Financial Due Diligence Flashcards

Question 1

What is the main purpose of financial due diligence in a transaction?

Accepted Answer

Financial due diligence is a structured review that tests whether a target company's reported financial position and performance are accurate, complete, and sustainable. Its purpose is to inform the buyer or investor about price, deal terms, and risk before committing capital. It replaces trust in the seller with evidence.

Question 2

Who typically commissions financial due diligence and who usually performs it?

Accepted Answer

The party considering the transaction, usually a buyer, investor, or lender, commissions financial due diligence. The work is often performed by an accounting firm, a corporate finance advisory team, or an internal deal team with accounting expertise. The commissioning party owns the scope and receives the findings, so its questions shape the review.

Question 3

How does financial due diligence differ from a statutory audit?

Accepted Answer

A statutory audit gives an opinion on whether financial statements are presented fairly under an accounting framework. Financial due diligence is commissioned by a transaction party, looks forward and backward, and answers questions the buyer cares about, such as normalized earnings and cash conversion. It gives less assurance but a broader commercial focus.

Question 4

What is a quality of earnings review and why do buyers request one?

Accepted Answer

A quality of earnings review is a detailed analysis of a company's reported profit to determine how much of it is recurring, accurate, and representative of future performance. Buyers request one because headline earnings can be inflated by one-time gains, aggressive accounting choices, or timing differences.

Question 5

What information should a due diligence request list typically include?

Accepted Answer

A request list asks the target for the documents needed to test its financial position, such as audited and management accounts, general ledger detail, tax returns, debt agreements, customer and supplier contracts, and forecast models with their assumptions. Missing or slow responses are themselves a useful signal for the review.

Question 6

Why is it important to define the scope of a financial due diligence engagement at the outset?

Accepted Answer

A defined scope sets the periods, entities, accounts, and questions the review will cover. Without a clear scope, teams can miss important areas or spend effort on low-value checks. Scope also clarifies what the review does not cover, so the buyer does not rely on work it never requested.

Question 7

What is a red flag in financial due diligence?

Accepted Answer

A red flag is an issue found during diligence that suggests a risk to value, reliability, or deal structure. Examples include unexplained revenue spikes near period end, frequent restatements, and heavy reliance on a few customers. A red flag is not proof of wrongdoing, but it signals where to dig deeper.

Question 8

How should a reviewer treat management representations during diligence?

Accepted Answer

Management representations are statements by the seller's leadership about facts, such as the completeness of records or the absence of undisclosed liabilities. A reviewer should treat them as claims to corroborate, not as evidence in themselves. Important representations are typically confirmed by documents, third-party confirmations, or later contractual warranties.

Question 9

What does normalizing earnings mean in financial due diligence?

Accepted Answer

Normalizing earnings means adjusting reported profit to remove items that will not recur and to reflect the costs and revenues a buyer should expect under normal ownership. Typical adjustments cover one-off legal settlements, owner compensation above or below market, and non-operating income. The adjusted figure then anchors valuation.

Question 10

What is the difference between EBITDA and adjusted EBITDA?

Accepted Answer

EBITDA is earnings before interest, taxes, depreciation, and amortization, a common measure of operating profit derived from reported results. Adjusted EBITDA starts from that figure and adds back or deducts specific items judged to be non-recurring or non-operating. Each adjustment must be supported, since it changes the value a buyer will pay.

Question 11

Why might a seller's adjusted EBITDA differ from a buyer's view of it?

Accepted Answer

Sellers tend to present the most favorable adjustments, such as adding back costs they consider discretionary or one-time. Buyers test each add-back against evidence and may reject items that recur, are operational in nature, or lack documentation. The gap between the two views is often the central point of price negotiation.

Question 12

What is revenue recognition and why does it matter for earnings quality?

Accepted Answer

Revenue recognition is the rule set that determines when a company records revenue, typically when it satisfies a performance obligation to a customer. Timing matters because recognizing sales early can lift current earnings without corresponding cash. Reviewers test reported sales against contracts, delivery records, and cash receipts.

Question 13

What are non-recurring items and how are they usually identified?

Accepted Answer

Non-recurring items are income or expense amounts unlikely to repeat in normal business, such as a restructuring charge. They are usually identified by reading the general ledger and comparing unusual entries against prior and later periods. Labeling an item non-recurring requires evidence, not just management's description.

Question 14

How can a reviewer test whether reported margins are sustainable?

Accepted Answer

A reviewer compares margins over several periods, by product line and customer, and against industry peers and the company's own pricing history. Sudden margin expansion without a clear operational cause, such as verifiable price or cost changes, deserves scrutiny. Sustainable margins are supported by consistent drivers, not by deferred costs or changing estimates.

