If you are new to M&A, contemplating a career in financial due diligence, or if you are an owner trying to understand what your investment banker is trying to convince you to spend money on before taking your company to market, you have come to the right place.  In this post, we are going to cover:

• What is financial due diligence?
• Are TAS & FDD the same?
• What is the difference between QofE and FDD?  
• What is the difference between an FDD engagement and a financial audit?  
• What are the differences between Buy Side and Sell Side Financial Due Diligence?
• Most Common FDD Analyses / Report Sections
• What FDD reports should really be called.
• FDD reports are normally rearview mirror looking.

What is financial due diligence?

Broadly speaking, Financial Due Diligence (FDD) is where an investor and/or its advisors analyze the financial performance of a business relative to the purported performance that has been represented by the owner or management team, often in the context of looking to invest in or acquire a business. In other words, if a company that is for sale tells prospective buyers that it generated $150 million in revenue and $25 million in EBITDA last year, financial due diligence is analyzing or fact checking that those metrics are accurate. 

However, revenue and profitability metrics alone can be misleading or may not convey the full story. Sophisticated investors want to understand the underlying drivers of financial performance. For example, two businesses with identical financial performance may derive wildly different valuations from an investor. The two businesses are in the same industry—enterprise software—and generate $150 million in revenue and $25 million in EBITDA. Both have grown at a 20% CAGR over the last five years and are forecasted to grow at a similar rate over the next few years. The first company’s largest customer represents 40% of total revenue, and the second company has no single customer that represents more than 2% of total revenue. All else being equal, which one is likely worth more than the other?  

A buyer is likely to value the second company higher than the first. Why? Greater customer concentration creates a higher degree of risk that might impair the first company’s earnings and free cash flow generation should it lose its largest customer. Put differently, the Quality of Earnings (and Quality of Revenue) is superior in the second business, because it is more diversified from a customer perspective when compared to the first company.  

Many prospective buyers perform some financial due diligence on their own. However, it is common for prospective buyers to hire third parties to perform more granular financial diligence. Financial due diligence is one of the common third-party studies commissioned during an M&A transaction. These third-party firms specializing in financial due diligence (“FDD”) services are often FDD groups within public accounting firms or FDD boutiques. Since most financial due diligence is performed in context of supporting an investment, merger, acquisition, business combination, joint venture, divestiture, carveout, business loan, recapitalization, or some other financial transaction, FDD groups are often part of or referred to as Transaction Advisory Services (“TAS”) groups within these firms. 

Are TAS & FDD the same?

FDD groups are often part of or referred to as Transaction Advisory Services (TAS) groups within these firms. For some firms, TAS and FDD are the same thing. For other firms, TAS may include a broader set of transaction advisory services beyond just financial due diligence, such as tax transaction advisory services, technical accounting services in support of deals, pre- and post-merger integration services, business consulting services, HR diligence services, IT diligence services, among other services. 

What is the difference between QofE and FDD?  

While Quality of Earnings (QofE) is usually a critical part of financial due diligence and while practitioners often refer to them synonymously, they are not the same thing. Practitioners commonly refer to financial due diligence reports produced by FDD service providers as Quality of Earnings reports or QofE reports, but this is a shorthand practice that is really a misnomer. The Quality of Earnings is usually just one section—admittedly a very important section, but just one section—of an entire FDD report.  

Why is this shorthand such a common practice? Well, valuations are often discussed as a multiple of EBITDA, and the Quality of Earnings section is the part of the report that analyzes adjustments to EBITDA to present it on a normalized basis. EBITDA is central to the valuation (or at least central to how valuation is commonly discussed). Viewed this way, any adjustment to EBITDA stands to potentially have a multiplicative impact on the valuation. For example, if a prospective buyer is valuing the $25 million EBITDA software business at 10x EBITDA, then they are valuing it at $250 million. If financial due diligence suggests the EBITDA is really $20 million instead of $25 million, this $5 million shortfall very well might result in a $50 million (or 10x) reduction to purchase price. As you will soon see, other financial diligence areas are more likely to have a dollar-for-dollar impact on the purchase price, rather than a multiplicative one. For this reason, disproportionate emphasis or focus is put on the Quality of Earnings section of FDD reports, resulting in the entire report often being referred to as a QofE report rather than an FDD report.

