Buy-Side Financial Due Diligence: What the Scope Should Cover

How does quality of earnings differ from an audit?

Quality of earnings looks at how sustainable and cash-backed a target’s earnings are, for the purpose of a specific deal. An audit gives reasonable assurance that financial statements are free from material misstatement under an accounting framework. One does not replace the other, and an audited company can still raise significant deal-specific questions.

An audit looks at the financial statements as a whole using audit materiality and prescribed standards. Due diligence may focus on a single customer contract, owner expense or month-end entry because it affects value or financing, even if it would never change an audit opinion. Its procedures and limits are set by the engagement scope.

Start with the decisions the buyer must make: whether earnings support the price, whether cash conversion supports the financing, and which liabilities need contractual protection. Accounting standards help assess the reported figures, but they do not prescribe a QoE method. The report should state its purpose, users and limitations without implying audit assurance.

What should the normalised EBITDA review test?

The EBITDA review reconciles reported results to the underlying ledgers and tests each proposed adjustment against evidence. The aim is a defensible view of historical operating performance, not the largest possible list of add-backs. Recurring costs, missing expenses and negative adjustments deserve the same attention as the seller’s proposed add-backs.

Typical adjustments include owner pay compared with the cost of a replacement manager, personal expenses, one-off legal costs and cut-off corrections. A claimed one-off cost needs checking: similar expenses in several years usually mean it is a normal cost of business. Vacant roles and deferred maintenance can also flatter historical earnings.

Keep historical normalisations separate from buyer synergies and future plans; a planned saving is not an achieved result. For each adjustment, record the period, ledger accounts, evidence, tax effect and any link to working capital or debt-like items. This cross-referencing prevents the same benefit from being counted twice in the valuation.

How should working capital, net debt and debt-like items be scoped?

Working capital diligence looks at the operating assets and liabilities needed to run the business, while net debt analysis identifies borrowings and agreed cash offsets. Debt-like items are other obligations the parties may treat as reducing the price. How each item is classified depends on the purchase agreement, not just on how it appears in the accounts.

Review monthly receivables, inventory, payables and accruals rather than only the latest balance sheet. Test overdue debtors, slow or obsolete stock, unrecorded supplier invoices and unusual payment patterns. A business can show attractive EBITDA while needing extra cash because customers pay slowly or stock is hard to sell.

Reconcile borrowings, accrued interest and financing arrangements to bank and lender confirmations. Consider shareholder loans, overdue taxes, deferred salaries, deal-related bonuses, lease liabilities and provisions individually. Their treatment is negotiated, so record whether each sits in working capital, net debt, another adjustment or outside the mechanism, and flag any overlap.

What do proof of cash and revenue testing show?

Proof of cash reconciles bank movements with recorded receipts, payments and balances, revealing unexplained differences and showing how well earnings turn into cash. Revenue testing checks that recorded sales reflect real customer arrangements in the correct period. Together they connect reported trading with evidence of actual economic activity.

Bank deposits are not necessarily revenue: they can include loans, capital, transfers between accounts and tax refunds. Customer receipts can also settle earlier invoices. A useful reconciliation separates these categories and explains timing differences, payment-gateway settlements and refunds. Agreement between bank and books alone does not prove every sale is valid.

Revenue analysis should look at customer and product trends, credit notes, returns, contract terms and collections after the period end. Customer concentration needs more than a ranked sales list: examine renewal terms, pricing concessions, disputes and whether the relationship depends on the seller personally. Separate contractual rights from management expectations.

How are the phases of a due diligence engagement organised?

A typical engagement moves through scoping, data review, detailed analysis, management discussions and reporting, with some overlap. The timetable depends on usable information and prompt answers more than on when the data room opens. Agree decision dates early and flag which open items could prevent a meaningful conclusion.

During scoping, confirm the entities, periods, currency, deal perimeter and intended users of the report. Request monthly trial balances, ledgers, bank statements, sales listings, payroll records and balance sheet schedules. Check that these reconcile before starting detailed work, and escalate missing records or inconsistent entity mapping quickly.

During fieldwork, keep an issues list showing information requested, owners and potential deal impact. Discuss findings with management before finalising so they can provide corrections or support. Distinguish an early red-flag update from the final report, and agree whether later trading updates or signing-to-completion work are included.

What should the buyer receive at the end?

The buyer should receive a report and supporting schedules that link findings to the investment decision and purchase agreement negotiations. Typical outputs include an EBITDA bridge, working capital analysis, net debt schedule, proof of cash and issues summary. Each should explain evidence, assumptions and limitations rather than presenting unsupported conclusions.

A useful report separates confirmed adjustments from items still to be negotiated or investigated. Schedules should trace to source records and show how totals reconcile. It may also cover customer concentration, revenue trends, cash conversion and accounting policies, while being clear about which commercial, legal, tax or operational areas are outside scope.

Agree in advance whether the team will join lender calls, help respond to seller comments or review financial definitions in the purchase agreement, since these are separate from issuing a report. Where SBA financing is involved, confirm the lender’s requirements and the current SBA guidance rather than assuming a single QoE format applies.

How should findings feed into the purchase agreement?

Due diligence findings should flow directly into price, structure and contract protections. Supported EBITDA adjustments affect the valuation, working capital findings set the peg, debt-like items enter the equity bridge, and unresolved exposures are addressed through warranties, indemnities, escrows or conditions. A finding that never reaches the agreement gives the buyer little protection.

Keep a single findings tracker that records each issue, its estimated effect, the evidence, and how it is handled: price adjustment, specific indemnity, completion condition, covenant or simple disclosure. Share it with the buyer’s legal advisers early, so that the drafting reflects the analysis rather than generic protections.

Make sure the financial definitions in the agreement match the analysis. Terms such as net debt, working capital, cash and accounting policies should use the same balances and policies tested in diligence. Differences between the two are a common source of post-completion disputes and price claims.

Finally, plan for the period between signing and completion. Agree whether management accounts will be reviewed during that period, how leakage or unusual transactions will be monitored, and who prepares the completion accounts. These steps protect the value identified during diligence until the deal closes.

Close the loop after completion by checking that indemnity claims, escrow releases and price adjustments follow the agreed process, and that the issues identified in diligence are tracked until they are resolved.

How does a quality of earnings review differ from a statutory audit?