What is Due Diligence? A Full Explanation

 

Have you ever purchased something—whether that be a car, a TV, or a computer—only for it to turn out to be a total dud? That regrettable outcome could have very well been avoided had you practiced what is known as “due diligence.”

In a general sense, due diligence refers to the process of exercising great care by taking precautions before making a decision or entering into an agreement of some sort. While the term can apply to a variety of settings, in this article we’ll be discussing what it means within a business context.

Think about it like this: companies don’t want to be ripped off any more than you do—especially when they’re looking to purchase a multimillion dollar business. To prevent that from happening, they hire accountants (like us) to perform due diligence prior to signing off on a deal. 

As accountants, our job is to provide an in-depth analysis of a company’s financial status, ensuring full transparency ahead of a purchase. It’s an important role that can quite literally make or break a deal. 

According to Ansarada, a fintech company that specializes in M&A software, approximately 46% of business deals fall through due to issues uncovered during the due diligence process. Let that sink in for a minute. That’s nearly one out of every two!

When talking about due diligence, it’s common for people to use the term interchangeably with “audit.” However, they’re actually two different things, as we’ll explain in the following section.

What’s the Difference Between Due Diligence and an Audit?

While similar, due diligence is not the same thing as an audit.

An audit provides verification that all existing financial records are accurate, whereas due diligence takes it a step further by analyzing those records and highlighting key areas of concern for investors. While both are good to have, due diligence can be thought of as an extra layer of protection that offers additional assurance.

Here’s an analogy that may make it easier to understand.

Let’s say that you’re buying a car. You decide to shop for a certified used car, as it includes a 150-point inspection that assures you that the vehicle is in good working condition. But be that as it may, it’s still not a guarantee. Think of this as an audit. 

Still wary, you decide to bring in your own personal mechanic to inspect the vehicle—just for good measure. Think of this as due diligence.

See the difference?

What Do Accountants Look at During the Due Diligence Process?

Accountants examine a variety of figures and reports during the due diligence process. Listed below are some of the most common. 

Income and Expenses

This starts with verifying the sales and costs that are claimed are valid and verifiable but goes much farther. We want to make sure they are in line with expectations and internally consistent. Often the same expenses are coded to different accounts, making comparisons difficult. Sometimes income is double counted or missing and we want to identify those instances. 

The value of the business itself is typically determined as a multiple of the adjusted profit, so we have to be sure this profit number is in fact correct!

Assets

Assets are valuable, which is why accountants will go to great lengths to ensure there are no inaccuracies in the reporting of them. Accountants check for discrepancies by looking at the financial information recorded in the company’s general ledger and comparing it to the actual physical assets. Other assets-related items like depreciation methods and maintenance expenses may also be reviewed as part of this procedure.

Liabilities

Equally as important as assets are liabilities, which is why it is one of the primary areas accountants focus on during the due diligence process. 

The objective is to confirm whether or not the company is repaying its suppliers, vendors, lenders, and/or banks. To achieve this end, accountants review the company’s books and then contact some of the individuals to whom the company is indebted. This investigative procedure verifies liability amounts and ensures that the company has made good on its dues.

Equity

How much a company is worth in terms of dollars and cents largely boils down to its equity. Simply put, equity is what’s left over once the business has paid back all the money it owes. 

assets – liabilities = equity

With that being said, it’s not the only factor buyers consider when assessing the overall value of a business. 

Cash Flow

It’s possible for a company to be highly profitable, only to suffer financially due to insufficient cash flow. This can happen when too many of its sales are in the form of credit.

Part of the due diligence process involves a full review of all cash inflows and outflows. This assessment is used to determine how well the company manages money.

Add Backs and SDE

Not all business expenses that one owner has are going to be the same for a new owner. For example, the current owner may have a business coach and enjoy traveling to conferences to learn more about the industry. These are legitimate business expenses, but not necessarily ones a new owner would choose to spend money, so in the process of valuing the business we “add back” these discretionary expenses to get a number called the SDE or “Seller’s Discretionary Earnings” which is the profit PLUS the amount of money the business earned that a new owner could decide to take as profit or spend differently than the current owner. 

Verifying the add backs and the SDE is a big part of the due diligence process. 

Trends

We don’t just care how the business did last month or even last year—we care a lot about how the business has been doing over the longer term and how those trends interact. Are sales up but profits down? Are sales up and profits staying level? Those are two very different situations. We look at the major indicators of the business to see how they are moving and if they are in sync or out of sync and what that might predict for the future value of the business and the opportunity or risk it presents to a new owner. 

Valuation Comps

Part of knowing if the price of the business is fair is to compare it to other similar businesses and see what they have sold for (“comps”) and how that matches up with the business we are looking at. If we can find other businesses with similar stats selling for similar prices it probably means the business is priced appropriately. 

On the other hand, if the valuation for this business seems out of line with what others are selling for, either higher or lower, then that is something to be aware of and take into consideration in moving ahead. 

Holistic Business Review

Even if the business review shows that the business you are looking at has very accurate and honest books and tax returns and everything checks out, that still doesn’t mean it’s a good business. A typewriter repair business that has great records still may not be a good place to risk your investment! 

We look at not only whether or not we can verify the numbers, but also at the overall business landscape and environment to try and determine if the business has good long-term prospects or if there are outside factors that may create problems even if everything is exactly as presented on the historical numbers side. 

Projections

Investors often want to know how they can expect the business to perform six months to a year or more down the line.

Accountants can make such predictions based on historical data. These are called projections.

Projections are valuable because they can help buyers forecast their return on investment and make sure the business can support the acquisition if it is taking on debt or needs to cover the new owner’s living expenses, etc.

How Long Does the Due Diligence Process Take?

This is a bit of a difficult question to answer, as the amount of time it takes to perform due diligence largely depends on the size of the project along with the workload capacity of the accounting firm in question. At CapForge, our turnaround time is approximately two weeks. 

Conclusion

Have more questions? Want us to review your books and help with a valuation or due diligence project? Contact us for a free consultation!

You can reach us via email at info@capforge.com or by phone at (858) 633-3573. Alternatively, you can always fill out the contact form below and one of our representatives will follow-up with you shortly.