Financial due diligence is a critical part of the investment process that is carried out after filtering potential options. The role of financial due diligence is indispensable regardless of the industry your business operates in. The aim is to bring more transparency and accountability into the system by highlighting any anomalies that prevail. A financial due diligence report is something that most private equity consulting firms and investors look forward to. It paints a complete picture of the financial health of a business. Let’s learn more about private equity and the role of financial due diligence in private equity.
What is private equity?
Private equity can be defined as an alternative investment tool that allows investors to invest funds into companies that are not on public exchanges. Investors get a percentage of a share in the company on account of their investment. It includes funds and investors who directly invest in private companies. Investors also indulge in buying out a publicly listed company through private equity. Both institutional and retail investors take part in private equity consulting. The capital obtained through private equity channels is mainly used by companies to improve technology & resources, make acquisitions and expand operations.
Key due diligence considerations for private equity
Due diligence is an essential part of the private equity process. However, the process can be time-consuming and exhaustive. Tracking and managing different aspects of the due diligence process for private equity can be hard. Knowing the objective of your due diligence process can set you on the right path. The main aim of any due diligence activity is to assess the risks related to a business and measure if it’ll be a profitable investment. Here are some of the most important due diligence activities that are conducted during private equity consulting.
- A comprehensive financial history of the potential private company, including series terms, revenue estimates, cash flow, cap tables, etc.
- A detailed report of major debt obligations, legal arrangements or agreements that can cause loss to the target company.
- A detailed overview of performance bonds or guarantees and credit of the potential company.
- An analysis report on the inventory costing system and other key procedures of the potential target.
- A copy of the bank statement and reconciliation documents, if any.
- A comprehensive analysis of competitors, industry leaders and trends in the market.
- A comprehensive description of the target company’s internal control procedures.
- A list of accounts receivable and accounts payable of the target firm.
Why does financial due diligence play a crucial role in private equity consulting?
Financial due diligence plays a crucial role in private equity consulting, as it helps to verify the accuracy of the information presented by the target firm. It helps to establish the authenticity of the facts by verifying and auditing the details presented during the deal. It provides the investors with complete coverage of the risks and opportunities associated with a particular investment. There are various ratios used to analyse the financial positioning of a company during a financial due diligence process. Some of these ratios are mentioned below.
- Gross profit margin
A gross profit margin fairly indicates the proportion of profit in each sale. This can be compared with the acceptable industry standard to measure if the investment prospect is good or not.
- Accounts receivable ratio
This ratio is used to measure the effectiveness of a business in collecting debts from different customers. A lower ratio means that a business is not that effective in collecting debts from its customers.
- Stock inventory turnover ratio
The stock inventory turnover ratio measures a business’s effectiveness at selling out its stock. A low ratio might indicate that the business has problems in selling the existing stocks.
What is a due diligence report?
A due diligence report can be explained as a key document that sheds light on important highlights of the due diligence process. It paints a comprehensive picture of the company’s financial records, intellectual properties, taxation, assets, liabilities, performance, future growth projection, etc. This can evaluate the real value of a company and enable investors to make insightful decisions. A due diligence report also helps to ensure the factual accuracy of the data presented. It also helps to figure out any existing anomalies or fraudulent activities in the process.
