Financial Due Diligence (FDD)

Financial Due diligence Interview Guide

Financial Due Diligence (FDD), sometimes referred to as M&A transaction advisory services (TAS) is an accounting related service offering performed as part of the M&A deal process. The FDD team is engaged primarily by Investors, Private equity clients and Corporate clients to support the deal process. Services provided primarily include  buy-side financial diligence, sell-side financial diligence or vendor due diligence (VDD) among other services depending on the engagement or project. When interviewing for FDD, it is critical to understand what financial due diligence is and the work that is performed.

When performing financial due diligence (both sell-side or buy-side) there are three critical analyses that everyone is required to understand, Quality of Earnings, Net Working Capital and Debt and Debt-Like Analysis or Indebtedness. All three analyses are compiled and put together in a excel-based "Databook" and provided to multiple parties as part of the deal process; Investment Bankers, Lenders, Private Equity and Corporate Clients. This is then compiled into a final report for potential buyers (sell-side report) and report for clients and their lenders (buy-side report).

Quality of Earnings Analysis (QoE)

Quality of earnings analysis or adjusted EBITDA is the first and most critical analysis performed as part of financial due diligence services. Investment bankers, private equity investors and corporate development teams build their models and valuations around adjusted EBITDA. The purpose of a detailed QoE analysis and report is to support these teams in calculating and determining the appropriate adjusted EBITDA. This includes identifying and quantifying  potential adjustments to EBITDA that would impact enterprise value and the final purchase/sale price of the business or target. The primary goal of it normalize EBITDA for various nonrecurring and non-operating transactions or activities to present a true view of EBITDA for the business on a normalized basis and present a view on judgmental matters that differ from Management, the sellers or buyers, Management and the Company's auditors.

To walk through a basic example of a simple quality of earnings adjustment, A target's facility and machinery was damaged due to an explosion during the fiscal year resulting in damages of $180,000 expensed and the company received insurance proceeds of $20,000 other income.

Reported EBITDA: $1,500,000

Facility damage expense: $180,000

Insurance Proceeds: $20,000

Adjusted EBITDA: $1,660,000

The non-recurring expense of $180,000 would be adjusted in the fiscal year and the insurance proceeds of $20,000 would be deducted from net expenses to get to a net adjustment of $160,000 in additional EBITDA for the business.

In summary, the quality of earnings analysis for adjusted EBITDA highlights key findings that may need to be considered/adjusted for for financial modeling/forecast purposes.

Net Working Capital Analysis

Generally net working capital is defined as current assets less current liabilities. However, in the context of financial due diligence we perform analysis over networking capital at a more detailed level.

On an adjusted basis, diligence adjusted net working capital is generally current assets, less current liabilities, excluding cash, indebtedness and income taxes. This is because M&A transactions and deals are generally executed on a cash-free and debt-free basis and is therefore reflected in the diligence adjusted networking capital calculation.

The key purpose of the networking capital analysis is to determine a normalized level of working capital to be delivered upon closing of the deal. During the end phases of the deal, the buyer and seller agree on what's called the net working capital "peg" or a normalized target value for working capital. This peg or target is critical because it has a direct dollar or dollar impact on the final purchase price of the business.

To demonstrate the impact, for example the buyer estimates a target normalized networking capital of $100,000 for the target business to be purchased based on historical performance and the expected purchase price of the business is $1,000,000 that was agreed upon between the buyer and the seller. During the time between signing and closing of the deal, the seller could potentially collect $20,000 in receivables before the deal closes and the seller officially takes ownership of the business. In this case, the Buyer of the business would be out $20,000 in cash as the seller had received the cash before the transaction closed. The peg was designed to prevent this and factor the change in working capital into the final purchase price. In this scenario, assuming the agreed upon peg is $100,000, all else equal the new networking capital on the date of closing  is $80,000 as accounts receivables would have declined by $20,000. Therefore, the new purchase price of the deal will be $980,000 to factor in the change in working capital peg to ensure the buyer is protected from the seller extracting value from the business between signing and closing.

The above is a simple example of the networking capital mechanism for an M&A deal. Setting the networking capital target based on normalized working capital is a key component of the M&A process and requires a detail analysis of potential adjustments.

Debt and Debt-Like Analysis

Similar to the networking capital analysis, the debt and debt-like analysis performed during financial due diligence has a direct impact on the final purchase price of the target or business. The final sales and purchase agreement typically includes a definition of indebtedness. These are defined as the obligations the buyer wants the seller to include in the definition of debt and fund, resulting in a dollar for dollar reduction in the purchase price. Some examples will include long-term and short-term debt, credit lines, revolvers, notes, pension liabilities and other off-balance sheet liabilities.

There is no perfect answer to the definition of indebtedness, the final outcome is always based on final negotiations between the buyer and the seller. The goal of this analysis is to identify and negotiate the most beneficial outcome for the client to ensure all debt and debt-like items have been treated appropriately in the context of the transaction. 

TAS Foundations Financial Due diligence Interview Package

We have developed and compiled a comprehensive interview guide including example case studies from FDD interviews at the largest accounting firms across the United States and Canada to support FDD candidates through the interview process. Our package includes;

- Full length detailed training package for Quality of Earnings, Net Working Capital and Debt-like Analysis.

- Example Databook

- Example FDD Report

- Example FDD Interview Case Studies

- Complete set of potential interview questions