Buying a small to medium-sized business is one of the most exciting—and risky—ventures you can undertake. It’s often referred to as the riskiest asset class, and whether you’re taking on private debt or signing a personal guarantee, you're committing significant capital.
This is why thorough financial due diligence is essential. It not only protects your investment but ensures you are seeing the business from the right perspective before making such a major financial commitment.
Start Here: Due Diligence Timeline
Once the letter of intent (LOI) is signed, your due diligence period begins. Typically, this lasts 30, 60, or 90 days. The LOI grants exclusivity and signals to the seller that you are serious about the deal.
For a deeper dive into the due diligence process, check out the full webinar, "Financial Due Diligence Essentials," where we break down each phase step-by-step.
Here’s a rough timeline of the due diligence process:
Day 1 to 30: Start with financial due diligence and SBA underwriting.
Day 30 to 60: Begin tax diligence.
Day 60 to 90: Initiate legal due diligence and begin drafting the purchase agreement.
Buyer Priorities: What You Must Get Right
1. Revenue Verification
Ask yourself: Is the revenue real, recurring, and stable?
Analyze financial statements using software like QuickBooks.
Review proof of revenue by looking at 12-month bank statements.
Compare receipts to reported revenue—ensure a variance within ±2%.
2. Expense Analysis
It’s crucial to differentiate between actual expenses and discretionary costs.
Understand whether owner salaries, personal travel, or bonuses will continue post-close.
Watch out for excessive add-backs in the broker's SIMs.
Travel expenses often remain, while salaries may be adjusted.
3. Cash Flow Truth
Free cash flow is the money that supports your SBA or private loan as well as your salary.
Build a pro forma model that includes debt payments.
Assess whether the business can support these expected debt loads.
4. What’s in the Balance Sheet
In asset sales, it’s essential to understand what exactly you’re buying:
Accounts receivable
Equipment
Other selected assets and liabilities
Before we dive deeper into analyzing income statements, it's crucial to have a comprehensive understanding of the broader financial due diligence process. Financial due diligence involves multiple factors that help ensure the stability and profitability of the target company.
For a comprehensive overview and detailed checklists on financial due diligence, check out this resource:
How to Conduct Financial Due Diligence + Checklist by DealRoom
This article provides an in-depth checklist for assessing the financial health of a business, including key aspects such as earnings volatility, expense scrutiny, quality of earnings, and cash flow quality. Read the full article here.
Deep Dive: Analyzing Income Statements During Due Diligence
Margins Matter
Gross Profit Margin = Revenue – Cost of Goods Sold
EBITDA Margin = Operational Performance
Net Profit Margin = Revenue – All Costs
Look for margin swings. A significant drop from 25% to 10% or a spike to 70% may indicate issues. Ask why.
Spot the Red Flags
Unexplained revenue spikes or declines.
Declining profit margins.
Poor financial records.
Customer concentration (e.g., 5–6 customers making up 75% of revenue).
Discrepancies between cash and accrual accounting methods.
Seasonality in cash flow.
These red flags could signal the need for price adjustments or restructuring the deal terms, like increasing the seller note.
Normalize Earnings
Adjust for one-time events:
A $450,000 lawsuit is unlikely to repeat. Add it back.
A one-time customer project shouldn’t be factored into your projections for ongoing revenue.
Owner compensation should be benchmarked and reflected in your EBITDA calculations. For example, $100K–$150K is a typical range.
Working Capital: A Deal Maker (or Breaker)
Working capital is one of the most negotiable aspects of a deal. It can make or break your acquisition, and you need to determine whether it’s included in the purchase price.
Assess what assets/liabilities are included (A/R, A/P).
Set a target for working capital and compare it to closing figures.
This is where expert help can make a huge difference in protecting your interests.
Assemble Your Deal Team
For successful due diligence, you’ll need a team of experts:
M&A CPA (Quality of Earnings)
M&A Attorney
SBA Lender or private bank
Industry experts (optional, possibly equity-based)
Due Diligence Mistakes to Avoid
Over trusting the seller.
Accepting vague responses without verifying data.
Rushing through the closing process without thorough reviews.
Missing written terms in the purchase agreement.
In Closing
Whether you’re under an LOI or actively searching for acquisitions, financial due diligence is your foundation for making informed decisions. Trust the seller, but verify every detail—from every line item to every margin and every bank statement.
Diligence can give you the insight you need to either walk away from bad deals or negotiate better terms.
If you’re in the process of acquiring a business, download our free Financial Due Diligence Checklist to ensure you’re covering all the critical areas before finalizing the deal.
Contact us today to learn how we can support your next deal.