Financial Due Diligence

In this fourth article in our Corporate Finance M&A insight series, we explain how to structure an issue-led FDD process that validates sustainable earnings, quantifies risks and critically translates findings into purchase price adjustments and SPA protections.

Financial due diligence sits at the heart of any acquisition process. Its purpose is deceptively straightforward: to validate that the business you think you are buying is, in fact, the business you are buying. In practice, this means stress-testing the sustainability of earnings, understanding genuine cash requirements, surfacing hidden liabilities and building a bridge from historical performance to the assumptions underpinning your investment case.

The most effective FDD is not a compliance exercise or a data-gathering assignment. It is an issue-led process that connects every material finding to a commercial consequence, whether that is an earnings adjustment (i.e. EBITDA), purchase price adjustment, valuation adjustment (i.e. net working capital or net debt), an SPA protection or a post-deal priority. Done well, FDD gives the acquirer the confidence and the evidence base to negotiate from a position of strength.

Quality of earnings (QofE)

The starting point for FDD is often normalising EBITDA. This involves removing exceptional items, adjusting for owner-specific costs, stripping out temporary effects and adding back one-off costs that reflect the business on a steady-state basis. 

Trading analysis

Revenue quality analysis goes deeper, distinguishing recurring income from project-based or one-off revenue, conducting detailed customer analysis, assessing churn and retention dynamics, and examining margin trends by customer, product or segment to understand the contribution of price versus mix effects. 

Cash conversion and net working capital

Cash conversion is the ultimate validator of earnings quality. FDD should map working capital seasonality across the financial year, assess debtor ageing profiles, identify inventory obsolescence risks and examine supplier payment terms. The output is a normalised working capital target that directly informs the pricing mechanism, whether that is a locked-box or traditional completion accounts.

Net debt 

What constitutes "net debt" is rarely as simple as it appears on the balance sheet. FDD should clarify the treatment of deferred revenue, staff bonuses and commissions, lease liabilities, deferred consideration, contingent liabilities, letters of credit, guarantees and onerous contracts. Getting the net debt definition right is critical — an ambiguous definition is a common source of post-completion disputes. 

Forecasts and business plan

Acquirers often pay a price based, at least in part, on forward-looking performance. FDD should rigorously test the assumptions underpinning the target's business plan, including revenue volume and pricing, hiring plans and operating costs. Comparing forecasts to historical performance highlights whether projections represent a genuine step-change or an exercise in optimism. Scenario analysis and downside cases provide the basis for structuring protections. 

Systems, data and financial control environment

The reliability of the numbers depends on the quality of the systems and the finance team producing them. FDD should evaluate the management information packs, financial close processes and internal controls. Weaknesses in these areas do not merely affect the accuracy of diligence findings or potential investment in new software and personnel, they create ongoing risks around post-deal financial reporting. 

Key deliverables

An effective FDD typically produces two primary outputs. First, a comprehensive FDD report structured around the key deal metrics, linking every finding to its commercial consequence, whether that is an adjustment to quality of earnings, working capital or net debt, an SPA protection or a post-deal consideration. Second, a financial workbook built from source data with extensive financial analysis supporting every number in the report. When preparing our financial workbook and FDD report, we are committed to highlighting any red-flag issues as they arise, providing early visibility of material issues that may affect the decision to proceed and mitigate fee exposure.

Common findings and practical responses

Certain findings recur across transactions. High customer concentration typically warrants retention incentives or earn-out conditions linked to key contract renewals. Aggressive revenue recognition or provisioning policies require EBITDA adjustment and tighter SPA accounting policies. Inventory risks may necessitate an increase in the working capital target or specific indemnities. Deferred revenue backed by cash is a commonly negotiated item in completion accounts, with the strength of the argument for treating it as working capital versus a debt-like adjustment varying significantly by sector depending on the nature of the underlying performance obligations. Deferred capital expenditure should be reflected in capital expenditure forecasts and may affect the consideration structure. Under-provided liabilities call for an adjustment to net debt, specific indemnities or escrow arrangements.

The role of FDD in selecting the pricing mechanism

FDD plays a pivotal role in informing the choice between locked-box and completion accounts. Under a locked-box, FDD must validate the balance sheet at the locked-box date and assess the adequacy of leakage protections. Under completion accounts, FDD informs the definitions, accounting policies and normalised working capital target that will determine the post-completion true-up. 

Our financial due diligence is designed for decisions, not merely for data. We quantify impacts, propose mechanisms and support negotiations through to completion.

Planning acquisition due diligence? Talk to our Corporate Finance team about an issue-led scope tailored to your transaction.