Financial Statement Analysis for Mergers and Acquisitions Due Diligence

7/23/2026

The first thing to establish with a client who has asked for due diligence work is what they are not getting.

This is not an audit. There is no opinion, no assurance, and no requirement that the procedures be sufficient to support one. The objective is different in kind: an audit asks whether the statements are fairly stated; diligence asks what the business actually earns, and what the buyer is taking on.

Those two questions have different answers on the same set of books, which is why an audited target still needs diligence — and why a buyer who says "it's audited, we're fine" is about to overpay or inherit something.

What the Analysis Is Actually For

Three deliverables, and everything else supports them:

Normalized earnings — what the business earns on a recurring basis, stripped of items that will not recur under the buyer's ownership. This drives the price.

A working capital position — what level of working capital the business needs to run, which drives the closing mechanism and moves real money at closing.

Identified exposures — liabilities, contingencies, and risks that belong in the purchase agreement rather than in a surprise.

The Adjusted EBITDA Bridge

The centerpiece, and where the negotiation happens.

You are building a bridge from reported results to adjusted EBITDA, one line at a time, each defensible on its own. Our post on EBITDA versus net income covers why the measure is used; here the issue is which adjustments survive scrutiny.

Adjustments that generally hold:

Owner compensation normalized to market. An owner taking well above or below a market salary for the role distorts earnings, and adjusting to what a replacement would cost is standard.

Related-party rent at non-market rates. If the owner owns the building and charges below market — or above — the adjustment to market rent is legitimate, and per our post on related party transactions identifying all such arrangements requires a search rather than a question.

Genuinely discretionary personal expenses run through the business, where they are documented and will not continue.

Truly non-recurring items — a specific legal settlement, a one-time move, a discrete event with a beginning and an end.

Accounting corrections, where a policy was applied incorrectly.

Adjustments that draw fire, correctly:

"Non-recurring" items that recur. A legal settlement every year is a cost of doing business. So is annual "one-time" severance.

Pro forma run-rate benefits from actions not yet taken — a price increase planned, a headcount reduction identified, synergies. These belong in the buyer's own model, not in the target's historical earnings.

Growth-adjusted or annualized recent months, where a strong recent quarter is extrapolated across a year.

Add-backs with no support, which is the majority of what a seller's initial adjustment schedule contains.

The discipline: test each adjustment as its own assertion, ask what evidence supports it, and ask specifically whether the cost disappears under new ownership — because that, not its label, is the test.

Proof of Cash

The most useful procedure in diligence and the least glamorous.

Tie reported revenue and expenses to actual cash movement across the period, reconciling the difference. It surfaces, quickly: revenue with no corresponding collection, expenses paid but not recorded, timing manipulation at period ends, unrecorded borrowings, and owner distributions characterized as something else.

A target whose proof of cash does not reconcile has a problem worth finding before closing rather than after.

Revenue Quality Is Not Revenue Growth

A business growing revenue can be worth less than a flat one, depending on where the revenue comes from.

Customer concentration. The single most consequential finding in small and mid-market diligence. Revenue heavily dependent on a few customers is worth less, and the analysis should extend to whether those relationships are contractual, whether they are tied to a person who is leaving, and what the renewal history looks like.

Retention and churn, computed properly — by customer cohort, not as a net figure that growth conceals.

Recurring versus one-time, distinguished honestly. Repeat business is not the same as contracted recurring revenue.

Pricing history, which reveals whether growth came from volume or from price, and whether price increases have been achievable.

Cutoff and recognition, especially in the months before a sale process, when there is both motive and opportunity to accelerate.

Backlog and pipeline, examined for how much of it converts.

The analyzing financial statements course and the Certificate in Financial Reporting and Analysis cover the analytical toolkit; the diligence-specific application is in how the questions are aimed.

The Working Capital Peg — Where the Money Actually Moves

The mechanism most under-analyzed relative to how much it is worth, and where a CPA adds the most value on a deal.

Most transactions set a target level of working capital to be delivered at closing, with a dollar-for-dollar adjustment for any shortfall or excess. Which means:

The level at which the target is set transfers cash directly between the parties. A target set too low benefits the seller; too high benefits the buyer. This is not a technicality — on many deals the working capital adjustment is one of the largest single numbers after the purchase price.

Setting it requires understanding the seasonality and the normal cycle, usually via a monthly analysis across at least a full year to identify the true average requirement rather than the balance on a convenient date.

The definition matters as much as the number. Which accounts are in and out — cash, debt, deferred revenue, accrued taxes, related-party balances — is negotiated, and an item excluded from working capital and not otherwise addressed simply falls to one party.

Seller behaviour before closing should be examined: slowed payables, accelerated collections, deferred purchasing, and inventory run-down all improve the closing figure while damaging the business.

Our post on working capital analysis covers the operational side; in a deal, the same analysis has a price attached to it.

Deferred Revenue Deserves Its Own Paragraph

Because it is where buyers get hurt.

Deferred revenue on the target's balance sheet represents an obligation to perform for cash already collected. The buyer inherits the obligation and does not get the cash — it was spent before closing.

Three consequences: whether deferred revenue is included in the working capital definition materially changes the economics; the cost to fulfill the obligation is what matters economically, not the recorded balance; and the purchase accounting treatment can produce a revenue figure after closing that differs from what the target reported, which surprises buyers who built their model on the target's presentation.

