Private Capital Investing

CHAPTER 5Accounting Due Diligence

INTRODUCTION

After developing a contextual understanding of the firm, its industry, and management's plans, we evaluate its financial performance. Financial risk measures the stability, flexibility, variety, and cost of a company's funding structure. The level of a firm's business and financial risks should be inversely correlated. Companies with low levels of business risk (steady and stable cash flow) can afford higher levels of financial risk than those with high business risk.

Different industries and companies may have varying factors that are important to assess. However, the main thing is to ensure that obligations are repaid in cash and that equity value creation is not a mere accounting exercise conducted with accounting adjustments. To this end, it is important to analyse the following elements:

1. a review of the quality of earnings (or quality of the accounting) that forms the basis of the financial analysis;
2. ratio and cash flow analysis;
3. creative accounting.

QUALITY OF EARNINGS

Whereas financial risk analysis should be conducted on the basis of financial statements audited by a reputable auditor, it is important to start the financial analysis with a review of the quality of the accounts. When reviewing the quality of accounts, the four basic principles of accounting should be borne in mind:

1. objectivity: everything should be directly measurable and verifiable, not influenced by personal bias or judgement;
2. matching: every dollar ...