Financial Due Diligence
The multiple gets applied to the number financial due diligence produces, not the one on the seller’s income statement. Sellers set that number early, or a buyer sets it.
4 Pillars of Financial Due Diligence
An audit asks whether the statements comply with a framework. Financial due diligence asks whether the earnings are repeatable and correctly stated on a cash-free, debt-free basis.
Quality of earnings.
Reported EBITDA gets rebuilt from the general ledger. Non-recurring items, out-of-period entries, owner compensation, related-party charges, and run-rate adjustments all move the number the multiple applies to.
Matters most to: the CFO defending the add-back schedule and the PE deal team pricing off it
Net working capital.
Monthly working capital across 24 to 36 months sets the peg. Closing working capital is compared against it and the price moves dollar for dollar.
Matters most to: whoever signs the completion statement
Net debt and debt-like items.
Borrowings and finance leases come off the price. So do accrued bonuses, pension deficits, deferred consideration, and swap break costs, which is where the argument happens.
Matters most to: the lender and the deal counsel drafting the bridge
Cash conversion.
EBITDA is not cash. Maintenance capex, receivable aging, and inventory turns decide how much of the reported margin reaches the bank.
Matters most to: the investment committee reading the downside case
All four pillars land in the same place: the price. Quality of earnings sets the multiple base, the peg trues up at closing, and net debt is deducted to reach equity value.
Financial Due Diligence Document Checklist
Monthly data matters more than annual data, because the peg and the seasonality both come out of the monthly series.
CFOs and finance directors: assemble this before a banker takes you to market. Buy-side: this is the request list.
Financial statements
3 to 5 years, plus current year to date
- ✓ Audited or reviewed financial statements
- ✓ Monthly management accounts
- ✓ Trial balance and general ledger extract
- ✓ Auditor management letters and audit adjustments
- ✓ Chart of accounts
Quality of earnings
Full period under review
- ✓ Seller add-back schedule with supporting evidence
- ✓ Non-recurring and out-of-period items
- ✓ Owner compensation and discretionary expenses
- ✓ Related-party and intercompany charges
- ✓ Run-rate and pro forma adjustment workings
Revenue
Monthly, 3 years
- ✓ Revenue by customer, product and geography
- ✓ Customer cohort, churn and net revenue retention
- ✓ Recurring revenue schedule, ARR or MRR where relevant
- ✓ Price and volume build
- ✓ Revenue recognition policy and cut-off testing
- ✓ Deferred revenue and contract liability roll-forward
Margin and cost
Monthly, 3 years
- ✓ Gross margin build by product line
- ✓ Cost of sales composition
- ✓ Headcount and payroll cost schedule
- ✓ Fixed versus variable cost split
- ✓ Overhead allocations across entities
Net working capital
Monthly, 24 to 36 months
- ✓ Monthly net working capital series
- ✓ Accounts receivable aging and bad debt provision
- ✓ Accounts payable aging and supplier terms
- ✓ Inventory aging, provisioning and turns
- ✓ DSO, DPO and DIO by month
Net debt and debt-like items
All outstanding at the reference date
- ✓ Facility agreements and drawn balances
- ✓ Finance and operating lease schedules
- ✓ Accrued bonuses, holiday pay and deferred compensation
- ✓ Pension and post-employment obligations
- ✓ Deferred consideration, earnouts and shareholder loans
Cash flow
Monthly, 3 years
- ✓ Cash flow statements and bank statements
- ✓ Proof of cash reconciliation, bank to ledger by month
- ✓ Capex history split into maintenance and growth
- ✓ Cash conversion and free cash flow build
- ✓ Trapped, restricted, and minimum operating cash
- ✓ Seasonal peak and trough borrowing
Forecast and budget
Current year plus 2 forward
- ✓ Budget versus actual by month
- ✓ Current year forecast with assumptions
- ✓ Pipeline and backlog support
- ✓ Cost savings and synergy assumptions
- ✓ Prior year forecast accuracy
Tax
Headline position only
- ✓ Tax provisions and deferred tax balances
- ✓ Reconciliation of book to taxable income
- ✓ Confirmation of filings up to date
Capital structure
All instruments outstanding
- ✓ Cap table and shareholder loans
- ✓ Dividend and distribution history
- ✓ Covenant compliance certificates
- ✓ Security granted and guarantees given
Commitments and contingencies
All open items
- ✓ Off-balance sheet arrangements
- ✓ Contingent liabilities and provisions
- ✓ Insurance claims history
- ✓ Capital commitments contracted but not incurred
Systems and controls
Current state
- ✓ Accounting system and close calendar
- ✓ Month-end close process and reconciliations
- ✓ Segregation of duties and approval limits
- ✓ History of restatements or prior period adjustments
Transfer pricing, tax exposures and filing history belong to the tax workstream. Contracts, litigation and corporate records belong to legal review.
