Financial due diligence
What a financial due diligence engagement actually involves.
The procedures, the sequence, the documents we need, and who you will be talking to. Buy-side financial due diligence and quality of earnings from Chartered Professional Accountants.
What we need to start
Half of any diligence delay is document chasing, so it is worth being precise about what the work runs on.
From you, the buyer
- The letter of intent
- The purchase price, and how it was arrived at
- Your lender’s requirements, if there is debt in the deal
- Your target close date
- A straight answer about what is worrying you
From the target
- General ledger for the two prior fiscal years and the trailing twelve months, exported from the accounting system rather than printed to PDF
- Bank statements for every account, same periods
- Payroll reports straight from the payroll provider
- Accounts receivable and accounts payable aging
- The fixed asset and capital expenditure schedule
- Leases, loan agreements, and anything that commits the business to future purchases
- Tax filings
- Customer detail sufficient to see concentration
And one thing that is not a document
- An introduction to whoever actually makes the entries
- Usually the external accountant, sometimes an internal controller, sometimes the owner
- Twenty minutes with that person explains more than a month of reading their output
Buyers usually have an instinct about which part of the story is soft. That instinct is useful and it shortens the work.
What happens in week one
The first week is interviews and the general ledger.
We meet target management to understand the organizational structure, the basis on which the financial information is prepared, the control environment, and how revenue is actually generated and recorded. Separately we speak to the target’s external accountant about their process, what they adjust at year end and why, and which of the proposed EBITDA adjustments originated with them rather than with the seller.
Then we read the general ledger. Not the financial statements, the ledger. We are looking for manual journal entries, adjusting entries clustered at period end, round numbers, entries posted by the owner, and related party activity moving between entities. This is also where we map the related party relationships, because in owner-managed businesses the company and the family finances are frequently the same set of accounts.
Proof of cash, also week one
We reconcile the bank statements to the books with receipts and disbursements tested separately rather than netted against each other. We work to a net variance in the range of three to five percent, and we tell you the number we got.
If revenue cannot be tied to money that actually arrived, that changes the scope of everything after it, and week one is when you want to know.
The part buyers do not budget for
Before earnings can be normalized, the financial statements have to be on a basis that can be analyzed at all.
We assess the accounting against the applicable framework, which is ASPE or IFRS for a Canadian target and US GAAP for an American one. We review revenue recognition, capitalization and depreciation policy, and how cost of sales is built.
Many owner-managed targets keep their books on a cash basis in an off the shelf accounting package, because that is what was needed for tax. Those financials cannot support a quality of earnings analysis in the form they arrive in, so the first real task is restating them onto an accrual presentation. That work is close to invisible in the finished report and it is frequently the largest single block of time in the engagement. When we give you a timeline after seeing the data room, this is the variable that moves it.
Send the LOI before you commit
We will look at the purchase price against what we can see and tell you where we would expect diligence to find problems.
Three numbers come out of the analysis
The quality of earnings schedule is the core of the file, and it deliberately does not resolve into a single figure. It is built in three tiers.
The adjustments management has proposed
Each one tested against supporting documentation rather than accepted.
The adjustments we identify ourselves
The ones nobody put forward.
Potential adjustments
The items where the facts are not yet clear enough to quantify with confidence.
That produces three EBITDA numbers rather than one. Buyers sometimes ask us to collapse them. We do not, because the spread between the second and third tier is the negotiating range, and a single number hides the specific thing you are paying to see. What sits inside those tiers is set out on the quality of earnings page.
Around that schedule sits the rest of the file. Revenue trends, customer concentration, seasonality, and gross margin by segment or product line. Payroll reconciled from the provider’s reports to the general ledger. Receivable aging tested for collectability and for how much of the balance sits past ninety days. Payables tested for completeness, which means looking for liabilities that were never recorded at all. Related party transactions assessed for whether the pricing is arm’s length. Inventory obsolescence where there is inventory. The capital expenditure schedule split between maintenance and growth, because only one of those is optional for the next owner.
Underneath all of it, the efficiency ratios
Receivable turnover, payable turnover, inventory turnover, and the cash conversion cycle they produce. Those feed the net working capital peg, which is calculated on every engagement and is explained in full on the quality of earnings page.
