FINANCIAL DUE-DILIGENCE
August 26, 2010 26

♣ Nitin Arora II
Associate Director

II

Corporate Catalyst India www.cci.in

Financial Due Diligence (FDD)
Financial Due Diligence is a reasonable level of enquiry into the financial affairs having a material impact on the prospects of the business A FDD review may not only look at the historical financial performance of a business but will generally consider the forecast financial performance also The objective is to ensure that prospective investors make an informed investment decision Its a fact gathering exercise with a focused analysis of information. The main sources of information for a FDD review include: Historical financial data including statutory accounts, g y , management accounts and reports and income tax returns Current financial data such as year-to-date management accounts Minutes of Directors’ Meetings and Management Meetings Directors FDD is about: Evaluation, Interpretation and Communication detailed

FDD – When Needed ?
Mostly sought for the following transactions: Disinvestments Strategic investments or a PE investment Acquisition of an undertaking / business Inbound and overseas investments Listing of securities in Indian or overseas market st g o secu t es d a o o e seas a et

Types of Due Diligence

Due Diligence Dili

Nature of Client

Nature of Work

Se S de Sell-Side (Vendor)

Buy-Side Buy Side

Financial

Tax

Legal

Commercial

Purpose of FDD
Identify potential risks for the buyer in its investment decision Evaluate quality of reported earnings and identify value drivers critical to the transaction Corroborate buyer assertions regarding target’s financial position target s Identify issues to be addressed in purchase agreements Assess strengths of financial personnel and systems Improve transaction structure Identify areas for post-acquisition attention It helps in better negotiation with the discovered information

Due Diligence Process
Understand Key Transaction Drivers

Define Scope and Information Req Req.
Analyze Historic Financial Statements

Discuss the Implications of Key Findings with the Management

Analysis of Preliminary Information
Test Assumptions Business Model

Issue the Final Report

Industry Research
Discussion with Key People to Validate Findings

Due Diligence vs. Audit vs
Due Diligence
• Scope and Procedures agreed with client • Does not test the underlying accuracy of information • Can cover future periods • Focuses mainly on quality of earnings • No defined form for deliverables • Limited access and timetable • Uses audit output • Level of materiality may be adjusted to meet client needs Audit • Procedures defined by GAAS in each country • Tests underlying accuracy of the information • Mainly backwards looking; does not cover forecast period • Typically balance sheet focused ( p ) • Financial statements (report) prepared as per GAAP • Scheduled timetables

Financial Statements
What Do They Tell Us?

Financial statements commonly consist of the following items: Income statement Balance sheet Cash flow statement Notes to the financial statements

Key performance indicators (KPI’s) based on financial statements and their development over time, provide good measures for the reasons behind positive or negative performance of a business: Gross margin Operating margin Working capital days g p y Debt Equity ratio

Why Do We Analyze Them?

Financial Statements

Financial statements are typically the basis for determining valuation Identify inconsistent accounting policies and one off items Understand the estimates and judgments used in reported numbers Historical results are used to challenge forecasts / projections Identify matters that impact valuation and transaction documents i.e. SPA / SHA etc. To advise on the level of recurring EBITDA/EBIT (Quality of Earnings Analysis)

What to analyse in FDD?
Income Statement (P&L)

Sales by region/ customer/ product product... Volumes Prices Cost of sales Raw materials (such as volumes, prices, supplier dependency) Manufacturing costs (costs per unit headcount …) unit, ) Margins by region/ customer/ product... Overhead costs - Fixed Vs Variable EBITDA/EBIT development over a number of periods

What to analyse in FDD ?
Balance Sheet
Current assets Inventory valuation Debtors ageing and provisioning Nature of long and short term advances Liabilities Payment terms Provisioning policy Fixed assets Degree of depreciation Capital expenditure Working capital items impact purchase price consideration Cash flow impacts Seasonality Net debt – Debt and Debt like items

Key issues in FDD
Revenue drivers and recognition issues Cost drivers and accrual issues Depreciation policies adopted Valuation of current assets - Non-provisioning for obsolete inventory and doubtful debts Adequacy of accruals Advance Tax / Provision for Taxation Contingent liabilities and off balance sheet items Change in control clauses

FDD s FDD’s Relation with Other DD s DD’s
Framework of Due Diligence is designed for “Client Success” Commercial due diligence compares future business plan and revenue potential with the industry trends Cost assumptions may be tested through technical and operational due diligence Various costs impact profitability e.g. employee related matters could eg be tested through HR due diligence Legal due diligence helps in spotting various hidden issues like arrangements with associates and stakeholders t ith i t d t k h ld Financial Due Diligence overlaps with all other areas of Due Diligence and should not be conducted in isolation

Questions?

Thank You