Financial due diligence in acquisitions: what to examine
The purchase price is shaped by what financial due diligence uncovers. How to analyse sustainable earnings, net debt and working capital.
Financial due diligence is the review that lets a buyer understand, in numbers, what it is actually acquiring. The seller’s financial statements and presentation show the company at its best; due diligence uncovers sustainable earnings, the real debt burden, the normal level of working capital and hidden liabilities that could affect the price. In this article I set out the main workstreams of financial due diligence and show, with a hypothetical example, how its findings feed into the purchase price.
What does financial due diligence answer?
Good financial due diligence looks for answers to four questions:
- What are the company’s sustainable earnings? Operating profit cleaned of one-off items, accounting choices and owner-specific arrangements.
- What is the real net debt? Bank borrowing plus other liabilities that behave like debt.
- What is the normal level of working capital? A reference level that stops the seller extracting cash before completion by collecting receivables early and delaying payables.
- Does profit turn into cash? Whether the relationship between operating profit and operating cash flow is healthy.
Tax, legal, HR and operational matters are usually reviewed by separate specialist teams; financial due diligence assesses the financial impact of their findings.
1. Quality of earnings and normalised EBITDA
The purchase price is often set by applying a multiple to a profit measure, usually EBITDA. Every adjustment to earnings is therefore magnified by the multiple in the price. Typical adjustments in a normalised EBITDA analysis include:
- One-off income: gains on asset sales, insurance recoveries, refunds relating to prior periods
- One-off costs: litigation, restructuring, advisory fees related to the sale process
- Owner-specific items: shareholder pay above or below market, related-party rents and service charges
- Accounting corrections: provisions not booked, missing accruals, cut-off errors
- Conditions that will not continue: a customer expected to be lost, a contract about to end
I discuss how to assess quality of earnings more generally in quality of earnings.
2. Net debt and debt-like items
Deals are often priced on a “cash-free, debt-free” basis: the enterprise value is calculated first, then net debt is deducted to arrive at the equity value paid to the seller. The definition of net debt is therefore critical to the price. Beyond bank loans and cash, whether the following are treated as debt-like is a matter for negotiation:
- Overdue tax and social security liabilities
- Employee termination benefit obligations
- Trade payables stretched well beyond normal terms
- Declared but unpaid dividends and amounts owed to shareholders
- Lease liabilities (depending on the reporting framework)
- Probable payments for litigation and claims
3. Working capital and the target level
The normal level of working capital is usually set as the monthly average of the last 12 months and written into the agreement as a target (peg). If working capital at completion is below the peg the price falls; if above, it rises. In seasonal businesses, using a monthly average neutralises the effect of completion falling at a seasonal extreme.
4. Cash flow analysis
The relationship between profit and cash is assessed through a detailed review of the operating section of the cash flow statement. If operating profit grows steadily but operating cash flow does not, the reasons — lengthening receivables, inventory build-up, aggressive revenue recognition — need investigating. I explain the sections of the cash flow statement and how to read them in how to read a cash flow statement.
A hypothetical example: how findings affect the price
The example below is entirely hypothetical, and the multiple is chosen only to illustrate the calculation. The seller presents EBITDA of TRY 50 million and proposes an enterprise value of TRY 300 million at a multiple of 6. Due diligence finds:
| Item (TRY million) | Amount |
|---|---|
| Reported EBITDA | 50.0 |
| One-off gain on an asset sale within other operating income | −3.0 |
| One-off litigation cost | +1.0 |
| Market salary of a shareholder working full time without pay | −1.5 |
| Recurring slow-moving stock provision never booked | −1.0 |
| Normalised EBITDA | 45.5 |
At the same multiple of 6, enterprise value is 45.5 × 6 = TRY 273 million: a TRY 4.5 million adjustment to EBITDA becomes a TRY 27 million difference in value.
On net debt, the seller calculated TRY 60 million as bank loans (80) less cash (20). Due diligence also identifies overdue tax and social security payables (5), employee termination benefit obligations (7) and trade payables stretched beyond normal terms (4) as debt-like items. Adjusted net debt is TRY 76 million.
| TRY million | Seller’s view | After due diligence |
|---|---|---|
| Enterprise value | 300.0 | 273.0 |
| Net debt | −60.0 | −76.0 |
| Equity value | 240.0 | 197.0 |
In addition, average working capital over the last 12 months is TRY 45 million, while the expected level at completion is TRY 38 million; the peg mechanism could produce a further price adjustment of about TRY 7 million at completion. All of these findings are open to negotiation, but without due diligence none of these differences would have reached the table.
Preparing for life after the deal
Due diligence is a roadmap not only for the price but also for post-deal integration. The control weaknesses, reporting gaps and system differences it identifies should be turned into the first-100-days plan. Aligning the acquired company’s financial statements with the buyer’s reporting framework also needs planning, and the measurement of assets and liabilities at fair value comes up in the process. IFRS 13 defines fair value as the price that would be received to sell an asset between market participants at the measurement date — an exit price.
Common mistakes
- Looking only at the latest year; trends over at least two or three years should be examined.
- Using the seller’s management reports without reconciling them to the accounting records.
- Leaving the definition of net debt to the contract negotiation; it should be settled together with the due diligence findings.
- Assessing tax and legal findings without quantifying their financial impact.
Conclusion
Financial due diligence establishes, independently of the seller’s presentation, the three elements that drive the purchase price: sustainable earnings, net debt and normal working capital. Even a small-looking EBITDA adjustment becomes a large price difference through the multiple. I cover valuation methods in valuing a company with discounted cash flow. You can read about my work on acquisitions and valuation on the financial management page.