A financial due diligence checklist for business buyers

Once you have agreed headline terms to buy a business, due diligence is your chance to check that what you have been told is true. It is also your last real opportunity to walk away or renegotiate before you are committed. Financial due diligence is the part that tests the numbers, and it is where the most expensive surprises tend to hide.

What financial due diligence is for

The goal is not to audit the business. It is to answer a small number of questions with confidence:

Is the profit real, and is it likely to continue?
Does the profit turn into cash?
What liabilities, risks or commitments come with the business?
Does anything you find change the price or the terms?

Due diligence usually runs alongside legal and operational review. Your lawyer handles the contract, the lease, licences and intellectual property; your accountant handles the financial and tax side. The two should talk to each other.

Before you start

Agree the scope and timetable in your letter of intent or heads of agreement. Make the purchase conditional on satisfactory due diligence, and set a realistic period for it. Your lawyer should draft or review those conditions.

Prepare a written information request so the seller knows exactly what to provide. A clear list saves weeks of back and forth.

The checklist

1. Financial statements

Profit and loss statements and balance sheets for at least the last three financial years
Year-to-date management accounts, and the same period last year for comparison
Who prepared the accounts, and whether they were prepared by an external accountant
Reconciliation of the accounts to the tax returns lodged with the ATO

2. Quality of earnings

A rebuild of seller's discretionary earnings or EBITDA, as relevant (see SDE vs EBITDA)
Evidence for every add-back: payroll records, invoices, contracts
Any costs the seller has reduced in the lead-up to sale, such as maintenance, marketing or staffing
Unusual or non-recurring income, such as grants, insurance payouts or one-off projects

3. Revenue

Monthly revenue for at least two to three years, to show seasonality and trend
Revenue by customer, with the largest customers' share of the total
Customer contracts, their terms and any change-of-control or assignment clauses
Revenue by product or service line, and the margin on each
Pricing history and any recent increases or discounts

4. Costs and margins

Cost of sales and gross margin trend
Major supplier relationships and any supply contracts
Wages as a share of revenue, and any recent changes in staffing
Rent, insurance and other fixed costs, and whether they will change under a new owner

5. Cash and bank

Bank statements for the period under review, matched to recorded revenue
Any cash takings, and how they are recorded and banked
Existing loans, overdrafts and equipment finance, which are normally paid out at settlement in an asset sale

6. Working capital

Aged debtors list, with any long-overdue amounts
Aged creditors list
Stock records, stocktake method and any obsolete or slow-moving stock
Agreement on the level of working capital included in the price, and how it will be measured at settlement

7. Assets

Fixed asset register, with age and condition of key equipment
Upcoming capital expenditure the business will need
A search of the Personal Property Securities Register (PPSR) to identify security interests over the assets you are buying

8. Tax

Income tax returns and assessments
Business activity statements and the GST position
PAYG withholding and superannuation guarantee compliance
Any ATO debts, payment plans, audits or correspondence
State taxes such as payroll tax, where the business is above the relevant threshold

In an asset sale, most historical tax liabilities stay with the seller, but you still need to understand them. Unpaid tax can signal poor record-keeping, and in some situations it can affect a buyer. In a share sale, the company's tax history comes with it, so the review needs to go deeper.

9. GST on the sale

Whether the sale will be treated as the GST-free supply of a going concern
Whether both parties are, or will be, registered for GST as required
That the contract records the agreement in writing

If the going concern conditions are not met, GST may apply to the price. This needs to be right in the contract, so confirm it with your accountant and lawyer.

10. Employees

A list of all staff with roles, pay rates, award or agreement coverage and start dates
Accrued annual leave, long service leave and personal leave balances
Which staff will transfer, and how their entitlements will be treated in the contract
Any underpayment risks, disputes or claims
Key person dependence, including on the seller

11. Lease and premises

A copy of the lease and any variations
Remaining term, options to renew, rent reviews and make-good obligations
Whether the landlord's consent is needed to assign, and any conditions

Your lawyer should review the lease in detail. A short or unassignable lease can undermine the value of the whole business.

12. Licences, contracts and compliance

Licences and permits needed to operate, and whether they transfer
Material contracts with customers, suppliers and contractors
Insurance policies and claims history

Making sense of what you find

Not every issue is a reason to walk away. Sort findings into three groups:

Deal breakers, such as profit that cannot be substantiated or a lease that will not be assigned.
Price or terms issues, such as add-backs that do not hold up, or upcoming equipment costs. These can justify a lower price, a retention, vendor finance or an earn-out. See earn-outs explained.
Housekeeping, such as minor record-keeping gaps, which you can fix after completion.

Due diligence is not about finding a perfect business. It is about knowing exactly what you are buying, so the price and the contract reflect it.

How we can help

Kainos Consultants carries out financial and tax due diligence for buyers, rebuilds earnings, and explains what our findings mean for price and terms, working alongside your lawyer. Read about our business sales and purchases service, or contact us to discuss a purchase.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.