Before an investor buys a business, or a stake in one, they want to know that the numbers are real. Financial due diligence is the review that answers this. It looks beyond the audited financial statements to test how sustainable the profit is, how much cash the business actually generates and what liabilities might come with it.
For buyers, it protects the price. For sellers, knowing what will be examined is the best way to avoid surprises late in the deal.
What buyers look at
1. Quality of earnings
Buyers want to know the profit the business can repeat. They adjust reported profit for one-off items, such as an insurance claim, a gain on selling property or unusual legal costs. They also adjust for owner-related items, such as family members on the payroll or personal expenses paid by the company. The result, often called normalised or adjusted EBITDA, is usually the basis for the price.
2. Revenue and customers
How much does the business depend on a few customers? Are major contracts about to expire? Is revenue recurring or project-based? A business where one customer brings in half of sales is usually worth less than one with a broad, stable customer base.
3. Working capital
Buyers examine receivables, inventories and payables to see how much cash is tied up in running the business, and whether the level at completion is normal. Slow-paying customers, old stock or stretched supplier payments all raise questions. Working capital adjustments are a common source of price disputes.
4. Net debt and debt-like items
The price is often agreed on a cash-free, debt-free basis, so buyers look for anything that behaves like debt: borrowings, hire purchase, unpaid taxes, overdue EPF or SOCSO contributions, amounts owed to directors, overdue supplier payments and provisions for claims. Each ringgit found here usually reduces the amount paid to the seller.
5. Tax exposures
Understated income, transfer pricing issues between related companies, and gaps in SST or e-Invoice compliance can become the buyer’s problem after completion. These are often dealt with through specific indemnities in the sale agreement.
6. Cash flow
Profit and cash do not always move together. Buyers compare reported profit with the cash actually generated. Warning signs include customers taking longer to pay, rising stock levels and essential spending on equipment that has been postponed to make profit look better.
What the findings change
Due diligence findings rarely stay in the report. They lead to price adjustments, specific warranties and indemnities in the sale and purchase agreement, conditions that must be met before completion, or in some cases the buyer walking away.
How sellers can prepare
- Keep financial statements audited and up to date, with clear explanations for unusual items.
- Separate personal and business expenses, and document transactions with related parties.
- Put tax filings and statutory contributions in order before a buyer finds the gaps.
- Prepare your own list of normalisation adjustments, with evidence, so that you shape the story.
- Review customer contracts, key supplier terms and any clauses triggered by a change of ownership.
- Consider a vendor due diligence review, where an independent party examines the business before buyers do.
In short
A well-prepared seller gets a smoother deal and a price that is harder to negotiate down. A careful buyer avoids paying for profit that is not really there. WS Group carries out financial and tax due diligence for buyers and investors, and helps sellers get ready before going to market.