And the things that never touch EBITDA
Forward purchase commitments, operating leases that never reach the balance sheet, outstanding litigation, and environmental exposure.
These can still be the reason you walk.
Findings do not wait for the report
The third tier of the quality of earnings schedule is a live list, and it is the honest picture of where the work stands at any point in it.
Items leave that list in both directions. Something that looked like a two hundred thousand dollar problem turns out to be a coding error and disappears. Something that looked like a coding error turns out to be a pattern. As the list changes we walk you through it, because a finding you hear about at delivery is a finding you can no longer act on. If the analysis is going to move the price, you want to be raising it while diligence is still running and the other side is still cooperative.
When it cannot be resolved before close
And often it cannot. The report says what we would want addressed in the purchase agreement. Warranty exposure, inventory risk and uncertain deferred revenue are the usual candidates for an escrow holdback rather than a price adjustment, and we say which we think fits.
Who is on the engagement
Avnit Sekhon, CPA
Director, Transaction Advisory
Runs the management and accountant interviews, builds the quality of earnings schedule, and sets the peg.
Alex McAulay, CPA
Founder and Chief Executive Officer
Signs the engagement letter and signs off on the report before it goes out.
You deal with the people doing the analysis. There is no account manager in between relaying questions, which matters mostly because diligence questions are usually follow-up questions and a relay adds a day to each one. More on both of them, and on the firm behind the practice, is on the about page.
How the engagement ends
The report is addressed to you and marked for internal use. It is your document, not the target’s, and you decide who sees it.
The engagement is complete when the final report has been delivered and confirmed, when the transaction closes, or when the transaction fails. That last one is written into the engagement letter deliberately. Deals die, sometimes because of what diligence found, and that is not treated as an unfinished engagement.
This is not an audit
A quality of earnings engagement provides no assurance opinion and is not an audit. Treewalk does not perform audit or assurance engagements.
The report states this on its first page rather than in a footnote.
Will you speak to the target’s accountant directly?
Yes, and we would rather do it early. The external accountant knows which adjustments were their idea, which were the owner’s, and what they were correcting at year end. That conversation is arranged through the seller, so the access has to be inside what the LOI contemplates. If a seller will not permit it, that is worth noting in itself.
The target’s books are on a cash basis in QuickBooks. Is that a problem?
It is normal rather than disqualifying. Most owner-managed businesses keep books for tax, not for sale. It does mean the first phase of work is restating the financials onto an accrual presentation before any analysis is possible, which lengthens the engagement. Cash basis records do not tell you the business is badly run. They tell you nobody has ever needed the numbers to answer this particular question.
Can our lender rely on the report?
Lenders read these reports regularly and many will ask for one. What we can tell you is that the report carries no assurance opinion, so it is not a reliance document in the sense a credit team may mean by that word. If your lender has a specific requirement about scope or addressee, raise it before the work is scoped rather than after. Both are straightforward at the start and awkward later.
Do you coordinate with our lawyer and the other advisors?
Yes. In practice that means running the data room requests so the target receives one coordinated list instead of four, and getting the deal risks that need contract language to your counsel while there is still time to draft it. A finding that arrives after the definitive agreement has been drafted costs more to deal with than the work that found it.
What happens if the deal dies part way through the work?
The engagement is complete on a failed transaction, which is stated in the engagement letter. You keep the work performed to that point. Some buyers ask us to write up what we found anyway, on the reasoning that a business that failed diligence once is often the same business coming back to market in eighteen months.
Send us your LOI. We will review the purchase price.
A buyer with a signed letter of intent has already agreed a number. This tells you whether that number survives contact with the accounts, before diligence starts and while the other side is still cooperative.
- A view on whether the multiple looks defensible on the information available
- Where we would expect diligence to find problems
- An honest answer if you do not need a full engagement
Avnit will email you back. Reply to that message with the letter of intent attached.
No cost. One business day.
Send us the LOI before you commit to a scope.
We will review the purchase price at no cost and tell you where we would expect diligence to find problems. If we think a full quality of earnings will not change your decision, we will say that instead.