The traditional view of due diligence was that it took place once a letter of intent was signed between the parties (or in some cases, a purchase and sale agreement).  However, the due diligence process is more than an information collection procedure; it is a verification process that may uncover items that should be included in the negotiations leading up to the letter of intent.

We believe that due diligence must be separated into two functions – investigation and verification.  The investigation aspect (i.e. the collection of information) involves developing an understanding of the business, assessing the risk of the acquisition and refining a pricing model based on the assessment of risk.  The verification aspect involves ensuring that one receives the quantity and quality of net assets that was anticipated in the agreed upon price and terms.

The due diligence process is comprised of both a financial review and an operation review.  The financial review is more commonly known, involving an examination of financials and the related financial analysis of cash flow and working capital.  The operational review is intended to complement the financial review and ensure that the purchasers obtains a complete and balanced perspective of the target business, and involves considering the market, tangible assets, production processes, human resources and so on.

Some examples of the types of information which should be requested by the purchaser in order to perform due diligence (both financial and operational) of the target include:

• Year end financial statements for at least the last three years;
• Internal monthly financial statements (with comparatives) for at least the most recent/current period;
• Current management-prepared budgets/projections;
• Current trade receivables and payables aging;
• Recent property appraisals;
• Sales and margin information by division or major product line;
• Analysis of historical sales by key customer;
• Recent corporate tax return;
• Key contracts – customers, suppliers, leases, etc;
• Employee analysis, including remuneration, years of service, benefits, labour agreements;
• Management analysis, including remuneration, biographies, contracts;
• Production capacity and processes;
• Financing agreements and details;
• Existence of litigation/lawsuits.

It goes without saying that a review of historic financial statements and current management budgets is essential to an assessment of any target acquisition.  Many purchasers however, make the mistake of over-emphasizing the review of the income statement to the exclusion of the balance sheet, statement of cash flows and the notes to the financial statements.  Since cash flow is ‘king’ when it comes to pricing most businesses, purchasers should consider the capital asset spending (“capex”), working capital fluctuations and debt service ability only obtainable from a detailed review of the complete financials.