What is the difference between an FDD engagement and a financial audit?  

A financial audit is supposed to validate or provide assurance over the accuracy of the actual financial performance over a period (i.e., income statement and cash flow statement) and the financial position as of a specific point in time (i.e., balance sheet). It is supposed to validate the financials “as is”, including the impact of one-time and potentially non-recurring events. This also includes the impact of non-operational items. Financial due diligence makes adjustments to create a normalized view of the operational performance of the business.  

There are other differences to keep in mind. The procedures of an audit are rigid. A company cannot tell its auditor it does not care about a set of specific procedures and to omit them from the scope of work and the engagement. In contrast, there are no specific or rigid procedures that must be followed in an FDD engagement. It depends on what the client cares about and the scope agreed by the FDD provider and the client. The duration of an FDD engagement is usually much shorter (often a matter of three or four weeks for a buy side FDD engagement) than an audit. Financial audits are historical looking. While FDD reports are also typically historical looking, they may include certain pro forma adjustments, or “as if” / scenario adjustments, to present the historical results on a basis more consistent with the go-forward operations of the business. There are also more gray areas or judgment areas in an FDD engagement, where FDD service providers and their clients may take a different approach on an adjustment based on whether they are on the buy side or the sell side.

What are the differences between Buy Side vs. Sell Side Financial Due Diligence?

It is intuitive why prospective buyers perform financial due diligence and often engage third-party FDD service providers to help with these efforts. Afterall, buyers want to be sure they are buying what they think they are buying. So, they kick the tires and check out the books. This is referred to as buy side financial diligence, or sometimes by its misnomer of a buy side QofE.  

However, why would a seller engage a third-party to perform sell side financial diligence? For the same reason someone selling their home might hire a home inspector before listing their house for sale—they might be able to remediate issues they learn of from the inspection that could detract from the sale or impair value, or at least they are privy to what a buyer’s inspection is likely to turn up and they can calibrate their expectations accordingly.

What are the most common FDD analyses / report sections? 

Most buy side FDD reports cover at least three main areas: Quality of Earnings (“QofE”) / adjustments to EBITDA, analysis of and adjustments to Net Working Capital (“NWC”), and identification of Debt and Debt-Like items (“DDL”).  In addition, FDD reports often cover other common analyses, which we will also discuss shortly. FDD reports are often formal PowerPoint / PDF reports with schedules, tables, charts, and commentary, and they are usually accompanied by a databook, or an Excel spreadsheet with all the detailed analysis included. Sometimes the client deliverable may only be the databook with embedded commentary within the spreadsheet. FDD analysis is commonly completed at the trial balance level, while leveraging supporting documentation, general ledger (“GL”) level detail, an audit workpaper review, and discussions with management.

• Quality of Earnings (Adjusted EBITDA): The Quality of Earnings (QofE) section of an FDD report seeks to identify adjustments to earnings (as measured by EBITDA) to present it on a normalized basis. It usually consists of various categories of adjustments—Management Proposed Adjustments (i.e., adjustments proposed by the seller, which are often identified by sell side FDD service providers), Diligence Adjustments (which often include things like adjusting management proposed adjustments; one-time, non-recurring items; accounting adjustments; and normalizing out of period items), and Pro Forma Adjustments.  
  
  These various adjustments may be necessary or prudent for a buyer to make to better reflect the earnings generating capacity (“EGC”) of the business they intend to buy. Examples of various adjustments include non-operating items like the gain on sale of equipment, adding back a one-off severance payment, correcting for end of period vacation accruals, or annualizing the full year impact of an acquisition where only a partial year of the results is reflected in the reported financial results.
  
  As mentioned earlier, as reflected in the phrasing—Quality of Earnings, this analysis hopefully does more than merely quantify adjusted EBITDA. Not all dollars of revenue and profit are created equally. Different revenue streams, customers, channels, product categories, and SKUs may vary in terms of their quality and contribution to a company’s overall revenue, profit, and free cash flow picture. While many of these analyses may be addressed in other parts of the FDD report, they ultimately speak to a company’s quality of earnings.
  
