A Brief Discussion on Financial Due Diligence Strategies in the Life and Health Field

Financial due diligence plays a crucial role in investment. Its core objective is to identify potential financial risks that may affect transactions through the analysis of the target company’s financial situation, assess the target company’s long-term business sustainability and profitability, and determine the true value of the target company.

The life and health field covers multiple sub-sectors such as biomedicine, medical devices, life science tools and services, healthcare products, healthcare services, and various types of "medical biology +" sectors. As of November 2024, there are approximately 517 A-share listed companies in the life and health field, with a total market value of about 6.33 trillion yuan. Given that different sub-sectors have their unique risk points and characteristics, financial due diligence needs to develop targeted strategies based on industry features. This article mainly analyzes the risks of three major tracks—biomedicine, medical devices, and life science tools and services—and briefly discusses the corresponding financial due diligence strategies.

I. Biomedicine Sector

(I) Typical Risks

The biomedicine industry mainly includes various innovative drug and generic drug enterprises under the Western medicine system. Based on the industry’s characteristics such as long R&D cycles, significant impact from regulatory policies, and dependence on sales channels, we have summarized the main risk points as follows:

R&D Risks: The biomedicine industry is R&D-driven, facing risks of long cycles, high investment, and high uncertainty in drug development outcomes.

Going Concern Risks: Biomedical enterprises usually rely on external financing in the early stages, leading to the risk of high dependence on continuous external financing.

Market Risks: The scale of the pharmaceutical market is greatly affected by medical insurance policies, competitors, and patent protection periods.

Revenue Recognition and Cost Allocation Risks: Enterprises may recognize milestone revenue in advance or underestimate R&D costs, resulting in distorted financial data.

R&D Capitalization Risks: To reduce current profits and losses and beautify operating results, enterprises may inappropriately capitalize R&D expenditures.

Sales Expense Risks: In order to build sales channels and expand markets, enterprises may face risks of paying improper commission rebates or commercial bribes to downstream parties.

(II) Typical Strategies

In response to the above main risk points, we have summarized the key targeted financial due diligence strategies in daily work:

Stress Test the Financial Model: Simulate the impact of R&D failure, patent invalidation, or changes in the market environment on the company’s cash flow and profitability.

Analyze Patent and Intellectual Property Status: Evaluate the patent layout, remaining protection period, and their impact on future revenue.

Examine Revenue Recognition and Cost Allocation Policies: Review whether the method of recognizing pharmaceutical revenue and the allocation ratio of R&D costs comply with accounting standards.

Review R&D Expenditures and Capitalization Treatment: Conduct an in-depth analysis to determine whether R&D expenses meet the capitalization requirements of accounting standards.

Verify the Reasonableness of Sales Expenses: Conduct verification and analysis on marketing expenses, promotion expenses, or other large-scale expenditures in sales expenses to clarify the nature of relevant expenses; at the same time, pay attention to the current accounts of other payables or accrued expenses to check for abnormal counterparties.

II. Medical Device Sector

(I) Typical Risks

The medical device industry mainly includes various medical equipment and medical consumables enterprises. Based on the industry’s characteristics such as short continuous product technology iteration cycles, significant impact from regulatory policies, and the particularity of hospital admission methods, we have summarized the main risk points as follows:

Product Iteration and Technology Risks: The technology update and iteration of medical devices are faster than those in the biomedicine industry, and the barriers to imitation are lower. Therefore, if the R&D and iteration progress lags behind, the risk of losing market competitiveness is high.

Regulatory and Registration Risks: Medical devices need to pass the certification of regulatory authorities. Although the risk of obtaining a medical device certificate is lower than that of pharmaceutical R&D, there is still a risk that product registration fails, preventing the product from being launched.

Market Access and Commercialization Risks: Medical devices are more dependent on hospital admissions and distributors, so there is a high risk that commercialization falls short of expectations due to the establishment of sales channels.

Manufacturing and Inventory Management Risks: Products need to meet strict quality standards, and batch stability is crucial. Quality defects or inventory backlogs will have a significant adverse impact on the company’s operations.