Question 15

Why do capitalized costs and changes in accounting estimates deserve close review?

Accepted Answer

Capitalizing a cost moves it from current expense to a balance sheet asset, which defers the hit to earnings and can flatter reported profit. Changes in estimates, such as useful lives, reserve levels, or capitalization thresholds, can shift profit between periods. Reviewers check whether policies are consistent and whether changes are justified and disclosed.

Question 16

What does a proof of cash or bank reconciliation test help a reviewer confirm?

Accepted Answer

A proof of cash compares cash receipts and disbursements recorded in the ledger with bank activity for the same period, identifying any unexplained differences. It helps confirm that reported revenue and expenses have actual cash counterparts. Unexplained gaps may point to unrecorded transactions, fictitious entries, or timing issues that need follow-up.

Question 17

What is cash conversion and how is it commonly measured?

Accepted Answer

Cash conversion describes how much of reported earnings or EBITDA turns into operating cash flow over a period. A common measure is operating cash flow divided by EBITDA, often expressed as a percentage. Persistently low conversion can signal aggressive revenue recognition, slow collections, or heavy capital needs.

Question 18

What is net working capital and why do buyers focus on it?

Accepted Answer

Net working capital is the difference between operating current assets and operating current liabilities, such as payables and accruals, excluding cash and debt. Buyers focus on it because a business needs a normal level of working capital to run after closing. Shortfalls at completion may require the seller to adjust the price.

Question 19

What is a normalized working capital target or peg?

Accepted Answer

A normalized working capital target is the level of net working capital the buyer expects to receive at closing for the business to operate normally. It is usually set from average monthly balances, adjusted for seasonality. If actual working capital at closing differs from the target, the purchase price is adjusted accordingly.

Question 20

Why can a seller reduce receivables or stretch payables before a sale, and why does it matter?

Accepted Answer

Before a sale, a seller may accelerate collections, delay supplier payments, or cut inventory to show stronger cash and lower debt-like balances. These actions can temporarily flatter reported cash flow and net debt. Buyers detect them by comparing monthly working capital trends with normal seasonal patterns and with cash flow from prior periods.

Question 21

What are cash-free, debt-free pricing terms in a sale agreement?

Accepted Answer

Cash-free, debt-free pricing means the seller keeps the business's surplus cash and repays its financial debt at closing, while the buyer pays a price for the operating business alone. The purchase price is then adjusted for the actual cash, debt, and working capital at completion. Diligence must therefore identify cash, debt, and debt-like items.

Question 22

What is free cash flow and how does a buyer use it?

Accepted Answer

Free cash flow is the cash a business generates after funding the capital expenditure needed to maintain and grow its operations. Buyers use it to judge how much cash the business can return to owners or use to service debt. It reflects real cash movements rather than accounting accruals.

Question 23

How should maintenance capital expenditure be distinguished from growth spending?

Accepted Answer

Maintenance capital expenditure keeps existing operations running at their current capacity, while growth spending expands capacity or enters new markets. The split matters because a buyer's cash flow forecast should reflect the spending required just to sustain earnings. Reviewers test the split using asset registers, project approvals, and historical spending against depreciation.

Question 24

Why is inventory valuation a common diligence focus?

Accepted Answer

Inventory is often a large asset whose carrying value depends on estimates of cost, net realizable value, and obsolescence. Overstated inventory inflates current assets and can hide write-downs that would reduce earnings. Reviewers attend stock counts, test aging reports, and compare reserves for slow-moving or damaged goods with actual sales.

Question 25

What is net debt and how is it calculated?

Accepted Answer

Net debt is financial borrowings minus cash and cash equivalents at a given date, often with certain lease liabilities included depending on the agreed definition. It shows how much borrowing remains after counting liquid resources. Buyers use it to move from enterprise value to the equity value payable to sellers.

Question 26

What are debt-like items and why are they deducted in a price adjustment?

Accepted Answer

Debt-like items are obligations not labeled as borrowings that behave like debt, such as unfunded pension deficits, deferred consideration owed to former owners, and taxes unpaid for prior periods. They are deducted because the buyer will bear their settlement after closing, reducing cash available to owners.

Question 27

Why do off-balance-sheet obligations matter in financial due diligence?

Accepted Answer

Off-balance-sheet obligations are commitments that do not appear as liabilities in the main financial statements but may still create future cash outflows. Examples include certain guarantees, purchase commitments, and contingent obligations described only in notes. Diligence reviews notes, contracts, and legal correspondence to identify them, since omitting them can understate the true debt burden.

Question 28

What are covenants in a loan agreement and why should diligence review them?

