Acquiring an established business in India can provide foreign and domestic investors with access to an existing customer base, workforce, infrastructure, technology, and market presence. However, the financial position of a target company needs to be understood before an acquisition is completed.

This is where financial due diligence becomes an important part of the acquisition process. It allows investors and management teams to examine the financial information of a target business and identify areas that may require further investigation before making an investment decision.

What Is Financial Due Diligence?

Financial due diligence is a structured review of the financial information and performance of a business before a transaction such as an acquisition, investment, merger, or restructuring.

The objective is to develop a clearer understanding of the company's financial position and the factors that influence its future performance.

A financial due diligence exercise may examine areas such as:

• Revenue and profitability
• Working capital
• Cash flow
• Debt and liabilities
• Customer and supplier concentration
• Operating expenses
• Capital expenditure
• Financial projections
• Accounting policies
• Contingent liabilities
• Related-party transactions

The scope can vary depending on the nature and size of the transaction.

Why Is Financial Due Diligence Important?

Financial statements provide valuable information about a company, but an investor may need a deeper analysis before proceeding with an acquisition.

A business may report growing revenue while simultaneously experiencing pressure on margins or working capital. Similarly, reported profits may not always provide a complete picture of the company's underlying financial performance.

Due diligence can help investors examine these areas in greater detail and identify questions that may need to be addressed before the transaction.

Reviewing Revenue Quality

Revenue is one of the first areas typically examined during financial due diligence.

The analysis may consider:

• Revenue growth trends
• Major customers
• Customer concentration
• Recurring versus one-time revenue
• Pricing changes
• Revenue recognition practices
• Seasonality
• Contract terms

A business with a high dependence on a small number of customers may have a different risk profile from one with a diversified customer base.

Understanding how revenue is generated can therefore be important when assessing the sustainability of the business.

Analysing Profitability

Reported profitability is another important area of review.

A due diligence team may examine gross margins, operating expenses, EBITDA, and other relevant financial indicators to understand the company's underlying performance.

The analysis may also identify unusual or non-recurring items that have affected reported results.

For example, one-time expenses or exceptional income may need to be considered separately when evaluating the company's ongoing operating performance.

Working Capital Review

Working capital can have a significant impact on the cash requirements of an acquired business.

A review may consider:

• Trade receivables
• Inventory
• Trade payables
• Outstanding advances
• Collection periods
• Payment cycles
• Seasonal working-capital requirements

A company may appear profitable but still require substantial working capital to support day-to-day operations.

Understanding these requirements can help investors assess the funding needs of the business following an acquisition.

Assessing Debt and Liabilities

Financial due diligence should also examine the company's debt obligations and other liabilities.

This can include:

• Bank borrowings
• Loans from related parties
• Lease obligations
• Outstanding statutory liabilities
• Contingent liabilities
• Guarantees
• Other financial commitments

Understanding existing obligations can provide greater clarity regarding the financial position of the target company and the obligations that may continue after the transaction.

Examining Cash Flow

Profitability and cash flow are not always the same.

A business can report accounting profits while facing cash-flow pressure due to delayed customer collections, high inventory levels, capital expenditure, or other factors.

Reviewing historical cash flows can therefore help investors understand how effectively the company converts its operating performance into cash.

Cash-flow projections can also be reviewed to understand potential future funding requirements.

Identifying Related-Party Transactions

Related-party transactions can be particularly relevant when evaluating a business that is part of a larger group.

Transactions may include:

• Loans
• Management fees
• Purchases from related companies
• Sales to group entities
• Shared services
• Rental arrangements
• Other intercompany transactions

These arrangements should be understood in the context of the target company's normal operations and financial performance.

For cross-border transactions, tax and transfer pricing considerations may also need to be evaluated separately.

Reviewing Financial Projections

Historical financial performance is only one part of an acquisition assessment.

Investors may also review management's projections for revenue, expenses, profitability, capital expenditure, and cash flow.

The assumptions behind these projections can be as important as the numbers themselves.

Questions may include:

• What assumptions support projected revenue growth?
• Are expected margins consistent with historical performance?
• What additional investment is required?
• Are new customers or contracts already secured?
• What factors could affect projected cash flow?

Reviewing the assumptions can help provide context around the company's expected future performance.

Accounting Policies and Quality of Financial Information

Different accounting policies can affect how financial performance is presented.

Due diligence may therefore involve reviewing significant accounting policies, adjustments, revenue recognition, depreciation, provisions, and other relevant areas.

The objective is to understand whether the financial information being reviewed provides an appropriate basis for assessing the business.

Where differences or unusual accounting treatments are identified, they may require further analysis as part of the transaction process.

Key Questions Before an Acquisition

A financial due diligence exercise can help investors address several important questions:

Is the reported revenue sustainable?

Are current profit margins representative of normal operations?

How much working capital does the business require?

Are there significant debt or contingent liabilities?

Does the company have customer or supplier concentration risks?

Are related-party transactions material to the business?

Are management's financial projections supported by reasonable assumptions?

The answers to these questions can contribute to a more informed evaluation of the target company.

The Role of a Financial Due Diligence Advisor

A professional financial due diligence consultant can assist investors and management teams in reviewing the financial information of a target business.

Depending on the transaction, the scope may include historical financial analysis, quality of earnings, working-capital assessment, debt and liability review, cash-flow analysis, projections, and identification of key financial risks.

For foreign investors considering an acquisition in India, financial due diligence can also be considered alongside broader tax, legal, regulatory, and business due diligence.

Conclusion

Financial due diligence is an important component of the acquisition process because it provides a deeper view of the target company's financial performance and position.

Reviewing revenue quality, profitability, working capital, cash flow, debt, related-party transactions, accounting policies, and financial projections can help investors understand the financial factors that may influence the transaction.

For businesses considering an acquisition in India, a structured financial due diligence process can support the broader transaction assessment and help management identify areas requiring further investigation before completing the deal.