Financial Due Diligence
Corporate acquisitions/mergers/taking over have become a part of business strategy to grow rapidly and widely. The objective is to increase the local / global market share. Incentives given under the Income Tax Act for
mergers and acquisitions have also given fillip to such activity.
A key element in such an exercise, whether it involves the acquisitions of another entity, unit or assets of an entity, is the performance of a “due diligence” review. Due Diligence may also required to be performed in cases of venture capital financing, lending, leveraged buyouts, public offerings, disinvestment, corporatisation, etc. Sometimes, in a restructuring exercise, while the unit may remain within a group, it may pass from under the charge of one management team to that of another team. This situation also gives rise to the need for a due diligence review.
Due diligence is a review of the enterprise, unit or assets, as the case may be, to be acquired. Due Diligence : Sub-Classification
Due Diligence can be classified into discipline-wise exercises. It may be mentioned here that these sub-classification should not be seen as totally mutually exclusive to each other. If considered mutually exclusive, it might result into a less-than-effective evaluation of the entity. The sub-classification of due diligence exercise could be as follows:
Commercial or Operational Due Diligence Financial Due Diligence
Tax Due Diligence
Information System Due Diligence Legal Due Diligence
Environmental Due Diligence Personnel Due Diligence
Of all the sub-classification of due diligence exercises, Financial Due Diligence has the highest significance with regard to a corporate restructuring exercise. The reason is quite simple to understand. For an investor, the final decision should necessarily be in the form of financial terms and information. It, therefore, becomes imperative that the results of all other kinds (sub-classification) of due diligence should be translated in monetary terms.
The financial due diligence is generally done by professional accountants. Professional accountants are also hired to conduct tax due diligence because of their knowledge and expertise in the area of taxation laws. The acquiring enterprise engages other professionals to conduct other aspects of the over all due diligence review exercise. For example, a lawyer or a Company Secretary may be engaged to carry out legal due diligence, an personnel professional may be engaged to conduct personnel due diligence, an engineer and a marketing professional may be engaged for conduct of operational due diligence. However, the implications of all the due diligence exercises should be ascertained by the professional accountants engaged to carry out financial due diligence review. Accordingly, accountants need to review the reports of the due diligence exercises performed for other aspects of business to evaluate the financial implications.
Timing of due diligence review exercise
There are no rigid rules for determination of the stage of acquisition at which due diligence review is conducted. The timing of the review is very much a situation-specific issue. It depends upon a range of factors that
beginning from the nature of the transaction (inter restructuring, acquisition), the relationship between the parties involved (related parties, first time negotiator), the regulatory frame work (for example, in a takeover of a listed company, the acquirer may not be able to perform such a review, given the time, constraints and as the target is under no obligation to allow one). The list is never ending. Its is at this point at which significant amount of professional fees, etc. are incurred for the services rendered by the various professionals attached with the process of acquisition. It has been mentioned that due diligence reviews can be sub-classified into discipline-wise exercises. Various kinds of due diligence reviews are undertaken depending upon the nature of target’s operations.
Objectives of Financial Due Diligence
There are certain inherent risks that increase significantly without due diligence. Where two parties are involved in a deal, representations are made to transferee about the entity, unit or assets being transferred. Completing a transaction without adequate information, or half-truths, can lead to a significant financial loss. Basically, the performance of a due diligence review seeks to ensure that the transferee, at a later stage, does not face
unpleasant surprises when the acquisition is over. The due diligence seeks to provide assurance to the transferee that the information available to him presents a true and fair view of the situation based on which negotiation is done.
Broadly, the review process would provide comfort on, inter alia, the following: True and fair view presented by the financial statements
Systems and controls established are followed Uniformity of accounting policies
Availability of records Quality of record keeping
Existence of fixed assets, and ownership of those assets Realisable value of business
Undisclosed liabilities
Possible exposure to future liabilities
Contingent liabilities, their nature and quantum of commitments made by the entity Compliance with various laws and regulations applicable to the entity
The initial price and other decisions are taken on the basis of net worth as well as trend of profitability of the target company, with an assumption that all contingent liabilities that may impact the future of the business have been recorded. The principal objective of financial due diligence, therefore, is usually to look behind the viel of initial information provided by the company and to assess the benefits and costs of the proposed
acquisition/merger by inquiring into all relevant aspects of the past, present and future of the business to be acquired/merged with.
