Buying a business? Your financial due diligence checklist

Buying a business can be a quick route to growth. You might acquire customers, skilled employees, intellectual property and years of trading history in a single transaction.

You might also acquire weak cash flow, unreliable forecasts and liabilities that were not obvious when the price was discussed. Get the decision badly wrong and the consequences can reach beyond the purchase price to your reputation, your existing business and, sometimes, your livelihood.

That is why financial due diligence needs to begin before the price and terms become difficult to change.

A financial due diligence checklist helps you look behind the headline figures, test the assumptions supporting a deal, and decide whether the business is worth what you are being asked to pay.

What is financial due diligence?

Financial due diligence is a detailed investigation into the financial position and performance of a business you are considering buying, investing in or merging with.

It should help you answer five basic questions:

• Does the business make as much money as the seller claims?
• Is that profit sustainable?
• Does the profit turn into cash?
• What debts, liabilities and financial risks would remain after the deal?
• What must happen for the forecasts to be achieved?

The process is not the same as an audit. As the ICAEW financial due diligence guideline makes clear, financial due diligence does not provide an audit or formal assurance opinion. Its scope is agreed for the particular transaction and shaped around the buyer’s questions.

An audit opinion addresses a set of financial statements as a whole. Due diligence might ask why margins rose sharply last year, whether a major customer is about to leave or how much working capital the company really needs.

There is no universal financial due diligence checklist

The right scope depends on the business and the transaction.

A professional services company with recurring monthly fees presents different risks from a manufacturer carrying large quantities of stock. A business dependent on one owner requires different questions from one run by an established management team.

You should therefore treat the following checklist as a starting point. It needs to be adapted to the size of the deal, the business model, the proposed purchase structure and the risks that matter most to you.

1. Begin with complete and current financial information

Start by establishing what financial information exists, how current it is and whether the different records agree.

A set of statutory accounts might show a healthy £300,000 profit. But those accounts could cover a period that ended more than a year ago. More recent management accounts might show falling margins, rising debts and a sharp deterioration in cash flow.

Both sets of figures may be accurate. Only one reflects the business you are considering buying today.

You may need to request:

• Statutory accounts for the last three to five years
• Recent monthly or quarterly management accounts
• Detailed profit and loss and balance-sheet reports
• Budgets, forecasts and cash-flow projections
• Aged debtor and creditor reports
• Bank statements and finance agreements
• Fixed-asset and stock records
• Tax returns, computations and correspondence
• Details of transactions with directors, shareholders and connected businesses

The management accounts should be compared with the statutory accounts and underlying accounting records. Significant discrepancies, gaps or unexplained changes need investigating.

Do not rely solely on documents downloaded from Companies House. Filed accounts may be historic and provide limited detail. Companies House also states that it performs basic checks but does not generally verify the accuracy of information submitted by companies.

Companies House records are therefore a useful starting point, but no substitute for current, detailed financial information.

2. Check where the revenue really comes from

A total sales figure tells you very little on its own. You need to understand what produced it.

Break revenue down by:

• Customer
• Product or service
• Location
• Sales channel
• Month or quarter
• Recurring and one-off work

This can expose customer concentration, seasonal trading patterns and reliance on contracts that may not continue after the sale.

Suppose a business reports £2 million of annual revenue. That sounds reassuring until you discover that £700,000 comes from one customer whose contract expires in six months.

You should also examine refunds, credit notes, disputed invoices and the company’s revenue-recognition policies. A late rush of invoices before year-end may deserve particular attention if it is out of step with normal trading.

3. Establish how much of the profit is sustainable

Reported profit is not always the same as maintainable profit.

That’s why financial due diligence commonly examines the quality of earnings by separating normal trading performance from one-off events and accounting adjustments. These might include:

• Exceptional legal or restructuring costs
• Grants or other non-recurring income
• Unusually high or low payments to owner-directors
• Personal expenditure passing through the business
• Income from a contract that has ended
• Temporary cost reductions
• Changes in accounting policies

This doesn’t mean every unusual cost should be added back to profit. If you look closely, you may find that some supposedly exceptional expenses have a habit of returning every year.

You should also distinguish between the company’s existing earnings and the savings you hope to make after buying it. Those savings may help justify the acquisition, but they are not part of the target company’s current performance

4. Compare profit with cash flow

A profitable business can still run short of money.

That’s why it’s a smart move to compare reported profit with cash generated from operations. Investigate any persistent gap, then look more broadly at the company’s total cash movements and future demands on cash.

Look closely at:

• Overdue customer balances
• Bad-debt provisions
• Slow-moving or obsolete stock items
• Extended payment terms and the reasons behind them
• Supplier arrears
• Capital expenditure
• Loan repayments
• Seasonal movements in working capital

A company may appear profitable because it has recorded sales that customers have not yet paid. Alternatively, it may need to hold far more stock than its headline profit suggests.

