Financial Due Diligence When Buying a Business
The riskiest part of buying a business isn’t what you can see – it’s what you can’t. Weak cash flow, unrealistic forecasts and buried liabilities rarely appear in the sales pitch, but they can shape your future far more than the headline price.
Financial due diligence helps you distinguish between those possibilities before the price and deal terms are fixed.
What financial due diligence actually does
Unlike an audit, due diligence doesn’t provide a formal opinion on a company’s financial statements. It’s a transaction-specific investigation designed around the questions that matter to you. Is the reported profit genuine? Will it continue? Does it generate cash? What obligations will remain after completion? What needs to happen for management’s forecasts to become reality?
There’s no universal checklist. The risks surrounding a subscription-based consultancy will differ from those of a manufacturer holding substantial stock. Nevertheless, the following areas provide a practical starting point.
Start with complete, current information
Begin by requesting complete, current financial information. Review statutory accounts covering three to five years, recent management accounts, budgets, forecasts, bank statements, tax records, aged debtor and creditor reports, and details of borrowing and connected-party transactions. Filed accounts alone are insufficient: they may be historic, abbreviated and very different from the company’s present position.
Understand revenue and sustainable earnings
Next, investigate where revenue comes from. Break sales down by customer, product, location, channel and period, and distinguish recurring income from one-off work. A company reporting £2 million in annual revenue may look secure until you learn that £700,000 depends on one contract that expires shortly after completion.
You should then establish the company’s maintainable profit. Remove genuinely exceptional income and expenditure, but challenge adjustments carefully. Costs described as ‘one-off’ sometimes recur with surprising regularity. Distinguish the target’s existing earnings from savings or synergies that you hope to achieve after the purchase.
Follow the money
Profit must also be compared with cash generation. Examine overdue invoices, bad-debt provisions, stock levels, supplier arrears, capital expenditure and seasonal funding requirements. Sales recorded in the accounts have limited value if customers don’t pay. Your real concern is how much additional cash the business will need after you acquire it.
Working capital deserves separate attention. Reviewing monthly patterns can reveal whether the seller has improved the completion-date cash position by delaying payments or collecting debts unusually aggressively. It can also help establish the normal level of working capital that should remain in the business.
Expose debt, tax and other liabilities
Identify every significant obligation, not only visible bank loans. Consider leases, invoice finance, shareholder loans, guarantees, customer deposits, pension commitments and contingent liabilities. Historic tax exposures also require careful review, particularly in a share purchase, where they remain within the acquired company.
Challenge the forecasts
Finally, test forecasts against evidence. Compare previous forecasts with actual performance, and assess confirmed orders, customer retention, staffing capacity, planned investment and market conditions. A spreadsheet formula is not proof that ambitious growth will occur.
The purpose of financial due diligence is not simply to uncover problems. It is to give you choices while you can still act – whether this means adjusting the price, restructuring payments, securing contractual protection, preparing an integration plan or deciding that the wisest investment is no investment at all.
For expert advice on conducting financial due diligence, speak to a reputable accountant today.
