Financial due diligence: what should you review before buying a company?

Buying a company means buying future results, not only past accounts

An acquisition often begins with a compelling narrative: a company with a strong history, relevant customers, an experienced team and attractive growth prospects. The figures may support that narrative, but they may also reveal a more complex reality.

That is the purpose of financial due diligence. It is not limited to checking whether the financial statements add up. It seeks to understand the quality of earnings, the sustainability of cash generation and the items that may change the economics of the transaction.

For a buyer, the main question is not simply how much the company sold or what EBITDA it reported. The buyer must determine how much of that performance can continue after the acquisition, what further investment will be required and which liabilities will effectively be assumed.

Reported EBITDA may not be recurring EBITDA

EBITDA is a common reference in company acquisitions, particularly when valuation is based on a multiple. However, the accounting figure reported in one year may include effects that do not represent the normal performance of the business.

A quality-of-earnings review will typically consider:

• non-recurring income or costs;
• shareholder or family expenses recorded by the company;
• remuneration above or below market levels;
• grants affecting reported earnings;
• related-party transactions;
• changes in accounting or revenue-recognition policies;
• temporary effects that benefited or penalised a particular year.

The purpose is not to manufacture a higher EBITDA. It is to arrive at a normalised and defensible measure of the profitability that the company may generate under comparable conditions after the transaction.

A relatively small difference can have a material valuation impact when multiplied. A EUR 200,000 EBITDA adjustment in a transaction valued at six times EBITDA may change the indicative enterprise value by EUR 1.2 million.

Financial debt is only the starting point

When price is discussed on a cash-free, debt-free basis, net debt is used to move from enterprise value to equity value. The difficulty lies in defining what should be treated as debt.

In addition to bank loans and finance leases, other debt-like items may include:

• overdue taxes and social security contributions or payment plans;
• suppliers outside normal payment terms;
• bonuses, holiday pay or employee liabilities already incurred;
• called guarantees or disputes with a probable financial impact;
• customer advances that require future expenditure;
• essential capital expenditure that has been deferred;
• commitments assumed outside the balance sheet.

Not all these items will necessarily receive the same treatment. Due diligence should identify and quantify them so that buyer and seller can agree how they affect price or the transaction documents.

Working capital can change the price paid

A business needs a normal level of receivables, inventory and payables to operate. If working capital is below that level at completion, the buyer will have to fund the shortfall immediately after the acquisition.

Many transactions therefore include a working-capital adjustment. A normal target is agreed and compared with the actual position at completion.

This requires more than reviewing the latest balance sheet. The analysis should consider seasonality, payment terms, receivables ageing, inventory turnover and suppliers that may have been paid unusually slowly.

A company may report solid EBITDA while consistently consuming cash. The difference between earnings and liquidity is one of the areas where financial due diligence creates the greatest value.

Revenue does not necessarily mean quality revenue

The same amount of revenue can carry very different levels of risk. Predictability depends on customer mix, contractual relationships and the ability to retain business without relying exclusively on the founder.

The review should consider:

• concentration among key customers;
• recurring and project-based revenue;
• contract duration and renewal provisions;
• changes in price, volume and margin;
• recent losses of major customers;
• dependence on one product, channel or market;
• the order book and the probability that it will be delivered.

Commercial information must also reconcile with the accounts. Growth reported by management should be supported by invoicing, collections, contracts or verifiable orders.

Converting EBITDA into cash is critical

EBITDA does not pay for acquisitions or repay debt. Available cash also depends on capital expenditure, working capital, tax and finance costs.

Historical cash conversion helps determine whether the business requires high recurring investment, funds customers for long periods or relies on early receipts to maintain liquidity.

This is particularly important when an acquisition will be partly debt-financed. The buyer must assess whether cash generation can support normal operations, required investment and the service of the acquisition debt.

Forecasts should be tested, not merely received

A business plan is always a view of the future. Due diligence cannot remove uncertainty, but it can test the coherence of the principal assumptions.

Budgets should be compared with historical performance. Margin development, available capacity and the additional costs required to deliver projected growth should be assessed. Downside scenarios are also necessary to test the resilience of the financial structure.

When the proposed value depends mainly on results that have not yet been achieved, the price structure may need to share risk through deferred consideration, an earn-out or other conditions linked to future performance.

Due diligence should influence both the decision and the transaction structure

A report should not end with a long list of observations that have no practical consequence. Its conclusions should help determine:

• whether the acquisition still makes sense;
• whether the price should be adjusted;
• which items should be included in net debt;
• the normal level of working capital;
• the warranties and indemnities to be negotiated;
• whether part of the price should depend on performance;
• the actions required during the first months of ownership.

Not every finding leads to a price reduction. Some findings improve the buyer's understanding, support contractual protection or enable a more realistic integration plan.

Preparing the information also benefits the seller

A company that anticipates these questions enters a sale process with greater control. Organising financial information, explaining adjustments and resolving inconsistencies before approaching investors reduces uncertainty and prevents every unanswered question from becoming a negotiating argument against the seller.

At Fenix Capital Partners, financial due diligence is treated as a bridge between accounting, valuation and negotiation. The objective is not merely to find risks, but to translate financial information into decisions on value, price, structure and contractual protection.