(II) Typical Strategies

In response to the above main risk points, we have summarized the key targeted financial due diligence strategies in daily work:

Verify Product Development and Registration Costs: Pay attention to the reasonableness of R&D expenses and whether the allocation of relevant costs is in line with the actual situation; focus on the impact of cash expenditures related to R&D, application registration, and future production on the company’s cash flow and going concern.

Analyze Sales Channels and Customer Concentration: Evaluate whether sales revenue depends on a single channel or customer, and the impact of such concentration on the company’s operating risks.

Examine Inventory and Quality Management: Assess the target company’s cost structure and yield rate, pay attention to whether the company’s inventory management policy is reasonable, and verify the risks of unsalable inventory, scrapping, and large-scale post-period returns.

Evaluate Gross Profit Margin and Pricing Strategy: Verify the gross profit margin level of different products and the reasons for fluctuations, and assess whether the pricing is competitive.

III. Life Science Tools and Services Sector

(I) Typical Risks

The life science tools and services industry mainly includes various CRO (Contract Research Organization) and CDMO (Contract Development and Manufacturing Organization) enterprises. Based on the industry’s characteristics such as dependence on upstream companies’ R&D investment, long project execution cycles, and high investment in R&D environment construction, we have summarized the main risk points as follows:

Customer Repetition and Dependence Risks: CRO/CDMO enterprises often serve various pharmaceutical companies. The market is a buyer’s market with high customer repetition and fierce competition, resulting in low bargaining power.

Market Prosperity and Demand Fluctuation Risks: The development of the industry is significantly affected by the prosperity of the biomedicine market. A downturn in the pharmaceutical industry will be transmitted upstream, leading to a reduction in orders.

Contract Performance and Project Management Risks: Projects usually have long cycles and complex contract terms, which may lead to risks of improper performance or failure to deliver on schedule.

Capital Expenditure and Unit Cost Increase Risks: Large-scale R&D/production facilities require high initial capital investment. If orders fall short of expectations, there will be insufficient capacity utilization, leading to pressure on costs from fixed asset depreciation.

(II) Typical Strategies

In response to the above main risk points, we have summarized the key targeted financial due diligence strategies in daily work:

Verify Customer Structure and Revenue Stability: Analyze customer concentration and evaluate the diversity of revenue and risk resistance capabilities.

Analyze Project Progress and Revenue Recognition: Verify whether the use of milestones to determine the performance progress under the time-period method is appropriate; second, evaluate whether the milestone payment progress matches the actual performance progress; finally, consider whether the revenue recognition at the balance sheet date between each milestone is appropriate.

Evaluate Capital Expenditure and Depreciation Matching: Analyze the reasonableness of relevant capital expenditures and their impact on cash flow; pay attention to the matching degree between the target company’s order situation and capital expenditures, and the impact of relevant depreciation expenses on the company’s profit and loss.

Examine Cost Control and Gross Profit Level: Analyze changes in direct materials, labor, and manufacturing costs in the cost structure, and pay attention to the target company’s cost control capabilities when orders fall short of expectations.

IV. Summary

This article briefly expounds on the typical risks and typical financial due diligence strategies for enterprises in different sub-tracks of the life and health field. We believe that in investments in the life and health field, due to the differences in the characteristics of different sub-sectors, financial due diligence for the three main sub-sectors—biomedicine, medical devices, and life science tools and services—needs to combine industry characteristics and develop differentiated due diligence strategies targeting their respective risk points: For the biomedicine industry, the focus is on the authenticity, reasonableness, and accuracy of R&D, going concern, revenue recognition, and sales expenses; for the medical device industry, more attention is paid to product iteration, commercialization, and the financial impact of manufacturing; for the life science tools and services industry, it is necessary to analyze customer dependence, project performance capabilities, the reasonableness of revenue recognition, and capital expenditures.

By implementing targeted due diligence strategies and identifying risks, we can provide a basis for judgment from different perspectives for investment decisions.

Source: He Wenqing, Risk Control Department
Review: Xue Yao
Release: You Yi