Financial due diligence, explained simply
An audit asks whether historical statements comply with the applicable framework. Financial due diligence asks a different question: what will this business earn going forward, and what claims on cash sit alongside the price?
The output is a set of figures the parties can negotiate on: adjusted EBITDA, a normalized working capital level, net debt and debt-like items, and an assessment of cash conversion.
The four questions financial due diligence answers
IllustrativeEach workstream produces a figure that flows into the price or the purchase agreement.
Deliverables
- Databook: the supporting analysis, usually in Excel, with every adjustment traced to source.
- Report: a written summary of findings and their price implications.
- Red-flag memo: in some processes, an early note on issues requiring resolution before further spend.
Worked example
Alder Creek’s information memorandum reports EBITDA of $5.0 million. Diligence identifies a $0.6 million gain on the sale of equipment, which will not recur, and $0.2 million of earned but unrecorded bonuses. It also normalizes the owner’s compensation, adding back $0.25 million paid above a market rate for the role.
After all adjustments, EBITDA is $4.6 million. The unpaid bonuses are also treated as a debt-like item to be settled by the seller at closing.
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Why it matters in a deal
Financial due diligence determines the earnings base for price, the working capital target, the debt deducted at closing and the protections negotiated in the purchase agreement. Acquisition lenders usually rely on it.
Red flags
- No reliable monthly financial statements
- Large manual entries posted at period end
- Revenue growing materially faster than cash collected
- Different figures for the same period in different documents