The Financial Due Diligence Checklist: What Buyers Examine Before Acquiring a Private Company

Key takeaways

• Financial due diligence tests whether the earnings, cash flow, assets and liabilities a buyer is paying for are real, sustainable and fully disclosed.
• The core of financial diligence is a quality of earnings (QoE) analysis, supported by reviews of revenue, costs, working capital, debt-like items, taxes and payroll.
• Most deal issues fall into a few categories: overstated EBITDA, customer concentration, working capital surprises, unrecorded liabilities and tax exposure.
• Findings feed directly into price, structure and protections: purchase price adjustments, escrows, earnouts and indemnification.
• Sellers who perform the same analysis before going to market avoid surprises, protect value and close faster.

A business looks great on paper: growing revenue, healthy margins, loyal customers. The buyer signs a letter of intent. Then diligence begins, and the picture changes. Revenue includes a one-time project. Margins depend on an owner who works 80 hours a week for a below-market salary. A large customer is about to put its contract out to bid. Sales tax hasn’t been collected in three states where it should have been.

Financial due diligence exists to find these issues before closing, when they can still be priced, structured or resolved. This article provides a practical checklist of what buyers examine and what sellers should prepare.

The goals of financial due diligence

• Validate earnings: Is reported and adjusted EBITDA accurate and sustainable?
• Understand cash flow: How do earnings convert to cash after working capital and capital expenditures?
• Identify liabilities: What obligations exist, recorded or not?
• Assess risks: What could cause performance to decline after closing?
• Inform the deal: What should change in price, structure or the purchase agreement?

The checklist

1. Quality of earnings

• Reconcile reported EBITDA to the financial statements and tax returns.
• Evaluate each management adjustment for support and recurrence.
• Identify additional adjustments (one-time revenue, unusual expenses, out-of-period items).
• Normalize owner and family compensation to market rates.
• Assess related-party transactions (rent, purchases, loans) at market terms.
• Review accounting policies for consistency and conformity with GAAP.
• Analyze monthly results for trends, seasonality and anomalies.
• Compare trailing-twelve-month (TTM) results with budget and prior periods.

Our articles on quality of earnings and normalization adjustments explain these steps in detail.

2. Revenue

• Revenue by customer, product line, geography and channel.
• Customer concentration: top 10 customers as a percentage of revenue, by year.
• Customer retention, churn and cohort analysis.
• Contract terms: length, renewal dates, termination rights, change-of-control clauses, pricing escalators.
• Backlog and pipeline support.
• Revenue recognition under ASC 606: timing, deferred revenue, multiple performance obligations.
• Price vs. volume analysis of growth.
• Credits, returns, rebates and allowances.
• Cutoff testing around period ends.

3. Cost of sales and gross margin

• Gross margin by product, service and customer.
• Supplier concentration and pricing terms.
• Inventory costing methods and capitalization of overhead.
• Labor costs, overtime and productivity trends.
• Impact of recent or expected cost changes.

4. Operating expenses

• Fixed vs. variable cost analysis.
• Headcount and compensation by department.
• Rent, leases and occupancy costs.
• Professional fees (watch for litigation or regulatory issues).
• Discretionary spending deferred to inflate profits (maintenance, marketing, hiring).
• Costs the buyer will need to add (CFO, IT, compliance, insurance).

5. Net working capital

• Monthly NWC for at least 12 to 24 months.
• Accounts receivable aging, bad debt history and reserve adequacy.
• Inventory aging, turns, obsolescence and physical count results.
• Accounts payable aging and vendor terms; any stretching of payables before sale.
• Accrued liabilities completeness.
• Seasonality and growth effects.
• Proposed definition and target for the working capital peg.

See our article on the net working capital peg.

6. Debt and debt-like items

• Bank debt, lines of credit, equipment loans and capital/finance leases.
• Shareholder and related-party loans.
• Deferred revenue and customer deposits.
• Accrued but unpaid bonuses, commissions and paid time off.
• Deferred compensation and severance obligations.
• Unpaid or deferred taxes.
• Deferred rent and lease obligations.
• Underfunded pension or multiemployer plan withdrawal liability.
• Outstanding litigation settlements and contingent liabilities.
• Earnouts from prior acquisitions.

7. Capital expenditures

• Historical maintenance vs. growth capex.
• Condition and age of key equipment.
• Deferred maintenance.
• Planned capital requirements.

8. Cash flow and cash proof

• Reconcile EBITDA to operating cash flow.
• Proof of cash: reconcile bank deposits to recorded revenue.
• Review unusual or large transfers.

9. Taxes

• Federal, state and local income tax returns and audit history.
• Sales and use tax compliance, including economic nexus in other states.
• Payroll tax compliance and filings.
• Property tax.
• Entity classification and S corporation election validity, where relevant.
• Transfer pricing and international tax issues, if applicable.
• Tax implications of the deal structure; see our article on asset sale vs. stock sale.

10. Payroll and employees

• Payroll registers and reconciliation to financial statements.
• Worker classification (employees vs. independent contractors).
• Overtime and wage-and-hour compliance.
• Benefit plans, including health and retirement plan compliance.
• Key employee retention risk and agreements.
• Union agreements, if any.

11. Contracts and commitments

• Customer and supplier contracts, including change-of-control provisions.
• Leases and their assignability.
• Loan covenants and guarantees.
• Purchase commitments and minimum volume obligations.
• Licenses, permits and franchise agreements.

12. Systems, controls and reporting

• Accounting system and month-end close process.
• Internal controls and segregation of duties.
• Prior audit or review reports and management letters.
• Reliability of management reporting and KPIs.

13. Projections

• Reasonableness of management’s forecast compared with history.
• Key assumptions and sensitivity.
• Current-year performance against budget.
• Pipeline support for projected growth.

Common red flags

• Large or growing gap between EBITDA and cash flow.
• Unsupported add-backs or adjustments that recur every year.
• Revenue spikes near year-end or before the sale process.
• Customer concentration above 20% to 30% with a single customer.
• Declining margins masked by revenue growth.
• Stretched payables or unusually low inventory before closing.
• Unreconciled accounts or frequent journal entries without support.
• Sales tax exposure in states with economic nexus.
• Related-party arrangements that won’t continue after closing.
• Owner doing multiple jobs for below-market pay.

How diligence findings affect the deal

Sell-side due diligence: prepare before you go to market

Sellers increasingly commission a sell-side quality of earnings or readiness review before marketing the business. Benefits include: – identifying and fixing issues on the seller’s timeline; – presenting credible adjusted EBITDA; – reducing retrading after the LOI; – shortening the diligence period; and – building buyer confidence.

Frequently asked questions

The bottom line

Financial due diligence protects buyers from overpaying and helps sellers defend their value. A disciplined checklist, applied early and thoroughly, turns uncertainty into informed decisions about price, structure and risk.

Foxboro Consulting Group, Inc. provides buy-side and sell-side due diligence services, quality of earnings analysis and transaction support. Contact us to discuss your transaction.

This article is for general informational purposes and does not constitute legal, tax, accounting or investment advice.