When we think about due diligence, some of the questions you hear in practice are simple.
Buy a good business with sustainable earnings.
But what does that actually mean?
What does a business with good sustainable earnings look like?
And how do we verify that when we look under the hood of a particular small business?
Those are the questions financial due diligence looks to answer.
The goal is to give yourself confidence in the ability to conduct this analysis at a higher level than just bare bones.
When conducting financial diligence or even preliminary diligence, it helps to think of the process in five buckets.
These include:
• Financial statement analysis
• Working capital
• Proof of cash
• QoE or EBITDA analysis and review
• Tax assessment compliance and risk procedure
Financial statement analysis focuses on two key statements:
• The income statement
• The balance sheet
These are the statements that house the presentation of the financial data.
Conducting this analysis the right way has two benefits.
It ensures:
• You are paying a fair valuation for the business
• You minimize the risk of hidden issues
Many buyers ask questions like:
• What is a fair price for this business?
• How can I limit risk when buying a business?
• How can I set myself up for success?
These questions are challenging in small business deal making.
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Most small business acquisitions involve companies with unaudited financial statements.
There are often no checks and balances verifying the financial reporting of the company.
This is because:
• It is not required by law
• As long as the business pays taxes, it can continue operating
There are certain instances where businesses require annual audits.
But in most privately held small businesses, there is no requirement that anyone checks the books for accuracy.
The only requirement is filing taxes in line with IRS standards.
Because of this, buyers must assess the financial reporting procedures themselves.
When conducting an income statement deep dive, three key margin metrics help evaluate the business.
These include:
• Net profit margin
• EBITDA margin
• Gross profit margin
Each metric provides insight into profitability.
Net profit margin shows overall profitability after all expenses.
EBITDA margin reflects operational performance before financing decisions.
Gross profit margin measures efficiency between revenue and direct costs.
Looking at margins allows you to quickly assess the health of the business.
Revenue metrics alone can be misleading.
Revenue can look impressive, but margins reveal what is actually happening underneath the hood.
Margins also help reveal changes in business performance.
For example, a company may show the following margin trend:
• 25% margin
• 9% margin
• 14% margin
• 30% margin
When a business shows a sudden jump in profitability, buyers should ask questions.
For example:
• Is the financial reporting accurate?
• Has the business performed exceptionally well?
• Were expenses reduced temporarily?
In one example, operating expenses decreased significantly.
The reason became clear during discussions with the owner.
The foreman of the company had been let go.
The owner decided to perform the foreman's duties instead.
For the owner, this seemed like a simple decision.
He had run the business for over 30 years.
The work only took him five or six hours per week.
But a new buyer stepping into the business would likely need to hire a foreman again.
That means the margin would not remain at 30%.
Instead, profitability would return closer to the historical margin in the 20% range.
This is why verifying sustainable earnings is critical.
You can find this and other content on my YouTube channel, including shorts, long-form videos, and guest discussions focused on buying small businesses and improving operations.
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Income statement analysis typically begins with two approaches:
• Vertical analysis
• Horizontal analysis
A vertical analysis evaluates each line item as a percentage of revenue.
This allows you to identify significant expenses quickly.
A horizontal analysis compares financial performance year over year.
Together, these methods help identify trends and anomalies in the financial statements.
During income statement analysis, line items can be categorized using a flag system.
These flags highlight items that require further investigation.
• Green — normal range
• Yellow — moderate percentage of revenue
• Red — significant percentage of revenue
If an expense category represents a large percentage of revenue, it should be flagged and investigated.
Buyers should ask questions such as:
What is the nature of this account?
What does it relate to?
Is it necessary for the business going forward?
Open-ended questions help extract information from management.
Examples include:
• What is the nature of this account?
• What are the components of this sales category?
• Why is revenue tracked under separate accounts?
• What contributed to changes in expenses?
Management teams often have deep knowledge about the business.
Open-ended questions help uncover details that may not be visible in the financial statements.
Another important step in income statement analysis is identifying owner-related expenses.
These may include:
• Cars
• Life insurance
• Personal insurance
• Owner credit card expenses
Small business owners often leverage tax laws and business expenses to benefit themselves.
These expenses may not be necessary to operate the business.
Identifying them helps determine the true profitability of the company.
Payroll expenses are often one of the largest line items in a business.
For example, payroll may represent:
• 43% of revenue
• 33% of revenue
To verify these numbers, buyers should perform a payroll reconciliation.
This involves comparing the payroll report from providers such as ADP or Gusto with the payroll expenses recorded in the financial statements.
Discrepancies may occur when companies use:
• 1099 contractors
• Owner payments outside payroll systems
Flagging these items early helps maintain accuracy in financial analysis.
Rent is another common area requiring investigation.
In many small businesses:
• The owner owns the building through a separate LLC
• The business rents the building from the owner
Sometimes the business may not pay rent during the year of sale.
Because the owner controls both entities, they may operate rent-free.
A new buyer will not have this luxury.
The buyer will likely need to pay rent, and possibly higher rent.
This can significantly reduce reported earnings.
Certain accounts often require additional attention during diligence.
These include:
• Miscellaneous expenses
• Repairs and maintenance
• Automobile repairs
• Advertising and marketing
Miscellaneous categories are often broad.
Buyers should understand what expenses are included.
Repairs and maintenance may also appear under multiple accounts.
Small businesses sometimes create new accounts in their accounting system rather than categorizing expenses consistently.
Understanding the nature of these accounts helps build a clear picture of the company’s operations.
A structured income statement review sets the foundation for financial due diligence.
This analysis helps buyers understand:
• The nature of revenues
• The nature of operating expenses
• The drivers of growth
• The drivers of decline
Conducting this analysis can take one or two hours.
But it provides the framework for understanding how the business actually performs.
Financial due diligence begins with understanding the income statement.
A detailed review of revenues, expenses, and margins helps buyers verify sustainable earnings.
Looking under the hood of the financial statements reveals the real performance of the business.
This analysis sets the stage for evaluating:
• The health of the business
• The drivers of profitability
• The sustainability of earnings going forward.
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