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Financial Due Diligence: What Every Acquirer Needs to Know

A practical guide from the advisory team at MDN Group

At MDN Group, we define financial due diligence in M&A as the structured process of verifying that the price being paid for a business accurately reflects its underlying operating performance. The goal is to understand not just what a company reports, but what it truly earns – and whether those earnings are sustainable.

Our advisory team organises buy-side financial due diligence around three core pillars: the quality of earnings analysis, the determination of net working capital levels, and the identification of debt and debt-like items. Each pillar addresses a different dimension of financial risk. Together, they give acquirers a complete and reliable picture of the business they are buying.

In this guide, we walk through best practices for each of the three pillars – from quality of earnings analysis to the correct identification of debt and debt-like items. Our aim is to provide both experienced and first-time acquirers with a practical framework for transactions of any size across EU markets.

“Financial due diligence is not simply a compliance exercise – it is the foundation on which a defensible purchase price is built. We have seen well-structured transactions unravel because a buyer accepted management accounts at face value without testing the quality of the underlying earnings.” – Peter Hubert, Partner, MDN Group

What Should I Be Looking At?

Quality of Earnings

A quality of earnings (QofE) analysis is a core component of any buy-side financial due diligence process. Its purpose is to measure the proportion of a company’s reported profits that derive from genuine, repeatable business activity – such as increased sales volumes or sustained cost reductions – rather than from one-off items or accounting adjustments. Common examples of adjustments that can inflate reported earnings include changes to inventory valuations, alterations in depreciation policy, and the premature recognition of accrued revenue.

In mid-market M&A transactions across the EU, adjusted EBITDA (earnings before interest, tax, depreciation, and amortisation) is typically used as the primary proxy for operating cash flow. Validating the adjustments that management has applied to arrive at adjusted EBITDA is therefore one of the most important tasks in our due diligence process. Our team examines whether each adjustment is genuinely non-recurring, appropriately sized, and consistently applied across reporting periods.

Our advisory team and the buyer’s accountants will focus on three categories of adjustment:

• Non-recurring (or non-operational) items of income and expense
• Normalising (pro forma) adjustments – for example, adjusting for an owner’s above-market salary
• Accounting policy adjustments

Beyond adjusted EBITDA, we also analyse free cash flow (FCF), which is calculated as: FCF = EBITDA ± ΔNWC – C – t, where NWC is net working capital, C represents normal replacement capital expenditures, and t represents taxes paid. Free cash flow provides a more complete view of the actual cash available for debt service, distributions to shareholders, or reinvestment in the business. Unlike EBITDA, it accounts for working capital movements and capital expenditure requirements, both of which can be material in asset-intensive industries.

In addition to earnings quality, our team frequently examines a range of supporting financial and commercial data points. These include forward capital expenditure requirements, product and service margin analysis, employee compensation and turnover trends, inventory composition and ageing, monthly and annual revenue patterns, and customer concentration risk. Customer concentration, in particular, is an area we flag regularly – where a single customer or small group of customers accounts for a disproportionate share of revenue, the buyer is exposed to significant downside risk if those relationships change after closing.

According to data published by the Institute for Mergers, Acquisitions and Alliances (IMAA), M&A activity in Europe has remained at elevated levels in recent years, increasing the importance of rigorous due diligence standards as deal volumes and valuations rise.

Net Working Capital Levels

Most M&A transactions are structured with the expectation that a normal level of net working capital (NWC) will be delivered by the seller at the point of closing. This ensures that the business can continue operating immediately after the transaction without requiring the buyer to inject additional capital. Establishing what “normal” means for a specific business – the so-called working capital peg – is one of the most technically demanding aspects of financial due diligence.

The working capital peg serves a protective function for the buyer. If the actual working capital delivered at closing falls below the agreed peg, the purchase price is adjusted downward accordingly. Conversely, if the delivered amount exceeds the peg, the seller may be entitled to additional consideration. Given the financial consequences of miscalculating the peg, our team dedicates considerable attention to this analysis.

Net working capital disputes are among the most common sources of post-closing litigation in M&A transactions. Our experience across EU deal markets confirms that ambiguities in how NWC is defined – particularly regarding the treatment of accruals, deferred revenue, and timing differences – can generate significant disagreements between buyer and seller after closing. Clear definitions in the purchase agreement, supported by thorough due diligence, are the primary defence against this risk.

