Red flags in due diligence, explained simply
Red flags direct where diligence spends its time. Each is resolved by explanation and evidence, by an adjustment to earnings, net debt or working capital, or by a protection in the purchase agreement.
Unresolved red flags usually lead to a lower price, a specific indemnity or escrow, or a decision not to proceed.
Common warning signs by area
IndicativeRevenue timing and working capital trends are among the most frequent areas of challenge.
Worked example
Alder Creek reports 10% revenue growth, but customers now take 62 days to pay compared with 45 days a year earlier. Diligence finds that the sales team extended payment terms to win orders ahead of the sale. Part of the growth was financed by customer credit, and the additional receivables affect the working capital target.
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Why it matters in a deal
How red flags are resolved shapes price, structure and protections. Identifying them early, ideally on the sell side, avoids late renegotiation.
Red flags
- Sales growth outpacing cash collections
- Concentration in one customer or supplier
- Costs reduced sharply before the sale
- Accounting policies changed between periods