Financial Due Diligence Checklist for M&A

1. Quality of Earnings (QoE)

The core question: Is reported EBITDA sustainable and normalized, or artificially inflated?

What to analyze:

• Revenue recognition policies — Is revenue recognized when earned, or pulled forward via aggressive policies (e.g., recognizing multi-year contracts upfront)?
• Non-recurring items — One-time gains (asset sales, legal settlements, insurance claims) that inflate EBITDA but won't recur post-acquisition
• Related-party transactions — Sales to affiliates at inflated prices, purchases from related parties at below-market rates (unsustainable post-close)
• Deferred expenses — Capex postponed to inflate current period EBITDA (maintenance deferred, R&D underspent)
• Owner/shareholder compensation — Founder taking below-market salary (will require market-rate hire post-close), or excessive perks (personal expenses run through company)

Red flags:

• Revenue spiking in last quarter before sale (channel stuffing—pushing inventory to distributors to inflate sales)
• Significant jump in gross margin in most recent year (pricing unsustainable, or cost deferrals)
• Large EBITDA add-backs labeled "non-recurring" but appearing in multiple years
• Key customer concentration >25% of revenue (risky if customer churns post-close)

2. Working Capital Analysis

The question: How much cash will the business require to operate post-close?

Working capital = (Accounts Receivable + Inventory) − Accounts Payable. If target company has been operating with stretched payables (delaying vendor payments) or aggressive collection (collecting receivables faster than sustainable), normalized working capital requirement post-close may be significantly higher than current balance sheet shows.

What to analyze:

• Accounts Receivable aging — What % of AR is >90 days overdue? Are there uncollectible receivables written off as "non-recurring" but indicative of weak credit policies?
• Inventory turnover — Is inventory slow-moving or obsolete? For product businesses, inventory write-downs post-close reduce working capital.
• Accounts Payable terms — Are payables stretched beyond standard terms (e.g., 90 days when industry norm is 30)? Normalizing will require cash infusion.
• Seasonality — Does business have seasonal working capital swings (e.g., retail inventory build before holiday season)? Calculate peak working capital requirement, not just year-end snapshot.

Red flags:

• Working capital declining while revenue grows (unsustainable—indicates stretched payables or aggressive collections)
• Large AR balance with few underlying invoices (indicates disputed invoices or revenue recognition issues)
• Inventory turnover slowing (aging inventory that may need write-downs)

3. Debt & Liabilities Assessment

The question: What obligations transfer to buyer, and are there hidden liabilities?

What to analyze:

• Debt schedule — Principal amount, interest rate, maturity dates, covenants. Is debt assumable or must be repaid at close (requiring buyer to fund payoff)?
• Covenants and change-of-control provisions — Does debt agreement require lender consent for acquisition? Do interest rates step up upon change of control?
• Off-balance-sheet liabilities — Operating leases (now capitalized under Ind AS 116, but verify historical treatment), guarantees provided to customers/vendors, letters of credit
• Contingent liabilities — Pending lawsuits, regulatory investigations, tax disputes, product warranty claims. Review legal opinion letters from target's counsel.
• Employee liabilities — Unfunded gratuity, leave encashment, ESOP obligations (especially if vesting accelerates upon change of control)

Red flags:

• Debt covenants breached or close to breach (indicates distress; lender may accelerate debt upon acquisition)
• Large "other liabilities" line item with insufficient disclosure (probe for hidden obligations)
• Pending litigation not disclosed in initial data room (especially regulatory or tax matters)
• Personal guarantees from founder on company debt (may need to be replaced by buyer guarantees)

4. Cash Flow & Capex Validation

The question: Does the business generate sustainable free cash flow, or is capex understated?

