Financial due diligence for buyers: a practical guide

Key points

• Due diligence usually starts after heads of terms, when the price you have offered rests on figures you have not yet verified.
• Quality of earnings is the centre of the work: does the earnings figure you are paying for hold up?
• Working capital and debt-like items decide how a headline price becomes the amount you actually pay.
• Profit and cash are different things. Cash conversion and forecasts show whether the business funds itself.
• Findings are most useful when they are raised before the sale agreement is settled.

Our glossary explains many of the terms used in this guide.

Where does financial due diligence fit in buying a business?

A typical acquisition of an owner-managed business moves through these stages:

1. First look: a review of the business's figures to decide whether it is worth pursuing.
2. Assessment and offer: deeper analysis, a view on value and structure, and an offer.
3. Heads of terms: the main commercial terms are agreed, often with a period of exclusivity.
4. Due diligence: financial, legal, tax and commercial checks of what you are buying.
5. Sale agreement and completion: your legal advisers negotiate the documents, informed by what due diligence found.

Financial due diligence sits at stage 4, but it builds on stages 1 and 2. Questions raised in a first look or an assessment become the starting point for diligence. Our guide to reviewing an acquisition opportunity covers the earlier stages.

What it is not: legal due diligence (contracts, property, employment, disputes, the sale documents) is carried out by your legal advisers; tax due diligence may be a separate piece of work for your tax advisers. Commercial and operational checks – customers, market, people, systems – are often led by you. Good financial due diligence connects to all of them, for example by flagging matters your legal advisers may want to address in the sale agreement.

How should financial due diligence be scoped?

The scope decides what will be examined, in how much depth, and what will not be covered. It should be agreed in writing before the work starts.

• A focused scope concentrates on the areas of highest risk identified earlier – usually quality of earnings, working capital and debt-like items. It often suits a smaller, simpler business with reasonable records.
• A comprehensive scope covers more areas in more depth – revenue and margins by line, customer contracts, forecasts and controls. It may suit a larger, more complex or higher-risk deal, or one where the information is weaker.

What this means in practice: before agreeing a scope, write down the three to five questions that would change your view of the deal if the answer were bad. The scope should answer those questions first.

Proplexo view: scope to the decision, not to a checklist

The value of due diligence lies in answering the questions that could change the price, the structure or the decision to proceed. A long checklist applied evenly to every area can look thorough while spending most of the time on matters that would not change anything.

A better test of a scope is whether each area in it is linked to a specific risk in this deal: an earnings adjustment that needs evidence, a customer whose loss would matter, a working capital pattern that needs explaining. Areas without such a link can usually be covered lightly or left out, and the scope should say so explicitly, so that nobody assumes they were examined.

Quality of earnings: does the profit you are paying for hold up?

Quality of earnings asks whether the earnings figure used to price the deal reflects sustainable trading. Sellers usually present an adjusted earnings figure – reported profit with adjustments for the owner's pay, one-off items and similar. Due diligence tests each adjustment and looks for adjustments the seller has not made.

The main questions:

• Are the seller's add-backs genuine? A cost described as one-off should not recur. A personal cost should be personal. Each adjustment needs evidence: ledger entries, invoices, contracts.
• Is the owner's role costed realistically? If the owner works in the business, a buyer needs to pay someone to do that work. Our guide to valuing a small business explains owner replacement cost.
• Is revenue recognised in the right period? Revenue brought forward into the last months before a sale, or income received for work not yet done, flatters profit.
• Are all costs in the accounts? Unrecorded accruals – bonuses, holiday pay, rebates owed to customers – reduce true earnings.
• Do the management accounts agree with the statutory accounts? If they do not, the monthly figures cannot be relied on without reconciliation.

Illustrative example C: the seller's earnings figure and the diligence view

Illustrative example. Company C is fictional: a wholesale distributor with a turnover of about £3.2 million. The figures are invented to explain the method; they do not represent any client or real business. No value or price is shown.

