Verifying the Earnings
Financial due diligence is the process of verifying that a business's reported earnings are real, accurate, and sustainable, the single most important part of investigating a business you're buying. Because you're paying a multiple of earnings, confirming those earnings is everything. This is where a buyer (and their CPA) digs into the numbers to make sure the price is justified.
Whether you're a buyer verifying a business or a seller preparing for scrutiny, get a broker's guidance to keep the deal on track.
Reconciling the Financials
The foundation is reconciling the profit and loss statements to the tax returns and bank statements, ideally three years. The numbers must tell the same story: reported revenue should match bank deposits, and the P&L should align with what was filed with the IRS. Discrepancies are red flags. This reconciliation is the reality check that separates verifiable earnings from optimistic bookkeeping. See how to read financial statements.
Scrutinizing Add-Backs
The add-backs that build SDE or Adjusted EBITDA get intense scrutiny. Each must be legitimate and documented, a real owner expense, a genuine one-time cost, a verifiable personal expense. Buyers strip out add-backs that don't hold up, which lowers the earnings and the justified price. Inflated add-backs are the most common way sellers puff up a valuation, and financial diligence is where they're caught.
Testing Revenue Quality
Not all revenue is equal. Buyers assess revenue quality, is it recurring or one-time, growing or declining, concentrated or diversified, and collectible? A business with durable, recurring, diversified revenue is worth more than one with lumpy, concentrated, or questionable revenue at the same total. Understanding the composition and trend of revenue is central to valuing the business correctly.
Receivables, Payables, and Working Capital
Buyers review accounts receivable aging (are receivables collectible or stale?), payables, inventory, and the normal working capital the business needs to operate. This informs the working capital adjustment and reveals whether the business is being delivered adequately capitalized. Hidden problems, uncollectible receivables, stretched payables, obsolete inventory, surface here.
Quality of Earnings
For larger deals, financial diligence culminates in a formal quality of earnings (QoE) analysis, a deep, independent examination of the sustainability and accuracy of the earnings. Whether formal or informal, the goal is the same: confirm that the earnings you're buying are genuine and will continue. If financial diligence doesn't hold up, it's a reason to renegotiate or walk away. Always involve a CPA. See the full checklist.
Note: This article is general educational information, not legal, tax, or accounting advice. Work with a qualified attorney, CPA, and advisors on due diligence for your specific deal.
Frequently Asked Questions
What is financial due diligence?
Financial due diligence is the process of verifying that a business's reported earnings are real, accurate, and sustainable. It involves reconciling the P&Ls to tax returns and bank statements, scrutinizing add-backs, testing revenue quality, reviewing receivables, payables, and working capital, and often a quality-of-earnings analysis. It's the most important part of investigating a business.
How do you verify a business's earnings?
By reconciling the profit and loss statements to the tax returns and bank statements, ideally three years, so the numbers tell the same story: revenue matches bank deposits and the P&L aligns with what was filed with the IRS. You also scrutinize the add-backs, test revenue quality, and review receivables, ideally with a CPA.
What is a quality of earnings analysis?
A quality of earnings (QoE) analysis is a deep, independent examination of the sustainability and accuracy of a business's earnings, common in larger deals. It confirms that the reported earnings are genuine and likely to continue, going beyond the surface numbers to assess how reliable and repeatable the profit really is.
Why are add-backs scrutinized in financial due diligence?
Because add-backs increase the earnings figure that the valuation multiple is applied to, so inflated add-backs directly inflate the price. Buyers verify that each add-back is legitimate and documented, a real owner expense, a genuine one-time cost, or a verifiable personal expense, and strip out any that don't hold up, which lowers the justified price.
Verifying a Business's Numbers?
Martin Navarro helps buyers dig into the financials and confirm the earnings are real. Let's talk, confidentially and with no obligation.
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