The question is not simply whether the business makes a profit. It is how much cash you will need to keep it running after completion.

5. Establish a normal level of working capital

Most trading businesses need a certain amount of cash tied up in stock and debtors. Supplier credit and other current liabilities reduce that requirement.

Financial due diligence should examine historical working-capital patterns and identify what a normal level looks like. This can become important when the final purchase price is calculated.

For example, a seller might improve the company’s apparent cash position by delaying supplier payments or aggressively collecting customer debts immediately before completion. The cash balance rises, but the business itself has not become more valuable.

Looking at working capital over several months can expose that sort of window dressing. Your financial due diligence adviser can then help you understand how the findings may affect the price or completion mechanism, working alongside the legal and corporate-finance advisers responsible for the deal documents.

6. Identify debt and other liabilities

Bank borrowing is usually easy to spot. However, other obligations may not be as clear. To get a fuller picture of debt and liabilities, it’s a good idea to review the following:

• Loans and overdrafts
• Hire-purchase and lease commitments
• Invoice-finance arrangements
• Director and shareholder loan accounts
• Guarantees and security given to lenders
• Overdue suppliers
• Customer deposits
• Provisions and contingent liabilities
• Pension obligations
• Commitments to future expenditure

You will also need to agree which balances are treated as cash, debt or debt-like items when calculating the final price.

A good financial due diligence review does more than list these balances. It explains which of them may require funding after completion, affect the price, or need to be addressed in the legal agreements.

7. Review the tax position separately

Tax problems don’t always appear clearly in the headline accounts, so your due diligence processes might need to cover:

• Corporation Tax
• VAT
• PAYE and National Insurance
• Construction Industry Scheme deductions, where relevant
• Employment status and off-payroll working
• Capital allowances
• R&D tax relief claims
• Outstanding returns or payments
• Enquiries, disputes or correspondence with HMRC

Tax due diligence is especially important when buying shares in a company, because historic tax exposures remain within that company after the purchase.

A clean payment record does not prove that every return and claim is correct. You need to understand the assumptions behind them and decide whether any risks require further investigation, a price adjustment or contractual protection.

8. Test the forecasts against evidence

Forecasts deserve particular scrutiny to check whether they are realistic. To test them, you could look at them alongside:

• Previous forecasts and actual results
• Confirmed orders and the sales pipeline
• Customer retention rates
• Market conditions
• Available production or staffing capacity
• Planned recruitment
• Future capital expenditure
• The additional working capital needed to support growth

If sales are expected to rise by 30%, ask what will produce that growth. If margins are also forecast to improve, ask what will change operationally.

A formula is not evidence.

9. Assess the quality of the financial controls

The numbers are only as dependable as the processes producing them.

Find out:

• How frequently management accounts are prepared
• Whether bank, debtor and creditor balances are reconciled
• Who controls payments
• How revenue and costs are authorised
• Whether budgets are monitored
• Which accounting systems are used
• How dependent the finance function is on one person

Weak controls do not automatically make a company a bad acquisition. They may, however, mean you need to spend more money improving its systems, recruiting staff or correcting unreliable records after completion. Those costs should be reflected in your plans for the business.

10. Turn the findings into action

The purpose of financial due diligence is not to produce the longest possible report. It is to give you the information you need to make the right decisions.

Depending on the findings of the due diligence process, you might decide to:

• Continue with the deal as proposed
• Negotiate a lower price for the business
• Change the payment structure
• Require a problem to be resolved before completion
• Seek appropriate contractual protection
• Prepare a post-acquisition action plan
• Walk away.

A red flag is not always a deal-breaker. A highly concentrated customer base, for example, may be acceptable if the relationships are strong and the price reflects the risk.

What matters is that you know about the issue while you still have choices.

Financial due diligence is only part of the investigation

Financial due diligence does not replace legal, commercial, operational, employment, tax or technology checks.

The British Business Bank’s guidance on buying a business recommends drawing on appropriate financial, legal and operational expertise. These different reviews should inform one another rather than operating as separate exercises.

A customer contract might look valuable in the revenue figures, but a solicitor will need to confirm whether it can continue after a change of ownership. A forecast may suggest rapid expansion, but your commercial due diligence should look at whether the market can support it.

Your financial adviser should help identify where the numbers raise questions for the other specialists and make sure the financial consequences of their findings are understood.

How THP can help with financial due diligence

If you are considering buying, investing in or merging with a business, THP can tailor the investigation to the proposed deal and the risks that matter to you.

Our financial due diligence services can include reviewing financial performance, cash flow, debts, liabilities, forecasts and the quality of the information provided. We can explain how the findings may affect the price, deal structure and risks you would take on, while working alongside your legal and mergers and acquisitions advisors.

The best time to begin is before the price and terms become difficult to change. Finding a problem early gives you choices. Finding it after completion generally gives you a bill. Get in touch with the THP team today to find out more.