What to analyze:

• Capex trends — Compare capex to industry norms and depreciation. If capex < depreciation for multiple years, indicates deferred maintenance (will require catch-up spend post-close).
• Operating cash flow vs EBITDA — Calculate OCF = EBITDA − Δ Working Capital − Cash Taxes − Maintenance Capex. If OCF is significantly lower than EBITDA, business is not generating cash despite reported profits.
• Cash conversion cycle — Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) − Days Payable Outstanding (DPO). Lower is better (faster cash conversion).
• Non-operating income — Interest income, rental income, or other non-core revenue streams that may not continue post-acquisition.

Red flags:

• Capex declining while revenue grows (maintenance deferred, equipment aging)
• Cash flow from operations negative despite positive EBITDA (working capital drain, or accrual-based earnings not converting to cash)
• Large "other income" contributing to profitability (not sustainable; adjust valuation accordingly)

Financial Statements (Historical 3 years + YTD)

• Audited financial statements (Balance Sheet, P&L, Cash Flow Statement, Notes)
• Unaudited management accounts (monthly/quarterly for last 12 months)
• Tax returns (Income Tax, GST) for last 3 years
• Reconciliation of book income to taxable income

Revenue & Receivables

• Revenue by product/service line, customer segment, geography (historical 3 years)
• Top 10 customers by revenue (% of total revenue, contract terms, payment history)
• AR aging schedule (current, 30-60, 60-90, 90+ days)
• Bad debt write-offs and provision methodology
• Revenue recognition policy (especially for SaaS, project-based, or multi-year contracts)

Costs & Payables

• COGS breakdown (raw materials, labor, overhead allocation)
• Top 10 suppliers by spend (% of total purchases, payment terms, contract terms)
• AP aging schedule
• Operating expense breakdown (SG&A detail by category)
• Related-party transaction schedule (all transactions with affiliates, owners, family members)

Debt & Liabilities

• Debt agreements (loan agreements, promissory notes, credit facilities)
• Debt repayment schedule (principal, interest, maturity dates)
• Covenant compliance certificates (last 2 years)
• Contingent liabilities register (pending lawsuits, tax disputes, warranty claims)
• Legal opinion letters from counsel (disclosing litigation and regulatory matters)
• Employee benefit obligations (gratuity, leave encashment, ESOP details)

Working Capital & Cash Flow

• Working capital schedule (monthly for last 12 months)
• Inventory aging report (slow-moving, obsolete items)
• Cash flow projections (management forecast for next 12 months)
• Capex schedule (historical 3 years + planned capex for next 2 years)
• Fixed asset register (gross block, accumulated depreciation, net book value)

Tax & Regulatory Compliance

• Income tax assessments and notices (last 3 years)
• GST returns (GSTR-1, GSTR-3B for last 12 months)
• TDS returns and Form 26AS reconciliation
• Transfer pricing documentation (if related-party transactions exist)
• Regulatory licenses and compliance certificates (industry-specific—e.g., FSSAI for food, NBFC license for finance)

1. Customer concentration risk (single customer >50% of revenue)

If one customer represents majority of revenue and has no long-term contract or is at risk of churn, business value collapses upon that customer's exit. Buyers either walk or demand earn-out tied to customer retention.

2. Undisclosed litigation or regulatory penalties

Pending tax disputes, environmental violations, or employment lawsuits discovered during DD create liability exposure. If material, buyers terminate or require seller indemnification (escrow holdback).

3. Revenue recognition fraud or aggressive accounting

Channel stuffing (booking sales before delivery), bill-and-hold arrangements (revenue recognized but goods not shipped), or side letters (undisclosed customer concessions) indicate earnings quality issues. Deal typically terminates if fraud is proven.

4. Working capital shortfall requiring immediate cash infusion

If normalized working capital is ₹5 crore but balance sheet shows only ₹2 crore, buyer must inject ₹3 crore day-one post-close. This reduces effective purchase price or is deducted from enterprise value during negotiation.

5. Key employee/management departure risk

If business is founder-dependent (no management team below founder) and founder is exiting, revenue and operational continuity are at risk. Buyers structure retention bonuses or multi-year earn-outs tied to founder staying post-close.