The working capital peg is typically calculated using one of two methods:

• As a historical average – calculated over a representative 12- to 24-month period
• As a percentage of revenue – particularly useful for high-growth businesses where historical averages may not reflect current working capital needs

The peg will typically fall in the range of 20% to 40% of annual revenue for many businesses, though this varies considerably by industry, seasonal patterns, customer and supplier payment terms, and the company’s growth trajectory. For businesses in sectors with long cash conversion cycles – such as manufacturing or project-based professional services – the peg may be significantly higher.

Key elements that we examine carefully in our NWC analysis include:

• Accounts receivable: we include only those balances that are collectible within a normal operating cycle, excluding overdue, disputed, or extended-term receivables
• Inventory: we assess both the quality and quantity, identifying aged, obsolete, or insufficient stock that may require additional capital post-closing
• Accruals: we review the completeness and consistency of accrued liabilities, particularly for items such as employee bonuses, holiday pay, and professional fees

Debt and Debt-Like Items

The majority of M&A transactions in the mid-market are structured on a cash-free, debt-free (CFDF) basis. Under this convention, the seller retains the company’s cash at closing and is responsible for settling all outstanding debt and debt-like items before, or simultaneously with, the completion of the transaction. This approach is standard because business valuations in the mid-market are driven primarily by an EBITDA methodology, which excludes the effects of the capital structure – meaning that debt and non-operating assets are separated from the operating enterprise value.

Interest-bearing debt is straightforward to identify. It includes items such as bank loans, overdraft facilities, capitalised equipment leases, mortgage obligations, and shareholder loans. The more complex task is determining which other items qualify as “debt-like”. These are liabilities that function economically like debt – because they represent future cash outflows that reduce the equity value of the business – but are typically non-interest-bearing and often relate to operational obligations.

Common debt-like items that our team identifies during due diligence include:

• Credit card liabilities
• Trade payables with extended or unusual payment terms
• Legal settlements or claims payable
• Accrued holiday pay, bonus obligations, and redundancy provisions
• Accrued but unpaid interest
• Deferred rent obligations

Deferred revenue requires particular care in the analysis. While the seller will typically retain the cash received from customers in advance, the buyer inherits the contractual obligation to deliver the related goods or services after closing. Our team evaluates the cost to the buyer of fulfilling those obligations. In software-as-a-service (SaaS) businesses, where deferred revenue arises from recurring subscriptions and the cost to service is low, it may be reasonable for the seller to retain this cash without an adjustment to the purchase price. In service businesses where fulfilment costs are material, a dollar-for-dollar deduction is more appropriate.

It is important to note that there is no universal standard defining what constitutes an appropriate CFDF adjustment. Letters of intent (LOIs) often lack the specificity needed to resolve ambiguities in this area. For this reason, we recommend that buyers – with the support of their legal and financial advisers – negotiate and document the definitions of cash, debt, and debt-like items precisely in the purchase agreement before proceeding to closing.

“Deferred revenue is one of the most frequently mishandled items in mid-market due diligence. Buyers and sellers often have very different views on who should bear the cost of fulfilment obligations after closing – and those differences can move the final purchase price by a meaningful margin if not resolved early.” – Denis Stukalov, Managing Partner, MDN Group

Other Important Areas to Examine

Financial Statements Prepared in Accordance with Applicable Accounting Standards

Within the European Union, financial reporting for companies above certain thresholds is governed by International Financial Reporting Standards (IFRS), as adopted by the EU. For smaller entities, national GAAP frameworks apply – for example, the German Handelsgesetzbuch (HGB) in Germany, the Plan Comptable Général (PCG) in France, or local equivalents in other member states. Our team verifies that the target company’s financial statements have been prepared consistently with the relevant standards applicable in its jurisdiction.

Key principles that we check for compliance with include the revenue recognition standard (under IFRS 15 for larger entities), which requires that revenue is recognised when performance obligations are satisfied – not simply when cash is received. We also check that the company provides full and accurate disclosure of all material information to ensure transparency for investors and other stakeholders. Where accounts have been prepared by management without independent review, we recommend that the buyer instruct an independent accounting firm to audit or review the financials as part of the due diligence process. Oversight in the EU is carried out by national competent authorities such as the Autorité des marchés financiers (AMF) in France, the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) in Germany, and the Autorità di Vigilanza sui Contratti Pubblici (CONSOB) in Italy, coordinated at the European level by the European Securities and Markets Authority (ESMA).

