Due diligence is one of the most important processes investors go through before deciding to invest. Their expertise allows them to identify which companies are worth their time, just by looking at investment decks and financial models. This blog gives you some insight in what pitfalls there are for a financial model, and where the opportunities lie to impress investors.
The main goal is to identify what the hidden costs are for companies, and what might cause financial problems in the future. This is done by analysing the three financial statements in a model: the income statement, the balance sheet and the cash flow statement.
In the income statement, it is important to show that your company has different reliable revenue streams. A problem that is often encountered is the large dependency on one revenue stream for a company to survive. If that revenue disappears, the company might be exposed to financial downturn. Another crucial aspect here is defining the expenses. By showing your expenses are directed towards growth, you show investors that you have a sound financial policy in place.
On the balance sheet, it is important to show that the organisation has enough liquid assets, combined with a solid basis of assets that hold their value over time. Your balance sheet also shows how the company is financed, with the debt-equity ratio being a major factor in investment decisions. Shown on the balance sheet are also patents, which might give an indication of how the products are valued, both in the present and the future.
By looking at the cash flow statement, analysis can be done on how much cash the company generates when all the financing and expenses are done. Cash is essential for day-to-day operations, and is therefore subject to rapid changes. This sensitivity can be a good thing, but also poses risks as delayed receivables for example can cause a short term lack of liquidity.