Having the advantage of being integral to thousands of healthcare transactions each year, VMG Health’s healthcare Financial Due Diligence experts are able to provide proprietary insight and market intelligence to our clients. Our professionals have the domain expertise and skills to assist organizations with the numerous types of analyses and support to enable effective strategic decision making.

What is financial due diligence?

Financial due diligence is a process of investigating, verifying and/or validating the integrity of a company’s financial information relative to a potential transaction or investment.  Financial due diligence is performed prior to the close of a transaction to provide a potential buyer assurance of the company’s financial performance.

Transactions that undergo a thorough due diligence process typically provide a higher chance of success.  Due diligence helps assure that a potential buyer is making an informed decision by enhancing the quality of information available to all decision makers.

Buy-Side Diligence

From a buyer’s perspective, financial due diligence allows a buyer to gain comfort that their expectations regarding the transaction are validated.  Relative to a merger and/or acquisition, purchasing a business without performing due diligence substantially increases the risk to the buyer / purchaser.

Sell-Side Diligence

From a seller’s perspective, financial due diligence is conducted to provide assurance to a buyer / purchaser and build trust that’s what’s being purchased has been vetted for potential exposures and the integrity of information and accuracy of their financial statements have been reviewed and free from errors and omissions.  While going through such a rigorous process, many sellers discover that the fair market value of their company is more than what they initially thought to be the case.  Lastly, many sellers that undergo such a process are more prepared for the onslaught of questions and information that a buyer will need to gain comfort as they perform their own due diligence.  

Reasons for Financial Due Diligence

There are many reasons why due diligence is conducted.  Noted below is a list of common reasons for such diligence:

  • To obtain information that would be useful to the buyer in valuing the transaction / investment opportunity
  • To confirm and verify information about the potential transaction / investment opportunity
  • To identify potential exposures relative to the transaction or investment opportunity and thus avoid mistrust between the buyer and seller
  • To assure that the transaction / investment opportunity meets the buyer’s investment criteria

Financial Due Diligence Type of Analysis 

When performing financial due diligence, the main areas of focus typically relate to a company’s (i) quality of earnings, (ii) debt and debt like items, and (iii) normalized level of working capital.  Refer below for further insights.

Quality of Earnings – Potential buyers focus on the historical earnings of the acquisition target excluding non-recurring and one-time costs/expenses, as this will affect the valuation of the company.  The items highlighted below provide an overview of the typical type of adjustments that are proposed at deriving at a company’s quality of earnings.

  • Management adjustments – These types of adjustments are commonly found when purchasing a business and consist of onetime or excessive compensation, transaction costs, legal settlements, and personal expenses (i.e. like a private jet, travel, etc.)
  • Due diligence adjustments – These types of adjustments primarily consist of accounting true-ups for bonuses and reserves, inventory valuation, revenue recognition, accrual / reserve reversals, etc.  These adjustments also include cost cutting and unsustainable margin type adjustments.
  • Pro forma diligence adjustments – Such adjustments occur when a company has made a recent acquisition or divestiture.  They are an attempt to answer how would historical earnings been impacted by recent changes to the business due to a fundamental change in structure, acquisition, or divestiture.  This includes any synergies associated with the elimination of positions or facilities, change in material contract terms, open positions, known cost increases, etc.).
    • Debt and Debt Like Items – From a diligence perspective, both the buyer and seller will want to understand what debts and liabilities are owed and outstanding by the company as such amounts will need to be reduced from the purchase price of the company (i.e. cash free / debt free transaction).  All liabilities should be categorized as either working capital or debt and debt like in nature.  Sellers have an incentive to have lower debt and debt like items; however, potential buyers want to ensure that they are not left taking on such liabilities post transaction.  Common debt and debt like items include, amongst others, deferred revenue, deferred compensation, aged accounts payable, legal settlements, and potential tax related exposures.
    • Normalized Level of Working Capital – Post transaction, a potential buyer will want to make sure they have adequate working capital to operate the company.  Both the buyer and seller will want to analyze the working capital of the company to better understand the needs of the operation.  Many times, various adjustments are needed to normalize working capital to estimate a target amount that should provided to the buyer post transaction. Such adjustments include the remove of CAPEX purchase, non-recurring items, and various accrual / reserve adjustment proposed within the quality of earnings analysis.  

Costs of Due Diligence

The costs of undergoing a due diligence process depends on the type of transaction, transaction size, scope of work, and duration of the effort, which depends heavily on the complexity of the business and/or transaction.  Such costs are easily justifiable compared to the risk associated with making an uniformed decision.  Parties involved in the transaction typically determine who bears the expense of performing due diligence.  Both the buyer and the seller typically pay their own diligence expense associated with hiring investment bankers, lawyers, accountants, and other consulting advisors.

Why Due Diligence Matters

Financial due diligence helps buyers, sellers, investors and companies understand the nature of the transaction, the risks and exposures involved, and whether the transaction is the right investment for them.  Essentially, undergoing a thorough due diligence process is like doing your “homework” about a potential investment and is essential to make a sound decision.