Ongoing Financial Commitments of the Business

We recommend that buyers review all ongoing financial commitments of the target business, including lease obligations, loan repayment schedules, and fixed employee compensation costs. A useful diagnostic question is: how much flexibility does management have to reduce overhead in the event of a revenue shortfall? Businesses with high fixed-cost structures and limited operational leverage carry greater downside risk in an economic downturn. We also verify that creditors are being paid within agreed terms and that no liabilities have been omitted from the balance sheet.

Reasonable Asset Valuations

Our team examines the asset valuations presented on the balance sheet to assess whether they are reasonable and consistently applied. The valuation methodology used for each asset class should be appropriate to its nature. Cash and near-cash instruments are reported at face value. Property, plant, and equipment are typically reported at historical cost less accumulated depreciation, in accordance with IAS 16. Intangible assets – which are particularly significant in technology and media transactions – require close scrutiny, as their valuations may involve significant management judgement.

Off-Balance Sheet Arrangements

A thorough due diligence process must identify any off-balance-sheet arrangements that could materially affect the business’s financial position after closing. Common examples include operating leases not yet capitalised under IFRS 16, contingent liabilities arising from product warranties, outstanding legal claims, or disputes with EU tax authorities such as national revenue agencies or VAT inspection bodies. We also look for any guarantees provided to third parties that do not appear on the face of the balance sheet. These items may represent significant future cash obligations that are not immediately visible from a review of reported financials alone.

For buyers seeking a broader context on best practices in financial due diligence within M&A transactions, the Harvard Law School Forum on Corporate Governance provides useful practitioner-oriented commentary on due diligence frameworks and risk areas.

How Long Should Financial Due Diligence Take?

The duration of the due diligence process depends primarily on the complexity of the target business and the completeness of its financial records. There is no single answer that applies to every transaction. What we can say from our experience advising on transactions across European markets is that it is always more efficient – and less costly – to invest time in thorough preparation than to discover problems after a purchase agreement has been signed.

For smaller business acquisitions, the complete due diligence process typically requires between 45 and 60 days. More complex transactions – including those involving private equity buyers, cross-border elements, or multiple operating entities – commonly extend to between 60 and 180 days. Transactions involving regulated businesses, particularly those subject to oversight by EU financial regulators, may take longer still due to the additional compliance verification required.

While the process of forming a view on a target begins the moment a buyer first reviews an information memorandum or management presentation, the formal due diligence process is initiated when two key documents are executed: the letter of intent (LOI), which sets out the principal commercial terms of the proposed transaction, and the non-disclosure agreement (NDA) or confidentiality undertaking. Once these are in place, the target company is obligated to provide access to its financial records and management team, and the buyer’s advisers can commence their structured review.

How MDN Group Can Support Your Acquisition

At MDN Group, we provide end-to-end buy-side advisory services to acquirers operating across EU markets – from initial target identification and valuation through to transaction structuring, negotiation, and closing. Our team has experience working with strategic buyers, family offices, and private equity sponsors on transactions ranging from small owner-managed businesses to complex, multi-entity group acquisitions. We coordinate all aspects of the due diligence process, acting as the central point of contact between our client, their legal advisers, and the target’s management team. To learn more about the full range of services we offer, please visit our services page.

Our sector coverage spans a wide range of industries, enabling us to provide due diligence support that is informed by genuine sector knowledge rather than generic financial analysis. We understand the specific working capital dynamics, regulatory considerations, and valuation benchmarks relevant to each industry in which we operate. Whether you are acquiring a technology business subject to IFRS revenue recognition standards, a manufacturing company with significant fixed-asset bases, or a professional services firm where human capital is the primary value driver, our team is equipped to guide you through the complexities. You can explore the sectors we cover in detail on our sectors page.

If you are considering an acquisition and would like to discuss how MDN Group can support your due diligence process, we would welcome the opportunity to speak with you. Our team combines deep M&A transaction experience with a commercially focused, practical approach that is designed to give buyers confidence at every stage of the deal process. To find out more about who we are and the people behind our advisory work, we invite you to visit our team page.