Financial Due Diligence Runs on Your Ledger
Monthly detail, not annual summaries. Structure the room that way from day 1.
Working Capital Peg and the Price Bridge
Enterprise value is the headline. Equity value is the cheque. 4 adjustments sit between them and only 1 carries real judgment.
For the banker running the process, this table is where the headline number stops being the number.
2 mechanisms, 2 measurement dates
The economics are the same. Timing and dispute risk are not.
Completion accounts.
Cash, debt, and working capital are measured at closing and trued up afterward. Protects the buyer against deterioration. Creates post-closing disputes.
Locked box.
Price is fixed on a pre-signing balance sheet with no true-up. The seller covenants against leakage instead. Certainty and a faster close.
The peg is usually a trailing 12-month average. Shorter windows favor whoever benefits from the current position, which is why the methodology is negotiated before the number is.
Red Flags in Financial Due Diligence
8 findings that reprice deals. Most are presentation choices rather than fraud, which is why they survive until someone opens the general ledger.
CFOs: fix the top 3 before launch. Buy-side: price the rest.
Add-backs that will not survive
Exceptional costs that recur every year in the same direction.
A run-rate argument on 1 quarter
Annualizing a good quarter. Buyers want 2 before they accept it.
Working capital stretched before the peg date
Collections pulled forward, payables pushed out, the peg set on the result.
Receivables aged into current
Slow balances reclassified rather than provided against.
Deferred revenue treated as working capital
A funded obligation on the wrong side of the bridge.
Revenue recognized before delivery
Cut-off testing at period end finds this first.
Capex classified to suit the story
Growth spend called maintenance, or the reverse, depending on which number needs help.
Related-party charges at non-market rates
Margin created or absorbed by an entity nobody is buying.
From Findings to Price Adjustments
A financial finding almost never kills a deal. It changes the number, the structure, or both.
Read the last column first. It decides who pays.
The order matters. An EBITDA adjustment is multiplied. A working capital adjustment is not. A finding worth the same on paper costs a seller several times more if it lands in the earnings line.
The Peg Moves the Price
36 months of monthly detail, versioned, with every restatement traceable.
Financial Due Diligence Scope and Timelines
Data quality drives the clock harder than deal size. A clean monthly series can halve the fieldwork.
If you are buying
Starts once the letter of intent grants exclusivity. 4 to 8 weeks of fieldwork alongside legal and tax. Providers commonly disallow a meaningful share of the seller’s proposed add-backs.
If you are selling
A sell-side report commissioned before launch. It preempts the retrade, sets the add-back narrative early, and gives bidders a base they can underwrite.
If you are raising or listing
Investors and underwriters test the same 3 pillars, and the forecast carries more weight than the history. On a listing, the numbers have to support what the prospectus says.
An independent accounting firm does the work, not the buyer’s own finance team, because lenders and investment committees rely on the report. On a private equity platform deal, the same review runs at every bolt-on.
Frequently Asked Questions
The questions CFOs and deal teams actually ask, in the order the process forces them.
The buyer’s independent review of historical earnings, working capital and debt. It tests whether the numbers are repeatable and correctly stated on a cash-free, debt-free basis.
Yes, and it is usually where the value is. An add-back survives if the seller can evidence that the cost will not recur. A list without support gets cut, and the multiple applies to the lower number.
Whoever commissions it. The buyer pays for buy-side work, the seller for a sell-side report. Both are deal costs, and lenders will often insist on one before funding.
Proceeds drop dollar for dollar at completion. There is no negotiation at that point, which is why the peg methodology is argued before the number is agreed.
In a competitive process, usually. It sets the add-back narrative before a buyer challenges it, and the difference between your number and someone else’s number is the whole point.
Buyers argue it should be, because it is a funded obligation the buyer has to deliver. Sellers argue the opposite. Where it lands can materially move the equity value.
The buyer either extends, closes without the answer, or walks. None is cheap, and all 3 are scheduling outcomes rather than diligence outcomes.
No. An audit tests compliance with a framework. Due diligence tests whether the earnings repeat. An audited target can still fail a quality-of-earnings review.
The working capital peg and the seasonality both come out of the monthly series. Annual statements hide the trough that sets the funding requirement.
Financial Due Diligence Starts With a Clean Ledger
Give the accountants the monthly series, the aging reports and the add-back support in 1 indexed place. The fieldwork gets shorter.