Important Terms Used in Financial Due Diligence (FDD)
Introduction to Financial Due Diligence
In the intricate dance of business transactions, Financial Due Diligence (FDD) plays a pivotal role. It’s the calculated step of verification, the rhythmic checking of financial health before a commitment is made. Just as you would scrutinize the mechanics of a car before purchasing, FDD is the due care investors take to ensure that their potential investment runs smoothly, free of hidden faults that could later derail its success.
Financial Due Diligence Jargon & Abbreviations | Important for Interview
Also Read: What is Internal Audit? Why does it matter?
| Term | Definition | Example(s) |
|---|---|---|
| Data | Raw information forming the basis for analysis. | Analyzing five years of revenue data to assess customer concentration, quantity, and price trends. |
| Databook / Datapack | An organized collection of data in an Excel format, facilitating analysis. | Excel file detailing financial metrics, enhancing scrutiny such as revenue trends, expense breakdowns, and market share analysis. |
| Reported Basis | Financials based on audited or reported balance sheets. | Examining company financial health using audited balance sheets, e.g., scrutinizing revenue growth and debt levels for accurate due diligence. |
| Adjustments | Involves actions like removing CFO salary to manipulate income. | Adjustment by Management: Excluding the CFO's salary to artificially inflate profits, a deceptive practice uncovered during due diligence. |
| Actual, Budget, Forecast | Actuals reflect past performance, while budgets and forecasts provide future projections, considering them provides varied perspectives for financial planning, including historical, projected, and forecasted data. | Actual: Reviewing audited financial statements for the previous fiscal year. Forecast: Evaluating predicted financial performance based on market trends and internal projections. |
| LTM (Last Twelve Months) | Analysis based on the most recent twelve months, often used on a rolling basis. LTM figures offer a current snapshot for meaningful comparisons. | LTM Revenue: Rs. 15 million reflects the company's recent financial performance. LTM EBITDA: Rs. 5 million indicates profitability over the last twelve months. |
| Clawback | The reclaiming of previously distributed funds, often relevant in Earnouts, crucial for ECLM (Excess Cash Lockbox Mechanism). | If a company faced a bad debt in the current year from a sale in the previous year, the clawback adjusts the previous year's sale, not the current year. |
| Debt-Like | Items in the balance sheet resembling debt but not explicitly classified as such. | A creditor existing in the books for more than the normal operating cycle days, including a finance element is a Debt-Like Item. |
| EBITDA vs. PBT | EBITDA: Earnings before interest, taxes, depreciation, and amortization. PBT: Profit before tax. | EBITDA: Rs. 10 million revenue - Rs. 5 million operating expenses = Rs. 5 million EBITDA. PBT: Rs. 5 million EBITDA - Rs. 1 million interest - Rs. 2 million taxes = Rs. 2 million PBT. |
Three Fundamentals of Financial Due Diligence
- Quality of Earnings (EBITDA):
The Quality of Earnings determines whether a company’s revenue is sustainable and repeatable. This metric scrutinizes the earnings to see if they are derived from the core business activities or if they have been inflated by one-time events or accounting anomalies. To ensure accuracy, we always check EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which represents operational business profits without the noise of financial structuring.
- Consideration of Cash-Like Items in Net Cash:
Net Cash goes beyond traditional cash holdings to include cash-like items — those assets that contribute to a company’s immediate liquidity and financial agility. This may encompass marketable securities, short-term investments, and certain receivables. By considering these items, we gain a more comprehensive view of the company’s immediate financial strength and flexibility.
- Net Debt (/Cash):
Net Debt is a crucial metric that factors in a company’s total debt, subtracting cash and cash equivalents to determine the net amount a company would have to pay off if all debts were due immediately. This metric reflects a company’s ability to service its debt and is a key indicator of financial stability.
These three fundamentals form the backbone of Financial Due Diligence, enabling experts to dissect and understand a company’s financial narrative thoroughly. Mastering these concepts is not just beneficial but essential for professionals engaged in the complex and nuanced world of FDD.
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