STATEMENT AND INFORMATION TO BE CALLED FOR FROM TARGET PRIOR TO STARTING THE DUE DILIGENCE
Corporate Documents
1. Memorandum and Articles of Association 2. Board Minutes copies for last five years
3. Financial Statements for say five years with complete schedules 4. Tax accounts (if different) with Tax audit reports/returns 5. Latest financial statements duly audited
6. Quarterly published results for last say eight quarters 7. Engineering Reports like report on environmental problems 8. Market studies/reports on company products
9. Details of patents, trade marks, and copyrights 10. Details of Licenses
Supply and sales agreements
Employment and consulting agreements Leases
License and franchise agreements Loan agreements/Debenture trust deeds Shareholders agreements
Agreements with labour and management Pension and profit sharing plans
ESOPs / stock purchase plans /sweat equity agreements Welfare benefit plans
Personnel handbook or policy manual Deferred compensation plans
Insurance policies
Agreements giving right to acquire /use company assets Tenancy rights/lease agreements
Sales and product warranty agreements Subsidies like S.T subsidy, Central subsidy
12. Details of MODVAT/CENVAT credit on capital goods 13. The transferability and possibility of continuance of the above 14. Acquisition agreements
15. Title documents to real estate property
16. Real property and asset identification with ownership/ lease details 17. Survey maps/reports
18. Mortgages
19. Guarantees and letters of comfort 20. Latest annual return
Key Information from Management
1. Analysis of Company’s past operating performance and projected change in operations 2. Segment wise profitability statements
3. Details of ownership of company’s securities
4. Potential defaults under existing contracts or potential litigation 5. All material correspondence with Govt. agencies
6. Pending laws or regulation that may effect the company’s business 7. Product backlogs, purchasing, inventory and pricing policies 8. Pending negotiation for the purchase or disposition of assets or liens
9. All related party transaction 10. SWOT analysis of the target
11. Projected financial statements with assumption (optimistic, pessimistic and most probable) Management
1. Organization chart
2. Key personnel and their detailed bio-data 3. Internal audit reports
4. Management letters issued by auditors 5. Personnel policies
6. Agreements with labour and staff unions
7. Policy for appraisal of executives, setting of KRA goals etc. 8. Training
9. Public relations 10. Safety
Finance
1. Details of all loans (long and short term) and charges 2. Assets taken on lease/HP
3. Overdues of loans and reschedulement, if any
4. Reserve Bank of India’s approvals for any Foreign Currency Loans Legal and Statutory
1. All appeals related to income tax, sales tax, excise, customs, etc. 2. Details of pending assessments related to above
3. Details of legal / professional expenses for last five years 4. Statutory liabilities if any overdue
5. Details of all contingent liabilities and all legal cases by or against the company 6. Exports and other obligation and commitments
7. Disputed taxes and duties and payment under protest Key Information from Outside Sources
1. Market studies 2. Product test data
3. Confirmation of customer satisfaction from major customers 4. Outstanding capitalization from the company’s stock transfer agent 5. Absence of defaults from the principal lenders and lessors
6. Absence of liens or judgement via searches of public records
7. Patent and trademark searches for possible infringing products or names 8. Certificate of good standing
9. Title search reports 10. Valuation reports, if any
11. Credit reports from ICRA, Dun & Bradstreet etc. CHECK LIST FOR DUE DILIGENCE REVIEW
(This list is illustrative only. It might require a modification keeping in view the facts and circumstances of each case)
Check list for other things to be done in due diligence review History of target
Company no.: Permanent A/C no.: Date of incorporation :
Date of commencement of business Brief history of business
Current operations and principal products Approval for sales:
• Board • Articles
• Member u/s 293(1)(a) of Companies Act • FI/Banks
• FEMA (if non resident) • Anti trust law if any
Changes in directors/auditors/CEO etc. in recent past and reasons Locational advantages
No. of emplyees (management, staff and labour) JV partner
Mission and vision Capital structure
Capital structure: authorised, issued, subscribed, paid up capital- type wise agree with member’s register and confirmation from registrar.
Bonus, rights issue history issue of ADR, GDR etc. Group company details (including associates, subsidiaries). Restriction on share transfers, lien on shares, lock in period, etc. S
oftware
Software/ERP used Computer controls
Adequate no. of licenses in place? Financial management
Financial and internal controls Budgetary control (effective?) Delegated powers
Derivatives and options MIS
(MIS v accounts) Forex management Break even point Dividend policy Accounting records
Accounting policies/practices-check changes if any in last five years Balance sheet
List of assets, location etc. (area, floor space etc)
Immovable property documents scrutiny-free and leasehold –cross check with Govt. taxes etc.-check for surplus land etc. for future expansion
Capitlization guidelines Unused/unsuable/surplus assets Revaluation reserve accounting
Major capital additions of last five years
Pre-operative expenditure capitalized and if in accordance with ICAI guidance note Analysis of investments especially group investments
Assets with impairment in values
Is any asset immediately to be subjected to any major repairs etc. Any asset acquired purely for tax planning?