1. Adjusted EBITDA presented by the seller: 310,000
2. Owner's role costed at £40,000 by the seller; market cost of the role, including employer costs, is higher (illustrative £70,000): (30,000)
3. A marketing campaign added back as "one-off" that has run every year: (18,000)
4. Revenue on a large order recognised in the year, though delivered after the year end: (12,000)
5. Staff bonus for the year not accrued: (9,000)
6. Supplier rebate relating to the previous year included in this year's profit: (7,000)
7. Legal costs on a settled dispute, not added back by the seller: 6,000
8. Adjusted EBITDA after due diligence: 240,000

What the example shows:

• Findings can move earnings in either direction. In this example, most reduce earnings because several of the seller's adjustments do not withstand review. That is not because sellers are unreliable; adjustments prepared for a sale are naturally presented in the seller's favour, and due diligence restores a buyer's view.
• The legal cost is a genuine one-off the seller missed.
• Timing issues are earnings issues. The early revenue and the prior-year rebate do not mean the money is not real – they mean it belongs to a different year.
• The difference matters because value is based on earnings. A lower maintainable earnings figure usually leads to a renegotiation of the price, which is why these findings need to be raised before the sale agreement is settled.

Working capital: what is the "normal level"?

Working capital is the money tied up in running the business day to day. For deal purposes it is usually defined as, broadly, normal trade debtors and stock less trade creditors and other agreed operating balances. The precise definition is agreed for the particular transaction.

Many deals assume the business is handed over with a normal level of working capital (often called the "peg" or "target"). If working capital at completion is below the agreed normal level, the price usually falls by the shortfall; if it is above, the price may rise. Due diligence establishes what "normal" really is.

Illustrative example D: monthly working capital and the normal level

Illustrative example. Company C is fictional; the figures are invented.

1. January: 410
2. February: 395
3. March: 430
4. April: 455
5. May: 470
6. June: 440
7. July: 420
8. August: 405
9. September: 450
10. October: 490
11. November: 520
12. December (year end): 380
13. Average of the 12 months: about 439

What the example shows:

• The year end is not typical. Company C collects debts and runs down stock before its year end, so December's £380,000 is the lowest point of the year. A normal level based on the year-end balance sheet alone would be about £59,000 lower than the twelve-month average.
• Seasonality matters. Working capital builds through the autumn. A completion in November would fall at the seasonal peak, so a single "normal" figure needs care – the twelve-month average, or a seasonally adjusted figure for the completion month, is usually more representative.
• Trends matter too. If working capital had been rising steadily, a buyer would want to know why: slower-paying customers, slower-moving stock, or suppliers being paid faster.

What this means in practice: ask for at least 12, preferably 24, months of month-end working capital, on a consistent definition, before agreeing the normal level. The definition and the figure are then written into the legal documents by your legal advisers.

Net debt and debt-like items: what comes off the price?

Many offers for owner-managed businesses are made on a cash-free, debt-free basis: the price assumes the business has no borrowings and no surplus cash. Borrowings are then deducted and surplus cash added when the final price is calculated.

Debt-like items are liabilities that are not borrowings but are treated like debt in negotiations, because they relate to the period before completion or will cost the business cash after it. Due diligence identifies them; which ones are deducted is negotiated and set out in the legal documents. Items commonly discussed include:

• tax, VAT or payroll liabilities that are overdue rather than simply payable on their normal date;
• corporation tax for periods before completion;
• accrued bonuses and other employee liabilities relating to the period before completion;
• finance leases and hire purchase;
• amounts owed to the owner or related parties that will be repaid at completion;
• customer deposits and deferred income (income received for work not yet delivered) – treatment varies and is often negotiated;
• deferred consideration still owed for earlier acquisitions;
• provisions for known obligations, such as property dilapidations.

What this means in practice: agree the list of debt-like items as early as possible, ideally in principle at heads of terms, so that diligence findings in this area are applied rather than argued about.

Cash conversion: does profit turn into cash?

A business can report healthy profits and still struggle for cash. Cash conversion compares the cash generated by trading with the earnings figure. Due diligence looks at:

• monthly cash flow over 12–24 months, alongside monthly profit;
• movements in debtors, stock and creditors that explain any gap;
• capital expenditure needed to keep trading – depreciation is added back in EBITDA, but the recurring need to replace equipment does not go away;
• one-off cash items, such as a delayed tax payment, that flatter a particular period.

Proplexo view: look at cash as well as earnings

Earnings often drive the price; cash helps determine whether the business can service any borrowing used to buy it and whether the new owner will need to put more money in. A diligence report that confirms earnings but does not explain cash leaves the buyer with half the answer.

Where earnings and cash diverge, the explanation is usually in working capital or capital expenditure. Both are within the scope of financial due diligence and both affect the deal: working capital through the completion mechanics, and capital expenditure through the true cost of owning the business.