  For example, take Amazon. In 2023, only ~16% of its revenue came from its Amazon Web Services (“AWS”) cloud computing business. Yet, AWS accounted for two-thirds of Amazon’s overall profitability (as measured by operating income). By comparison, in 2022, AWS accounted for ~16% of revenue and all Amazon’s operating profit, as the rest of the business lost money. Or look at Costco, which as of 2023, makes more than half (~56%) of its total operating income from its membership revenue, even though it accounts for less than 10% of total net sales (Costco makes less than an 11% gross margin on merchandise sales, which accounts for over 90% of total net sales).
  
  
• Net Working Capital Analysis: Just like earnings from the income statement needs normalized or adjusted, the balance sheet—more specifically Net Working Capital (NWC)—often needs adjustments to present it on a normalized basis. There are non-operating items (e.g., financing or income tax related items) found in NWC, along with non-recurring and one-time items. These items often need to be adjusted to better reflect the working capital required by a new buyer to operate the business in the ordinary course going forward. Many of the identified non-operating items may be debt or debt-like items, which non-coincidentally happens to be the third category of analysis most commonly found in FDD reports. Identification of debt and debt-like items is the close cousin of net working capital analysis. 
  
  Furthermore, it is best practice to examine the quality of earnings adjustments to see if there should be any corresponding adjustments made to net working capital. Often (but not always), if there is an adjustment to the income statement, there is often a corresponding adjustment needed on the balance sheet and vice versa. 
  
  Note that sell side FDD reports customarily only include definitional adjustments to net working capital in their presentation, i.e., they only exclude cash, debt, and debt-like items. Other adjustments are commonly left to prospective buyers to determine on their own.
  
  Net working capital analysis is important to prospective buyers for multiple reasons. First, in the purchase and sale of a business, the buyer and seller commonly agree on a net working capital target or peg that is supposed to represent the ordinary level of net working capital required to operate the business. If the level of net working capital delivered at close differs from the target, then the purchase price is adjusted upwards or downwards accordingly. Thus, NWC is a common purchase price adjustment mechanism.  
  
  NWC has the potential to impact purchase price in a second and arguably more fundamental way. Net working capital is the fuel that keeps a business operating. It is how a business finances it operations.  Changes in net working capital impact free cash flow, and since a business is worth the net present value of its future cash flow streams, then the NWC attributes of the business directly impact valuation (especially if diligence finds that the NWC requirements of a business are different than what the prospective buyer originally thought). Thus, examining adjusted net working capital and the company’s cash conversion cycle metrics are critical to understanding its free cash flow dynamics and is important to most prospective investors.
  
  
• Debt & Debt-Like Items: Private M&A transactions are commonly completed on a cash-free, debt-free basis.  Much like when you buy a house, you do not assume the mortgage of the seller. It is the seller’s responsibility to pay off that debt, and as a buyer, you want to acquire the asset free and clear of any liens or other non-operational financial claims, so you insist that the seller pay off the debt at close out of the sale proceeds, so the purchase is unencumbered. Similarly, if the seller had a duffle bag of cash sitting on the counter or a safe full of gold bars in the bedroom, they would most certainly take that with them at close and not leave it behind. That is the cash-free part. Some homeowners use debt to fund the home purchase and others are all cash buyers. Debt and cash are two sides of the same coin and are a function of the capital structure (use of debt) and tax structure (c-corp vs. s-corp vs. LLC; tax structure or more specifically the amount of tax owed is also a function of the amount of debt on the business, as interest expense—up to certain limits—is tax deductible).  
  
  A cash-free, debt-free transaction normalizes the transaction to be capital and tax structure independent. Identifying definitional debt (e.g., revolving lines of credit, term loans, subordinated debt, interest expense) and debt-like items (e.g., past due accounts payable, customer deposits, unfunded pension obligations, etc.) is necessary to make sure the buyer does not assume liabilities that should be the responsibility of the seller (i.e., you do not want to mistakenly assume someone else’s mortgage obligation or unpaid taxes due to the IRS).
  
