In the world today, a cautious sense of relief is beginning to take hold as vaccines are increasingly being rolled out and the scourge of Covid-19 starts to take a back seat in the international news media. The world we are starting to imagine for the future can justifiably be dubbed, ‘post-Covid’.
As anyone in the professional world will be able to attest, the pandemic has fundamentally changed the environment in which we do business. This, in turn, has altered our investment decisions and the necessary checks and audits that need to be performed.
What is Financial Due Diligence
Due diligence is something that companies normally perform in order to avoid committing an offense and to ensure that they are operating within the boundaries of the law.
Similarly, financial due diligence (FDD) is the term used to describe an inquiry or investigation into a potential investment to confirm the facts that could significantly influence investment decision-making. The purpose of this could be for a merger or acquisition, issuing new shares, or any other transaction where risk is relevant and necessary to make a decision using reasonable care.
An FDD is commonly misunderstood as an audit. The key difference between them is that an audit looks back, while an FDD looks both backwards and forwards, to uncover vulnerabilities and opportunities, and to reveal a realistic future for the company.
The primary purpose of an FDD is an assessment of the financial health of a business.
What do we mean by “Financial Health”?
Financial health can be summarised in four main internal areas of a business:
- Liquidity is the cash on hand that can be used by the business today.
- Solvency compares the assets of a business to its liabilities to measure whether a company can meet its long-term financial obligations.
- Profitability measures profit against revenue and costs, to give a broad overview of a business’s current financial position and viability. The gross profit, net profit and EBITDA margins are good indicators for understanding and strengthening profitability.
- Operating efficiency measures operating costs against sales to show how profitably a business is serving its customers.
These four aspects taken together make up the overall health of the business, and they can be used as a measure of present performance and future success.
Why perform an FDD?
FDD’s are very useful, especially where investment transactions are concerned. For starters, investment transactions that undergo a due diligence process offer higher chances of success.
Due diligence contributes to making informed decisions by enhancing the quality of information available and identifying all material risks. Such risks will need to be managed should the acquirer proceed with the transaction.
The risks may also be used as negotiating power for the acquirer in determining the value at which the transaction takes place. Alternatively, if the risk is outside of the acquirer’s appetite, the process might result in an unsuccessful transaction.
A systematic process helps to ensure that buyers and sellers are on the same page. This helps to prevent any entity from unnecessary harm to either party throughout a transaction.
FDD’s Post-Covid shift
With market stability returning in what we are tentatively calling the ‘post-Covid era’, FDD’s focus has changed and there are new factors to consider in a business environment that is fundamentally different.
An FDD looks both backwards and forwards, and it is therefore useful for envisioning a realistic future for a particular company. FDDs will now need to assess how businesses responded to the pandemic and how they may have carried on differently. Investors may specifically consider new post-pandemic liabilities. Identifying a company’s ‘new normal’ – in other words, the way that it does business now and in the future – may be necessary.
Furthermore, we expect there to be a focus on areas such as supply chain risk, health and safety, financing arrangements and cybersecurity, given the accelerated digitisation in many sectors of the economy. A business’s digital capabilities will be of utmost importance.
Also, going forward, force majeure clauses in fundamental legal agreements will be relevant especially with the possibility of future waves of the pandemic.
In the current environment, we are seeing an increase in ‘quasi-distressed’ deals coming to the market which is where companies are needing to dispose of assets to support their core business post-pandemic.
While Covid-19 hasn’t changed the overall purpose of an FDD, it is important to assess the impact that the virus has had on the FDD process. It would be difficult to find even one company that has not been affected by the pandemic in some way, so it is only natural that financial and professional advice is needed now, more than ever.
If you think you might need professional assistance in assessing the risks of a potential investment transaction, contact Creative CFO for FDD support.
References
Arnoldi, M. (n.d.). Pandemic has influenced due diligence priorities for M&A activity, says law firm. [online] www.engineeringnews.co.za. Available at: https://www.engineeringnews.co.za/article/pandemic-has-influenced-due-diligence-priorities-for-ma-activity-says-law-firm-2020-09-14/rep_id:4136
International, B. (n.d.). Post-COVID Due Diligence. [online] blog.benchmarkcorporate.com. Available at: https://blog.benchmarkcorporate.com/post-covid-due-diligence
https://www.nortonrosefulbright.com/en-za/knowledge/publications/2021/q1. (n.d.). Due diligence in the time of COVID. [online] Available at: https://www.nortonrosefulbright.com/en za/knowledge/publications/ce966575/due-diligence-in-the-time-of-covid
