Financial Due Diligence: Buyer’s Guide

Financial due diligence is the cornerstone of a successful business acquisition. If you don’t verify the company’s financials before signing the purchase agreement, you risk buying a business based on inaccurate or inflated earnings. In this deep-dive webinar, Patrick O’Connell walks through the process of conducting financial due diligence, covering critical areas like income statements, balance sheets, working capital, quality of earnings, and proof of cash.

Why Financial Due Diligence Matters

"Trust, but verify." That phrase captures the essence of financial due diligence. In small business deals—especially those involving SBA financing—buyers must verify every financial number that justifies the Letter of Intent (LOI). Skipping or rushing this step can lead to costly surprises.

Patrick shares a cautionary tale of Justin, a searcher who bought a construction business using SBA financing. Without a proper quality of earnings analysis or a strong deal team, Justin missed key red flags. The business folded shortly after the acquisition, leading to bankruptcy. Justin's story highlights why diligence must be rigorous—not DIY.

The Due Diligence Timeline

Due diligence typically lasts 90 days post-LOI. The process kicks off with financial reviews and SBA or bank underwriting. Legal and tax due diligence usually run parallel. Patrick provides a visual timeline of this process and recommends buyers take a screenshot to keep handy.

Watch the Full Webinar

Watch now to gain a practical, insider view of the diligence process for small business acquisitions.

Whether you’re under LOI or preparing to evaluate your first deal, this video will give you the clarity and tools to proceed with confidence.

The Five Buckets of Financial Diligence

Patrick outlines five critical components:

1. Income Statement Analysis
   Review the profit and loss (P&L) statements over the past few years. Track revenue, expenses, and gross margin trends. Identify one-time items or unusual spikes that need explanation.

2. Balance Sheet Review
   Focus on accounts receivable (AR), accounts payable (AP), and other liabilities. Verify if the business has debt or related party transactions. Look for red flags like shareholder loans or employee advances.

3. Working Capital Evaluation
   Often the biggest deal killer. Define early in the LOI what’s included in working capital. Align expectations with the seller. A real case shared in the webinar shows how working capital moved from $500K to $900K, saving the deal from collapse.

4. Quality of Earnings (QoE)
   Take reported EBITDA and adjust for one-time, non-recurring, or owner-specific expenses. Examples include personal vehicle costs, owner bonuses, or out-of-period refunds.

5. Proof of Cash / Revenue
   Use bank statements to match revenue and expense records. This helps identify fraud or poor accounting. If variance exceeds 2% on revenue or 5% on expenses, it’s a red flag.

Real-Life Examples

Patrick demonstrates financial statement analysis using QuickBooks data. He highlights:

• Gross margins remaining stable at 70% over three years

• Year-to-date 2024 margins spiking to 80%—a potential sign of unrecorded costs

• Expenses rising 28% from 2022 to 2023 with minimal income growth, signaling potential issues

He also covers a real example of adjusting EBITDA for a $146K owner bonus hidden under miscellaneous expenses. Identifying this allowed proper normalization of earnings.

Tips for Working Capital Negotiation

Patrick emphasizes clarity in LOIs:

• Is working capital part of the deal?

• What does it include (AR, AP, inventory)?

• How will it be calculated (12-month average, last month, etc.)?

Failure to address this leads to confusion and last-minute deal term renegotiations. Sellers may resist, especially if they don’t understand the mechanics.

Adjusting Deal Terms Post-Diligence

Due diligence doesn’t just confirm value—it can change it. If you discover issues:

• Consider a seller note to offset overvaluations

• Add an earnout to de-risk uncertain future earnings

• Restructure payment schedules to reflect new findings

Patrick warns that purchase agreements should not be drafted until financial diligence is complete.

Can You Do Diligence Yourself?

Technically, yes. But Patrick cautions that many SBA lenders now require third-party due diligence. Even if not required, involving professionals shows commitment and increases lender confidence.

Further Reading 

• Business Buying Masterclass: Financial Due Diligence
  Elliott Holland & Chris Williamson, The SMB Center
  In-depth breakdown from LOI through quality-of-earnings and red flag detection
• Quality of Earnings Report: Ultimate Guide for SMBs
  ProjectionHub, 
  Best practices in pre‑LOI due diligence for valuation and financing alignment risk.lexisnexis.com+15projectionhub.com+15thesmbcenter.com+15

• Due Diligence Checklist – Small Business Acquisitions
  ComCap Financial
  Comprehensive list covering QoE, tax returns, bank statements, assets and contracts duedilio.com+1thesmbcenter.com+1
• Due Diligence in Search Fund Acquisitions
  Security Bank & Trust Co
  Distinguishes preliminary vs confirmatory diligence phases and eight focus areas.
• The Complete Guide to Financial Due Diligence
  CapLinked blog
  Detailed guide: including financial statements, cash flow, compliance, technology tools

Final Thoughts and Resources

Effective due diligence protects buyers from poor investments. It ensures you understand the business’s actual performance, mitigates risk, and helps you structure a deal that works.

Patrick offers a downloadable Financial Due Diligence Checklist—the same one he uses in live deals. You can find it by scanning the QR code in the video or connecting with him on LinkedIn.

Whether you're a self-funded searcher, ETA operator, or investor, applying these steps is essential to closing successful, sustainable deals.