A Brief Discussion on the Methodology of Financial Due Diligence at Different Stages of an Enterprise
Against the tide of technological innovation, the business world is undergoing unprecedented rapid transformation, and the uncertainties faced by industries and enterprises in their development process have increased accordingly. This article will take the different stages of an enterprise as an entry point to explore how to effectively conduct financial due diligence, providing key data support for clarifying the enterprise's business model, evaluating historical operating performance, and revising future forecasting assumptions, thereby facilitating investment decisions and valuation negotiations.
New technologies, new products, new applications, and new models often bring boundless imagination to investors. For enterprises in the early growth stage, their products and business models may still be immature, and there may be gaps in operating data, which relatively limits the scope of financial due diligence. The following financial due diligence methods can be used to reasonably convert the enterprise's future development expectations into quantitative indicators.
On one hand, by consulting industry experts or comparing the key technical indicators of products between the target enterprise and comparable companies, the maturity and reliability of its technology can be intuitively evaluated. On the other hand, in-depth analysis of expense items and cross-validation with business information can be conducted.
For example, by focusing on the changes in R&D expenses invested in various projects and their composition, the enterprise's technological independence (whether it involves outsourced/cooperative R&D), R&D pipeline, and technical reserves can be evaluated. Paying attention to investments in patent applications, experiment and testing expenses, and even changes in the number of R&D team members and salary structure can, to a certain extent, verify the progress of experiments for a specific R&D project and whether it has reached the expected milestones.
For existing customers, attention is usually paid to customer reviews, sales channels, customer structure and repurchase rate, and whether there are adverse changes in sales prices and commercial terms.
For potential customers, it is necessary to clarify the verification and on, it is necessary to clarify the verification and onboarding progress of benchmark customers, including information such as the entire process of customer verification and its current progress, the expected time to achieve sales and shipments, the logic of sales volume growth, and whether exclusive supply is provided. In this process, the information obtained from management can be verified through customer interviews, and the growth paths of similar technologies and comparable enterprises can be referred to for auxiliary judgment.
For early-stage growth enterprises, due to the incomplete construction of upstream infrastructure in the industrial chain, high costs often become a major factor restricting the large-scale application of the enterprise and its downstream. Therefore, it is necessary to analyze the composition and change trend of the target enterprise's product costs, as well as its advantages and disadvantages compared with similar products, to verify whether the business model can form a closed loop.
Among them, for manufacturing enterprises, it is usually necessary to analyze the cost composition, supply chain stability, and bargaining power by combining the BOM (Bill of Materials) and the production process, and pay attention to the potential impact of technological iteration on cost reduction. For design-oriented enterprises, it is necessary to analyze the standardization and replicability of products, as well as the reusability and expandability of technical platforms, by combining financial data and management interview information.
Based on the above analysis of technology, product costs, customers, and market space, the key assumptions in the management's profit forecast can be verified, and the future development expectations of the target enterprise can be reasonably re-evaluated by adjusting expected profit margins and growth rates.
Since enterprises at this stage usually have net cash outflows, on the basis of profit forecasts, it is also necessary to consider the enterprise's basic operating expenses (such as changes in personnel, settlement methods with upstream and downstream partners) and capital expenditure plans to achieve a reasonable production state, calculate cash flow gaps, and evaluate the timing of the next round of financing. The sustainable operation capability of the target enterprise is judged by combining the operation management and capital operation capabilities of the core team.
When products and business models are gradually verified by the market, the construction of industrial chain infrastructure is more complete, competition among existing players will intensify, and enterprises may even face threats from cross-industry new entrants, thus entering the stage of competitive breakthrough.
At this stage, financial due diligence needs to quantitatively evaluate the core team, market and business model, products, and profitability of the target enterprise, so as to identify its core competitiveness and judge whether this core competitiveness can remain stable in the dynamic development of the industrial chain, enabling the enterprise to achieve sustained growth and profitability.
The following three analytical methods can be relied on:
An enterprise's core products usually constitute its main source of revenue. By sorting out the material flow and cash flow related to the R&D, procurement, production, and sales of core products, the application scenarios and monetization methods of the products can be clarified—specifically, identifying the supplier and customer structure, customer acquisition channels, and market positioning of the enterprise's core products, and exploring what resources and advantages the enterprise relies on to earn the price difference between the supply and sales ends. On the basis of the profit model, combined with the analysis of changes in revenue, gross profit margin, net profit margin, and cash flow, a preliminary judgment can be made on the driving factors affecting business growth.
Core competitiveness can be reflected in factors such as qualifications/licenses, capital and talent reserves, technical capabilities, brand/channel advantages, cost control capabilities, production capacity structure, and first-mover advantages. It often needs to be judged by combining the characteristics of the industrial chain and the link where the target enterprise is located. In management interviews, in-depth understanding of the target enterprise's business strategy and competitive advantages/disadvantages can be obtained in a targeted manner, and verification can be conducted through comparable company analysis: comparing the financial indicators, operating efficiency, and operating KPI indicators of the target enterprise with those of representative companies in the same industry to study whether the enterprise has indicators higher than the industry average level at key nodes of the industrial chain.
The key to judging competitive breakthrough enterprises lies in evaluating the quality and sustainability of growth drivers, which often relies on a comprehensive judgment of the industry, the enterprise, and the core team. Through the analysis of the prices of raw materials and finished products, the evolution of industry market demand and the enterprise's competitive environment can be intuitively understood. At the same time, it is also necessary to comprehensively evaluate whether the core team has the ability to respond to changes in market demand and technical paths, as well as adjustments in competitors' strategies. This usually needs to be judged by combining information such as milestone events in the enterprise's historical operations and personal resumes, and consolidated by analyzing equity incentive arrangements.
Under the influence of external factors such as the macro environment, industry ecology, and technological evolution, when an enterprise's growth rate tends to be stable or even declines, it can change the trend of its growth curve through product innovation and repositioning. For enterprises in the cycle-transcending stage, financial due diligence needs to quantitatively verify their ability to withstand pressure and shape a second growth curve, which should be carried out from the following two perspectives:
First, evaluate financial stability, including capital reserves, debt-servicing capacity, and cash flow status, to ensure that the target enterprise has a safety cushion to cope with market fluctuations and operational risks. Second, analyze market stability: evaluate customer loyalty and the completeness of the sales team/channels, and combine industry comparisons to assess whether there are adverse changes in sales scale and profit performance. At the same time, examine team stability: pay attention to changes in the number of personnel in various business links and talent reserves to ensure that the enterprise has sufficient talent support and response capabilities when facing market changes.
Similar financial due diligence methods used for "early-stage growth" enterprises can be adopted to analyze and verify new technologies, new products, and new customers. The difference from "early-stage growth" enterprises is that mature enterprises have industrialization experience and resource accumulation in their original business fields, but also face path dependence and sunk costs. Therefore, additional attention needs to be paid to analyzing the supporting or negative impact of historical accumulation on new businesses.
This article briefly expounds on the methodology of financial due diligence for enterprises at different stages, with an overall focus on verifying the growth potential of the target enterprise. In the actual implementation of projects, financial due diligence also needs to evaluate the authenticity and standardization of financial records, and judge whether the target enterprise has major financial risks or actual listing obstacles. In addition, factors such as time windows and access rights may affect the scope of due diligence. Given that different industries have different development laws, and different enterprises have different historical backgrounds and management teams, specific projects in practice need to be carefully analyzed in combination with the actual situation of the industry and the enterprise to ensure the comprehensiveness and effectiveness of financial due diligence.
Source: Mao Qianyun, Risk Control Department
Review: Xue Yao
Release: You Yi