Forecasts: are the assumptions supported?

If the price or your funding relies on a forecast, due diligence tests whether its assumptions are consistent with the business's track record:

• Is forecast growth in line with past growth, and is it explained by identifiable customers, contracts or capacity?
• Do forecast margins match recent actual margins?
• Does the forecast include the costs a new owner will bear, including the owner replacement cost?
• How does the current year to date compare with the forecast for the same months?

A forecast that departs sharply from the track record is not necessarily wrong, but the reasons need evidence. If you are borrowing to fund the purchase, a lender will ask the same questions.

Information and controls: can the figures be relied on?

The reliability of every other finding depends on the underlying records. Due diligence considers:

• whether management accounts are prepared monthly, on time and on the same basis as the annual accounts;
• how balances such as debtors, stock and accruals are checked and reconciled;
• unusual manual entries close to period ends;
• how dependent the finance function is on one person, often the owner.

Weak records do not automatically stop a deal, but they increase the uncertainty in every other number – which a buyer may reflect in the scope, the price or the protections sought.

What warning signs should a buyer look for?

• management accounts that do not reconcile to the statutory accounts;
• revenue or margin improving sharply in the months just before a sale;
• debtor days rising, or creditors being paid more slowly than before;
• "one-off" adjustments that appear in more than one year;
• tax, VAT or payroll arrears;
• a forecast that departs sharply from the trading record without a clear explanation;
• key customer relationships or pricing decisions held only by the owner;
• large or unusual manual adjustments at month or year ends.

None of these is conclusive on its own. Each is a reason to ask for evidence.

From findings to price and terms

Due diligence findings are usually used in one or more of these ways:

• Price: a lower maintainable earnings figure, or more debt-like items, usually leads to a price discussion.
• Structure: part of the price may be deferred (a fixed amount paid later) or made conditional on future performance through an earn-out. These are different: deferred consideration is certain but later; an earn-out is uncertain as well as later. Our guide to deferred consideration and earn-outs explains both.
• Completion mechanics: findings on working capital and net debt feed the agreed definitions and the normal level. Deals use either completion accounts (the final price is adjusted using a balance sheet drawn up at completion) or a locked box (the price is fixed by reference to an earlier balance sheet, with protections against value leaving the business in between). The choice and the drafting are matters for your legal advisers; financial due diligence informs both.
• Protections in the sale agreement: matters found in diligence may be addressed through warranties, indemnities or specific provisions. Your legal advisers decide how.
• Whether to proceed: occasionally the right answer is not to.

Proplexo view: findings have most value before the documents are settled

A finding raised early can be reflected in the price, the structure or the protections while those are still being negotiated. The same finding raised after the main terms of the sale agreement are settled has much less effect, because the room to change them has narrowed.

That is why diligence is most useful when it reports progressively – flagging significant matters as they arise rather than holding them for a final report – and when the buyer, their legal advisers and their financial adviser agree in advance what level of finding should be raised immediately.

How can a buyer keep due diligence efficient?

• Use a structured request list. Ask the seller to provide information in an organised data room against an agreed list. Get our buyer's information request list by email.
• Share what you already know, including any earlier review, so the work does not repeat it.
• Agree what matters for this deal – the questions that would change your view – before the work starts.
• Raise questions as they arise, rather than all at the end.
• Coordinate with your legal advisers, so financial findings reach the sale agreement in time.

What does financial due diligence cost?

The cost depends on the work, and the work depends on:

• the size and complexity of the business – companies, sites, revenue streams, systems;
• the quality and availability of information;
• the risks identified at earlier stages;
• the timetable;
• how quickly the seller and their accountant respond.

Any separate requirements of a lender funding the purchase are handled separately from your own due diligence.

Proplexo's current price for Financial Due Diligence is shown on the service page. The scope and fee for a particular deal are agreed with you before work starts.

How Proplexo can help

Our Financial Due Diligence service is focused or comprehensive, scaled to the size and complexity of the deal. It covers quality of earnings; revenue, margins and customer concentration; working capital and cash conversion; balance-sheet and debt-like items; and forecast review. We agree the scope with you at the start, report in plain English, and work alongside your legal advisers.

If you are earlier in the process, an Acquisition Assessment helps shape your offer before due diligence begins.

This article is general information for owner-managed businesses, not advice on your circumstances.