate value, finance teams focus on five critical areas in the financial data room:
1. Quality of Earnings (QoE)
This is the bedrock of FDD. It separates "accounting profits" from repeatable, sustainable core performance. Teams look for Normalization Adjustments, stripping away one-time legal settlements or non-market salaries to find the true Adjusted EBITDA.
2. Revenue and Customer Analysis
High revenue numbers can be deceiving. Analysts dig into:
- Customer Concentration Risk: If one customer accounts for 40% of revenue, the valuation must be discounted due to instability.
- Churn Rates: Understanding why customers leave and how long they stay.
- Revenue Quality: Differentiating between recurring contracts and one-time projects.
3. Working Capital and Cash Flow Health
This pillar determines if paper profits convert to usable cash. Red flags include:
- Accounts Receivable Aging: Customers paying slower and slower, masking potential bad debt.
- Inventory Turnover: Massive buildups that suck cash out of the business without guaranteed future sales.
4. Debt and Off-Balance Sheet Items
Lurking "landmines" can blow up deal economics. Analysts search for:
- Pending litigation or unknown tax exposures.
- Underfunded pension liabilities.
- Environmental cleanup costs.
5. Forecast Assessment
Every target company presents a "conservative" growth story. FDD stress-tests these assumptions by modeling the unit economics (e.g., Customer Acquisition Cost vs. Lifetime Value) and building conservative "downside" scenarios.
The Role of FP&A: The Bridge to Integration
The Role of FP&A: The Bridge to Integration
If you are in FP&A, your role is pivotal. You are the bridge between historical numbers and the forward-looking plan. Your team must:
- Tear apart growth claims: If a company claims 20% growth, what is the required hiring plan and CapEx?
- Scrutinize Synergies: Cost synergies (office closures) are reliable; revenue synergies (cross-selling) are highly speculative and should be heavily discounted in models.
Final Strategic Thought
FDD is not a box-checking exercise; it is the firewall that protects shareholder value. Master it by prioritizing the Quality of Earnings and never letting deal enthusiasm override forensic investigation.
