Ever wondered what companies do before making a merger and acquisition, Joint ventures, or private equity investments? They try to bridge the gap between the raw financial data and the commercial reality. And this is done through Financial due diligence.
Financial due diligence is an investigation performed before an acquisition or investment to evaluate whether the historical financial performance, quality of earnings, assets, liabilities, cash flows, working capital, and other metrics truly represent the business, and whether any issues could affect the valuation or the purchase price.
You may be wondering: if a statutory auditor has already audited the financial statements, then why does financial due diligence exist? But the context is different. Where the auditor answers whether the financial statements are free from material misstatements, the Financial due diligence, vouches the overall health, and the factors affecting the valuation.
Taking a light example, Company XYZ Limited has 5 customers with revenues of 10 crores, 20 crores, 50 crores, 100 crores, and 500 crores from each customer for the financial year 2025-26 (But there was news that the 5th Customer won’t purchase anything again from the company). The revenue was correctly recognised as per the provisions of IND-AS 115, and the auditor gave an unmodified opinion. But the financial due diligence will definitely take into account the news on its own valuation, because the earning quality in the near future may have a great impact.
The next question that would be in your mind is,
What is the quality of earnings?
Quality of Earnings assesses whether a company’s reported net income is an accurate and repeatable measure of its underlying profitability. High-quality earnings are backed by real cash flow, come from core operations, and are likely to recur. Low-quality earnings might be propped up by one-time gains, aggressive revenue recognition, changes in accounting estimates, or non-cash adjustments that don’t reflect the actual health of the business.
Let’s say a company reports total income of Rs. 130 crores for the year: Rs. 100 crores from core operations, and Rs. 30 crores as a one-time gain from the sale of land. Since land sales aren’t a recurring source of income, including that Rs. 30 crores would overstate the company’s sustainable earning power. To assess the quality of earnings, we’d strip out this non-recurring gain and treat only the Rs. 100 crores of operating revenue as the ‘true’ or normalized earnings. Since that’s the figure that reflects the company’s actual, repeatable performance.
Why EBITDA over PAT?
Honestly, the main reason we use EBITDA instead of PAT in financial due diligence comes down to stripping away all the noise that has nothing to do with how well the actual business runs. PAT is heavily distorted by choices the previous owners made, like how much debt they decided to take on (which racks up interest), what tax bracket or exemptions they fell under, and what arbitrary depreciation methods they picked for their equipment. When you’re buying a company, you are usually wiping the slate clean: you’ll restructure the debt, change the tax profile, and manage assets differently. EBITDA cuts straight through all of that baggage by eliminating Interest, Taxes, Depreciation, and Amortization, giving you a clean, objective baseline of the company’s true, core operational earning power so you can actually compare apples to apples.
Can there be Positive EBITDA & Negative Cash flow?
A company can easily show a healthy positive EBITDA while its bank account is bleeding cash because EBITDA only measures accounting profitability on paper, not actual cash movement. This disconnect typically happens due to timing traps and cash drains that sit completely outside of EBITDA’s view. For instance, if a business makes massive sales on credit, its EBITDA spikes, but if those customers take months to pay, or if cash is heavily tied up in unsold inventory, no actual money enters the bank. At the same time, EBITDA completely ignores massive cash outflows like heavy capital expenditures for equipment, steep interest payments on debt, corporate tax bills, and the rapid paying down of supplier accounts, all of which can easily swallow up operating profits and leave the business with negative cash flow.
What are some key red flags?
- One customer contributing around 80% of total revenue.
- Receivable outstanding for 400 days
- Obselete Inventory
- Consistent negative operating cash flow
- Tax notices & huge demand
- Ficticious sales
- High related party transactions (Not at arm’s length price)
- Round tripping of funds
What documents do you request during FDD?
- Financial statements (Audited & Excel)
- Sales & Purchase register
- Bank statements
- GST & Income tax returns
- Customer Ageing & Vendor Ageing
- Fixed Asset registers
- Loan Regsiter (Borrowing & Advances)
- Employee list with KYC Documents (PF/ESIC/LWF Returns & Challans)
- Contracts & Customer and Vendor concentration
- MIS & Management accounts
- Important credentials, and many more (Depending upon the buy side & sell side)
A Typical FDD Process
- Engagement scoping
- Information request list
- Data analysis
- Management Q/A
- Site visits (Maybe)
- Red flags identification
- Draft report & finding discussions
- Final report