Accepted Answer

Covenants are promises in a loan agreement that restrict the borrower or require it to maintain certain financial ratios, such as leverage or interest coverage. Breaching a covenant can trigger default or accelerated repayment. Diligence should review them to confirm compliance, identify change-of-control clauses, and understand whether the transaction itself requires lender consent.

Question 29

What is a change-of-control provision and why does it matter in an acquisition?

Accepted Answer

A change-of-control provision allows a counterparty, typically a lender or a key contract holder, to take specified action when ownership of the target changes. It may require repayment, consent, or renegotiation. Identifying these provisions early helps the buyer plan financing, avoid unexpected costs, and protect revenue from important contracts.

Question 30

What are contingent liabilities and how should they be assessed?

Accepted Answer

Contingent liabilities are possible obligations that depend on uncertain future events, such as pending litigation, product warranty claims, or environmental claims. They are assessed by reviewing legal letters, claims registers, and management's estimates, then judging both the likelihood of an outflow and whether it can be reasonably estimated.

Question 31

Why must tax liabilities be reviewed carefully in financial due diligence?

Accepted Answer

Tax exposures can carry large amounts and long look-back periods, and they often sit in provisions or notes rather than on the face of the balance sheet. Reviewers examine filed returns, open tax years, audit correspondence, and whether provisions reflect likely outcomes. Unrecorded exposures are typically addressed through specific indemnities or price adjustments.

Question 32

What is a debt maturity profile and why does it matter to a buyer?

Accepted Answer

A debt maturity profile shows when borrowings and other repayment obligations fall due, usually grouped by time period. It matters because large near-term repayments may require refinancing, equity injections, or asset sales. Buyers compare the profile with forecast cash flow to judge whether the business can meet its obligations without strain.

Question 33

How do management accounts differ from audited financial statements in diligence?

Accepted Answer

Management accounts are internal financial reports prepared by the company for its own managers, usually unaudited, and they may be produced on a different basis or with fewer adjustments. Audited statements have been examined by an independent auditor against an accounting framework.

Question 34

What makes a financial projection reliable enough to support a valuation?

Accepted Answer

A reliable projection rests on assumptions that are explicit, consistent with historical performance, and supported by evidence such as contracts, pipeline data, or market information. Reviewers test whether growth, margins, and capital spending align with the company's track record and capacity. Projections prepared mainly to support a sale price deserve extra skepticism.

Question 35

What is a sensitivity analysis and how is it used in due diligence?

Accepted Answer

A sensitivity analysis measures how a result, such as valuation or debt capacity, changes when key assumptions move within plausible ranges. In due diligence it shows which drivers matter most, such as pricing, volume, or input costs. Buyers use the results to set downside cases and avoid relying on a single optimistic scenario.

Question 36

Why is customer concentration a risk that diligence should quantify?

Accepted Answer

Customer concentration exists when a large share of revenue comes from a small number of customers, so the loss or renegotiation of one contract can materially affect earnings. Diligence quantifies the share of revenue and gross profit from the largest customers, along with contract terms and renewal history. This evidence informs pricing, earn-out design, and protective terms.

Question 37

How do earn-outs and deferred payments connect to financial due diligence?

Accepted Answer

An earn-out makes part of the price depend on future performance, such as revenue or profit targets, while a deferred payment is paid later regardless. Diligence shapes both by establishing a reliable baseline, defining how earnings will be measured, and identifying risks that could disrupt targets. Vague definitions of earnings in the agreement often lead to later disputes.

Question 38

What are representations, warranties, and indemnities, and how does diligence inform them?

Accepted Answer

Representations and warranties are contractual statements by the seller about the business, such as the accuracy of financial statements, and indemnities are promises to compensate the buyer for specified losses. Diligence findings shape which statements the buyer requires, how broad they should be, and where specific indemnities or escrow are needed.

Question 39

Why should the scope and reliance limitations of a diligence report be stated clearly?

Accepted Answer

A diligence report states the procedures performed, the information relied on, and what was not verified, so readers understand the level of assurance. Clear limitations protect the author and help the commissioning party decide where additional work is needed. Readers who ignore the stated scope may treat limited procedures as a full audit.

Question 40

How should findings from financial due diligence be prioritized for decision makers?

Accepted Answer

Findings should be ranked by their potential effect on value, cash, and deal feasibility, with issues that could stop or restructure the transaction placed first. Each finding should state the evidence, the estimated impact where it can be measured, and a recommended response such as further work, a price change, or a contract protection.

Financial Due Diligence Flashcards

1Purpose and scope of diligence

2Earnings quality and normalization

3Cash flow and working capital

4Debt, liabilities and net debt

5Valuation, risk and reporting

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