What Goes Into a Due Diligence Report (With Structure)

What a due diligence report is for

A due diligence report is not an audit. An audit gives an opinion on whether financial statements are fairly presented under an accounting framework. A due diligence report asks a different question: given what we now know, what should this buyer pay, and on what terms?

That makes it a risk document written for one reader. It looks forward, not just back. It is concerned with whether earnings will continue under new ownership, whether the cash the business needs to operate is really there, and whether there are liabilities that would land on the buyer after the deal closes.

The standard structure

Formats vary between firms, but a financial due diligence report usually follows this shape:

Quality of earnings, explained

Quality of earnings is the most important section of most reports, and the most misunderstood. Buyers usually price a business on a multiple of earnings, so every rupee of earnings that turns out not to be recurring is worth several rupees of price.

The analysis starts with reported profit and adjusts it in three broad ways. One-off items are removed: a legal settlement, an insurance recovery, a large one-time contract. Owner benefits are normalised: family members on payroll who do not work in the business, personal expenses run through the company, or an owner's salary set well above or below what a replacement manager would cost. Accounting policy choices are aligned: revenue recognised early, inventory valued generously, or costs capitalised that a buyer would treat as expenses.

The result is maintainable earnings: what the business can be expected to earn, year after year, under a new owner. When a seller's schedule of adjustments cannot be supported by documents, those adjustments fall away, and the price usually follows. Sellers with well-kept, reconciled books, often the product of a Virtual CFO engagement, tend to see far fewer disputed adjustments.

How findings are graded

A good report does not just list problems. It says what each one means for the transaction. Most findings fall into one of four grades:

• Deal-breaker. Something serious enough that the buyer should reconsider the transaction altogether, such as evidence of misstated revenue.
• Price-adjuster. A finding that changes what the business is worth, typically a reduction in maintainable earnings or an item that should be treated as debt.
• Warranty or indemnity item. A risk that may or may not crystallise, dealt with by making the seller contractually responsible if it does.
• Post-completion fix. A weakness in controls, systems or compliance that the buyer can correct after taking over, and should budget for.

These grades feed directly into the price and the purchase agreement, which is why diligence and business valuation work are usually read side by side.

Financial vs legal vs commercial due diligence

Financial due diligence, the subject of this article, is usually carried out by accountants and covers earnings, cash, debt, tax and financial controls. Legal due diligence is carried out by lawyers and covers title to assets, contracts, employment, licences, litigation and regulatory standing. Commercial due diligence, often done by strategy consultants or industry specialists, tests the market, competitive position and the business plan. On larger deals all three run in parallel and the findings are brought together; on smaller ones the buyer may combine or skip some, which is a judgement about risk rather than a formality.

How to read one as a buyer

• Start with the bridge. Find the reconciliation from reported profit to adjusted earnings. Every adjustment should have a reason and a source you can follow.
• Read the scope and limitations. What the provider was not given, or was not asked to look at, is as important as what they found.
• Check the working capital peg. The normal level of working capital agreed in the contract often moves more value than the headline price negotiation.
• Map every finding to a response. If a finding has no corresponding price change, warranty or post-completion plan, it has not been dealt with yet.

If you are preparing for a transaction and want a provider to run this work for you, see our due diligence support service.

Frequently asked questions