Liabilities That Are Not on the Balance Sheet

The checklist that earns the fee. Look for:

Unaccrued sales and use tax exposure from unregistered nexus — the classic one, and per our post on nexus rules it compounds silently and is the seller's own money rather than the customers'.

Payroll tax and worker classification exposure, particularly a target using contractors for work that looks like employment.

Accrued but unrecorded compensation — earned vacation, bonuses, commissions.

Retirement plan compliance failures, including testing failures and late deposits.

Unfunded or under-accrued benefit obligations.

Warranty, return, and rebate obligations measured against actual history rather than the accrual.

Litigation and claims, including matters not yet formally asserted.

Environmental and regulatory exposures.

Leases and contractual commitments, including change-of-control provisions that trigger on the transaction itself.

Customer and supplier contracts with consent requirements, which can make the deal harder rather than costlier.

Related-party balances and arrangements that will not survive the sale.

Cash Flow, Capex, and the Question Nobody Asks

EBITDA is not cash, and the difference is where over-leveraged deals originate.

Maintenance capex versus growth capex. The critical split, and one that requires judgment rather than a general ledger query: what must be spent to keep the business at its current capacity. A target with deferred maintenance shows better EBITDA and hands the buyer a bill.

Working capital consumption in growth. A growing business consumes cash, so growth in the model needs a working capital assumption attached.

Free cash flow conversion, computed across several years, which reveals whether the earnings are real.

Asset condition, which is a physical question and not a financial statement one.

Independence, Reliance, and the Engagement Letter

Three professional matters to settle before the work starts.

Independence. Performing diligence for a buyer where the target is an attest client of the firm — or for a client acquiring an attest client — requires evaluation before acceptance, per the discussion in our post on independence and non-attest services.

Reliance and third parties. Lenders and investors frequently want to rely on the report. Who may rely on it, and on what terms, belongs in the engagement letter, not in an email after the fact.

Scope, stated in the report. What was and was not examined, and the explicit statement that this is not an audit and no opinion is expressed. Diligence reports get read years later by people who were not in the room, occasionally by people looking for someone to blame.

Broader coverage runs through the financial statements training catalog and the fraud and forensic accounting courses, since diligence findings sometimes become forensic engagements.

Where Diligence Goes Wrong

• Treating an audited target as diligenced, when the two answer different questions
• Accepting the seller's adjustment schedule rather than testing each item as an assertion
• Allowing pro forma synergies and planned actions into historical adjusted EBITDA
• "Non-recurring" items that recur annually, accepted at face value
• Skipping proof of cash, the cheapest high-yield procedure available
• Measuring churn net of growth, which conceals it
• Ignoring customer concentration or failing to ask whether the relationship is contractual
• Setting the working capital target from a single date rather than a monthly cycle
• Leaving the working capital definition vague, so excluded items fall to whoever is less careful
• Not examining pre-closing behaviour — slowed payables, run-down inventory, accelerated collections
• Overlooking deferred revenue, its cost to fulfill, and its purchase accounting effect
• Missing unregistered sales tax and worker classification exposure
• Not splitting maintenance from growth capex, and inheriting deferred maintenance
• Modelling growth with no working capital consumption attached
• Missing change-of-control provisions in leases and key contracts
• Not resolving independence before accepting the engagement
• Leaving reliance by lenders undefined in the engagement letter

The summary for a CPA doing this work: normalized earnings and the working capital peg are the two numbers that move money, so test every add-back against whether the cost actually disappears under new ownership, build the working capital target from a monthly cycle rather than a date, run a proof of cash early because it finds things fast, and write the exposures — sales tax, worker classification, unaccrued compensation, change-of-control clauses — into a list the lawyers can turn into representations.

Frequently Asked Questions

How is due diligence different from an audit?

The objective differs. An audit asks whether the statements are fairly stated and produces an opinion; diligence asks what the business actually earns and what the buyer is taking on, and produces no assurance. Both questions have different answers on the same books, which is why an audited target still requires diligence.

What is the test for whether an EBITDA add-back is legitimate?

Whether the cost actually disappears under new ownership — not what the adjustment is labeled. Owner compensation normalized to market, related-party rent at market, documented discretionary personal expenses, and genuinely discrete one-time events generally hold. Pro forma synergies, planned-but-untaken actions, annualized strong quarters, and recurring "non-recurring" items do not.

Why does the working capital target matter so much?

Because most deals adjust the price dollar-for-dollar against it, so where the target is set transfers cash directly between the parties — often one of the largest numbers after the purchase price itself. It should be built from a monthly analysis across at least a full year, and the definition of which accounts are included is negotiated, not given.

What should a buyer understand about deferred revenue?

It is an obligation to perform for cash that was already collected and spent before closing. Whether it sits inside the working capital definition materially changes the economics, the cost to fulfill matters more than the recorded balance, and purchase accounting can produce post-closing revenue that differs from what the target reported.

Which undisclosed liabilities surface most often?

Unregistered sales and use tax exposure, worker classification and payroll tax exposure, accrued but unrecorded vacation and commissions, retirement plan compliance failures, under-accrued warranty and rebate obligations, and change-of-control provisions in leases and customer contracts that trigger on the transaction itself.

Why does maintenance capex need to be separated from growth capex?

Because EBITDA is not cash, and a target that has deferred maintenance reports better earnings while handing the buyer a bill. Establishing what must be spent to hold current capacity requires judgment rather than a ledger query, and it is what turns reported earnings into something a lender's model can survive.