List of inventories and policies
Slow/non moving/unsuable inventories ; inventories not in present manufacturing program Whether cut-off proper?
Confirmation for third party stocks Valuation of inventories proper?
Aged analysis of receivables, advances etc. assessment of bad and doubtful debts/advances Dues from Govt./Govt. bodies
Confirmation
Creditors, liabilities
Provision for warranties, sales returns etc.
Provision for premium payable on redemption or debentures etc. Wealth tax, property tax etc. liability
Confirmation
Reconciliation and confirmation of bank/ loan accounts Cash confirmation
Compliance with S 58 A Deferred revenue expenditure
Review of muster rolls, salary registers, PF, ESI etc. Deferred taxes Physical verification Physical verification of : • Investments • Stocks • Fixed assets Profit and loss Account
P&L analysis and comparison with previous period and budget Income recognition policy
Extra ordinary and non recurring expenditure and income Analysis of other income
Depreciation and amotization policies
Consumption of key raw materials etc. actuals v norms
Inter company transactions within group /inter division transactions Transactions immediately before decision to sell
US GAAP v Indian GAAP reco, if any Ratio analysis
Benchmarking /inter firm comparison Marketing and selling
Market segments and market shares
Competitor data; prices; market shares; volumes; R&D etc. New market opportunities
Channels of distribution Evaluation of distributors
Advertisement policy
Selling arrangements, sale promotion; sole selling agencies and company law compliance Export pricing
Govt. controls in sales area
Sales analysis by region, product, sales channels, types of products, customers etc Credit policy
Brand value, position
Import parity price, price break up at each stage of sale etc. Order backlog, LD etc
Reliance on few customers Product lists, catalogues etc Manufacturing /operations Manufacturing process
Technology absorption and foreign tech know how Capacity and utilization (any dispute with Govt.?) Balancing required for debottlenecking
Factory lay out Power back up Patterns, moulds, dies Is technology latest? Pollution and environment Spares /support availability R&D (what is in pipeline?) Quality (ISO, SEI-CMM etc) Awards
Purchasing
Availability of key raw materials Purchase efficiency
Imports and time required
Import duties; MODVAT/CENVAT available Forward commitments, hedging etc
Govt. controls
Reliance on one supplier for key raw materials
Inter company purchases within the group Interviews within key executives
Gauge style of management, commitment, employee morale, freedom in work, key problems and issues, SWOT of company and SW of individual
Search
Search in office of the registrar, sub registrar of assurances, ROC, Civil courts, Revenue courts Municipal offices etc
General
Lease for premises etc. are current?
Any expected changes in legislation affecting the industry/unit? Is the price asked too good to be true?
IPR related issues
Long range outlook for industry Post acquisition aspects
What is likely to change after the proposed merger/ take over? Resultant goodwill if any, and its impact on buyer’s income statement Impact of merger/ acquisition from the angle of :
1. Cultural issues
2. Accounting policies and methods 3. Audit
4. Planning and control 5. Treasury
6. Organization
7. Personal policies and practices 8. Production
9. Possible surplus labour
10. Possible surplus office space and admin. Overhead 11. R&D
12. Surplus assets 13. Communications 14. Purchasing 15. Products
16. Market and prices 17. Sales organization 18. Sales prices 19. Advertising
20. PR 21. Tax 22. Legal 23. Listing
Contents of a Due Diligence Report
The contents of a due diligence report will always vary with individual circumstances. Following headings are illustrative.
Executive Summary Introduction
Background of target Objectives of due diligence
Terms of reference and scope of verification Brief history of the company
Share holding pattern Observation on the review
Assessment of management structure Assessment of financial liabilities Assessment of valuation of assets
Comments on properties, terms of leases, lien and encumbrances Assessment of operating results
Assessment of taxation and statutory liabilities
Assessment of possible liabilities on account of litigation and legal proceedings against the company Assessment of net worth
Interlocking investments and financial obligations with group/ associates companies, amounts receivables subject to litigation, any other likely liability which is not provided for in the books of account
SWOT ANALYSIS Comments on future projections
Status of charges, liens, mortgages, assets and properties of the company
Suggestion on ways and means including affidavits, indemnities, to be executed to cover unforseen and undetected contingent liabilities
Suggestion on various aspects to be taken care of before and after proposed merger / acquisition Epilogue
In effect of due diligence is a combination of proprietary audit, statutory audit and internal audit. It can be a big tool in the strategic decision making of an entity. In this sense it can truly help the entity entering, into the merger / acquisition to increase its shareholders’ wealth.
