Financial due diligence in times of considerable planning uncertainties and inflation

​​​published on 22 June 2022 | reading time approx. 4 minutes

Financial due diligence (FDD) is one of the key decision-making aspects for potential investors in transaction projects. In particular, corporate planning, as an essential component of FDD, is used to calculate enterprise value. High inflation rates expected and considerable uncertainty lead to significant planning risks that should be taken into account at all levels.

Companies make a large number of economic decisions in the course of their business activities. Those decisions are always made on the basis of available information and planning. The higher the uncertainty about information relevant to decisions, the more complex is, as a rule, the decision-making process itself.

Currently, fuelled by a multitude of global political, technological and climate-related events, uncertainty is growing and it is impossible to predict future developments including short-, medium- and long-term consequences. Worth mentioning are currently, in particular, the Covid-19 pandemic and the resulting consequences for business life. As the pandemic escalated, lock-downs, shop closures and high infection rates could be observed worldwide. As a result, companies had to factor in high turnover losses, supply chain problems and modified production structures. The already high pressure for transformation towards digital business models and processes intensified again and abruptly increased investment needs. As the Ukraine crisis started, the problems around the already strained supply chains, among others, were once again exacerbated and primary products and raw materials became more difficult to obtain. Businesses and consumers today are facing high inflation in the euro area as well as considerable planning uncertainties as a result of the diverse triggers.

It is now important to take these uncertainties and inflation into account as part of financial due diligence. As a rule, the objective of an FDD is to analyse factors influencing the purchase price. The decisive factor for the purchase price are the business plan calculations, i.e. forward-looking budget figures. Those particularly relevant include EBIT(DA) and cash flow, working capital and net debt.

The analysis of EBIT(DA), cash flow, working capital as well as net debt

The calculation and check of EBIT(DA), based on the income statement prepared under commercial law, essentially refers to the sales revenues, the cost of materials and personnel expenses and other operating expenses.

Simply put, the planning of sales revenues is the factor of the output and the unit price of the goods or services. The planning assumptions made by the company should be particularly considered and require extensive detailed calculations. Due to supply chain problems, lower sales volumes may be expected, growth rates and market growth may be significantly reduced compared to the historical figures, or high order backlogs may not be attributable to improved business performance but rather result from current supply bottlenecks or building safety stocks by customers. Thus, it is possible that the sales revenues will drop in the future as soon as the conditions go back to normal. The importance of already legally effective orders and customer relationships will increase, while the importance of potential new customers and submitted proposals will deteriorate due to the increased uncertainty. It is also a matter of question to what extent increased purchase prices can be passed on to customers. This should also be analysed on a case-by-case basis.

Likewise, the planning of material expenses due to the increased prices for primary products as well as raw materials should be analysed in detail. As with the challenges involved in auditing sales revenues, it is difficult to estimate how prices will develop due to disrupted supply chains, but also increased energy and production costs. As foreseen, the costs are expected to grow significantly, and thus gross margins are expected to decline.

For many companies, personnel expenses are one of the main cost items. Their development will be driven by several aspects. On the one hand, employees will demand wage and salary increases as a result of inflation. At the same time, however, it is important to note that the figures will vary depending on a given collective agreement. In addition, the increasing shortage of skilled workers is a critical factor in many sectors. Other operating expenses are expected to follow other cost increases, as a result of which both EBIT and EBIT(DA) will be exposed to increased risks in the future.

A company's cash flow is usually determined using the indirect method, i.e. the annual result calculated under commercial law is adjusted for items affecting the cash flow. This operating part of the cash flow is supplemented by changes in working capital and cash effects from financing and investing activities. Due to the current and expected high inflation rates, financing costs are expected to increase due to rising interest rates. It cannot yet be foreseen to what extent companies will currently resort to debt capital to make necessary investments (e.g. for the digitisation of the business model). However, due to the increased cost of capital, fewer investments are profitable, as a significantly higher return must be achieved. Cash flows from investing activities must also be analysed in depth with regard to the expected price development, e.g. planned replacement investments.

The analysis of working capital will increasingly have to take into account the recoverability of assets as well as the completeness of liabilities. Greater attention should be paid to changes in payment behaviour with regard to payment deadlines, but also to the interim financing of, for example, deliberately increased inventories and the provision of services. The calculation of long-term working capital within the framework of corporate planning should be considered separately.

The net debt should be thoroughly examined for other relevant debt components. In particular, a company may fail to deliver on any previously concluded financial covenants due to the expected decline in its business. This can result in increased financing costs, but also in the termination of credit lines, for example.

Significance for company valuation

Financial due diligence is an essential component and the basis for determining enterprise value. It encompasses all factors relevant to the purchase price which are intensively examined and discussed. As a result of the current uncertainties and inflation, the complexity as well as the scope of financial due diligence is expected to increase significantly. It is not yet finally foreseeable how the transaction market will react to the increased inherent risk. Nevertheless, companies' enterprise values are expected to decline, although this will always have to be examined on a case-by-case basis.