Comparison of Commercial & Financial Due Diligences
Financial Due Diligence (FDD) provides the information and analysis needed to form a view on commercial prospects. But the goal of FDD does the include going beyond the internal analysis or assess rationality and grounding for the future operations and sales. FDD consultants can rely on Commercial Due Diligence (CDD) providers for application of forecast assumptions in financial modeling of the future operations, as CDD examines external environment (and how it might change) regarding the target’s capabilities to operate successfully and meet market challenges. CDD provides a market insight to forecasts and point to which sensitivities should be run as part of the financial modeling. CDD also researches management competency, and FDD does not.
Limitations of Financial Due Diligence:
- FDD is more internally and historically focused; it uses history to explain the logic of future sales.
- FDD consultants collect market information from the target’s management (they do not go out to talk to customers, suppliers or other business participants to assess the target’s market assumptions or theoretical risks).
Therefore Commercial Due Diligence is more needed when making strategic acquisitions. CDD goes to test the logic behind assumptions that stand at the basis of any financial model and test theoretical risks of future business operations. Also, CDD does not need historical figures to build future projections as the results of future operations are not linear to historical data, it depends on many other factors (discussed in).
If an investor relies only on the results of the financial due diligence in making a decision about acquisition, they probably are making several assumptions about the business, for instance:
- Business profit margins are not under pressure of market forces and, therefore will remain similar in the future.
- The future sales will stay similar to the past or will show slight increase in the future periods.
- The relationships with customers are strong, and it will remain in the future.
- Accounting policies have been consistent and reasonably applied to calculate objective profits and will always represent objective financial position of the target in the future.
- There are no potential threatening liabilities significantly higher than maintenance costs.
Looking forward in the future, it can be said with a certain amount of confidence that some of the assumptions made above will not actually be approved even in the short term. Because of the market rivalry, technology changes, and other external pressure factors, the target’s marketing position, competitive advantage, profit margins are also be subjects to pressure and most probably change. The question is: does the target company possess the resources and capabilities to cope with all these pressures to adapt, sustain or develop in toughening marketing conditions. And this is the question to Commercial Due Diligence not Financial Due Diligence.
Again, Financial Due Diligence cannot provide the insights of the target business as financials are backward looking. When acquiring a company, you are buying its future and its future depends on the health of its markets and how well it serves the clients. Quantitative financial analysis should not be the guiding instrument in the due diligence process. It is only by understanding commercial forces influencing the target business can you obtain awareness of a company’s future.
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