  Identification of definitional debt is a fairly straightforward process.  However, parties may disagree on the treatment of certain items as debt-like or not. For example, customer deposits, deferred revenue, and certain accrued bonuses may be treated by some parties as debt-like, while others may argue these are ordinary course liabilities / part of operational net working capital. If a buyer assumes liabilities that it should otherwise not assume, because they should be the responsibility of the seller, then this certainly impacts purchase price, or the amount paid and assumed by the buyer. A buyer assuming liabilities that it should not is a drag on generating a return and is the equivalent of having paid more for the business. In the less common instances where the buyer and seller agree for the buyer to assume certain debt or debt-like items, the purchase price is reduced by these amounts to account for non-operational liabilities that must be repaid by the new owner.
  
  Sell side FDD reports commonly do not include a Debt & Debt-Like items section. Much like the NWC analysis in a sell side report commonly only adjusts out definitional items (cash and definitional debt), sellers often leave it to buyers and their advisors to formulate their own judgment on identifying the debt and debt-like items.

What FDD reports should really be called.

FDD reports should really be called Free Cash Flow (FCF) Analysis Reports. Why? Well, let us examine the formula for Unlevered Free Cash Flow (“Unlevered FCF”). Unlevered FCF equals EBITDA minus the Change in Net Working Capital minus Capital Expenditures.  Why unlevered? Well, much like EBITDA is before the impact of capital structure and tax structure, here, we too, are trying to use a measure independent of who owns the company and how it is capitalized. Notice, two of the three most common analyses in an FDD report—analyzing and normalizing EBITDA and NWC—are two of the three drivers of Unlevered FCF. Coincidence? I do not think so!

As alluded to before, a business is worth the net present value (“NPV”) of the future free cash flow it is expected to produce. Why then do people talk about businesses being valued as a multiple of EBITDA and not FCF? Well, for starters, EBITDA is easier to calculate than FCF. Calculating the change in NWC requires two balance sheets—the most recent one and one from a year prior. There are often many non-operating items buried in trial balance accounts that are not readily evident looking at a summary balance sheet. There are also often gray items that require judgment and get negotiated on a case-by-case basis, making it relatively harder to calculate. 

But what about this third component of FCF that we have not talked much about—Capital Expenditures (“Capex”)? If it is so important, then why is it not always a standard analysis in an FDD report (like the QofE, NWC, and DDL)? Well, for businesses with modest capex spend, it might not be important to spend time and dollars having an FDD service provider do a deep dive on it. For businesses that have low capex requirements / low capex spend (and low NWC requirements), EBITDA is actually a good proxy for FCF (i.e., big number (EBITDA) less two small numbers (change in NWC and capex) is close to the big number!). However, for capital intensive businesses like manufacturers, asset heavy transportation and logistics firms, energy and power companies, etc., it would be remiss to not include an evaluation of fixed assets and capex spend (including an evaluation of maintenance vs. growth capex levels) in the FDD analysis. It is a common analysis in such reports in more asset heavy businesses—as it should be.

Thus, FDD reports should really be called FCF Analysis reports, as they examine the critical components of Unlevered FCF to better inform prospective buyers of the normalized earnings and free cash flow generating capacity of the business, which is what is being used directly or indirectly to value them.  

FDD reports are normally rearview mirror looking.

While the past is not a guarantee to the future, it is a starting point. FDD reports usually analyze historical periods (the last two fiscal years and the most recent year-to-date (YTD) and trailing twelve month (TTM), or some prefer or latest twelve months (LTM) periods are the most common periods analyzed). FDD reports and databooks commonly provide a set of recast financial statements, so it pushes all the adjustments to the individual line items, providing an easier adjusted set of financials off which to forecast.

From a risk management standpoint, many FDD firms (especially those that are part of accounting firms), are cautious about helping clients forecast the future. Whether an FDD service provider is the party providing the forecasting and visibility services or not, insights from the FDD report and databook often provide a solid foundation for creating various forecasts or scenario analysis. Furthermore, some of the key performance indicator (“KPI”) analysis done by some FDD firms or their sister data analytics teams examine even more upstream or input variables (e.g., pipeline conversion metrics, bookings, backlog, etc.), which can be used to forecast more downstream or output variables (e.g., revenue and profit).

The financial results of a business are nothing more than a scorecard of all the strategies, tactics, decisions and indecisions, and actions and inactions performed by a business during a period of time. Good financial due diligence peels back the onion of financial performance to tell a story while yielding deeper and deeper insights into the business, which empowers investors to make better informed decisions.