Financial due diligence, explained.

Financial due diligence is a buyer-side investigation of a target company’s historical financial performance, conducted before an acquisition closes. Its purpose is to test whether reported earnings are accurate, sustainable, and supported by the underlying accounting records.

It is not an audit. An audit expresses an opinion on whether financial statements comply with an accounting framework. Financial due diligence asks a different question: what will this business actually earn under new ownership, and what is the buyer really paying for. The work typically covers earnings quality, working capital, debt and debt-like items, revenue durability, and cost structure.

Financial due diligence typically includes a Quality of Earnings analysis, a net working capital analysis, a proof of cash, a review of debt and debt-like items, and an assessment of revenue and customer concentration.

A standard lower middle market scope covers:

• Quality of Earnings. Normalizing reported EBITDA for non-recurring, non-operating, and owner-discretionary items.
• Net working capital. Monthly trending to set the working capital target written into the purchase agreement.
• Proof of cash. Tying reported revenue and expenses to actual bank activity.
• Debt and debt-like items. Deferred revenue, accrued vacation, capital leases, unpaid payroll taxes, deferred compensation.
• Revenue analysis. Customer concentration, churn, retention, pricing, and mix.
• Cost structure. Gross margin by product and customer, and fixed versus variable cost behavior.
• Balance sheet review. Receivables aging, inventory valuation, fixed assets, related-party balances.
• Forecast assessment. Whether management projections are consistent with historical performance.

Scope varies by provider. Buyers should confirm in writing which of these are included rather than assume the list is standard.

A traditional financial due diligence engagement usually takes three to six weeks from data room access to final report. Smaller transactions with clean accounting can finish in two to three weeks. Deals with multiple entities, cash-basis books, or missing periods commonly run eight weeks or longer.

The dominant variable is not deal size, it is data readiness. Most delay comes from incomplete general ledger exports, unreconciled intercompany accounts, and slow seller response to follow-up requests, not from analytical difficulty. A buyer who resolves data access before the engagement starts removes most of the calendar risk.

A Quality of Earnings analysis tests whether a company’s reported earnings reflect sustainable, recurring operating performance. It produces a normalized or adjusted EBITDA figure, supported by a bridge showing every adjustment made to the reported result.

Because purchase price in most middle-market deals is a multiple of adjusted EBITDA, each dollar of adjustment moves valuation by that dollar times the multiple. At a 5x multiple, a disputed $200,000 add-back is a $1 million argument. A QoE also examines revenue recognition policy, margin trends, and the accounting basis of the books, since a normalized figure is only as reliable as the records beneath it.

A Quality of Earnings report is one component of financial due diligence. Financial due diligence is the broader engagement, and the QoE is the earnings-focused deliverable inside it.

In practice the terms are used loosely, and many providers sell a "QoE" that also covers working capital, debt-like items, and revenue analysis. The distinction matters at scoping. A buyer who commissions only a QoE may receive a normalized EBITDA figure with no working capital target, no proof of cash, and no debt-like items schedule, all three of which change the final purchase price and the terms of the agreement.

The core request is three years of financial statements, monthly profit and loss statements, monthly balance sheets, trial balances, general ledger detail, bank statements, and receivable and payable aging reports.

A complete request list also includes:

• Tax returns covering the same three years
• Payroll registers and an employee census
• Revenue detail by customer by month
• Material customer and vendor contracts
• Debt agreements and lease schedules
• Fixed asset register with depreciation schedules
• Inventory reports and the valuation methodology used
• Related-party transaction detail
• Any add-back schedule already prepared by the seller or their advisor

The general ledger is the item most often left off and the item most necessary. Summary financial statements cannot support an EBITDA adjustment, because the adjustment lives in individual entries. Transaction-level detail can.

Buyers find problems by testing the statements against the underlying accounting records rather than reading the statements on their own. Issues surface at transaction level, in timing, classification, and breaks in pattern.

The techniques that produce the most findings:

• Trend revenue and gross margin monthly rather than annually, which exposes smoothing that annual figures hide.
• Tie reported revenue to cash receipts, which catches recognition ahead of delivery.
• Review manual journal entries posted near period ends, where discretionary classification concentrates.
• Compare each period’s expense classification against the others, since inconsistency is the most common signal.
• Search the ledger for related-party names and for round-number entries.
• Test whether items labeled non-recurring appear in more than one year.

Most material problems in this size range are not sophisticated. They are inconsistent classification and undocumented adjustments that persist because nobody read the ledger.