What is Financial Due Diligence: Steps, Tools & Red Flags

In 2011, tech giant HP announced an $11 billion acquisition of UK software company Autonomy. On paper, it looked like a smart, strategic move, until it wasn’t. Just a year later, HP announced an $8.8 billion write-down. They blamed accounting irregularities that were missed during the deal. Lawsuits followed, reputations took a hit, and the financial losses were staggering.

Why did it happen? Poor financial due diligence (FDD). A deeper review of Autonomy’s financials could have revealed red flags like aggressive accounting practices and unrealistic revenue claims before the deal was closed.

This story shows that skipping or rushing that step can turn even the biggest deals into billion-dollar disasters. Here, we explore what financial due diligence is, key objectives, red flags, and essential tools, such as data rooms for mergers and acquisitions.

What is due diligence in finance?

During financial due diligence, companies investigate the financial health of a target company. The process takes from two weeks to several months, depending on the deal complexity. 

This involves examination of financial records, performance, and risks of the target company. While financial due diligence starts with the analysis of financial statements, it also digs a little deeper into:

• Verifying earnings quality and sustainability.
• Uncovering hidden risks, such as debt, lawsuits, or tax liabilities.
• Assessing the company’s future potential.

How is financial due diligence different from other types of due diligence?

Apart from financial due diligence, businesses also conduct legal, tax, and operational DD. Here is how they differ:

These types of due diligence are not interchangeable. All of them are crucial during mergers and acquisitions, funding, IPOs, and other business transactions.

Why financial due diligence is crucial in M&A

During M&A, businesses conduct financial due diligence to reveal risks and opportunities that may impact valuation and deal success. This is the integral part of the formal “Due Diligence Phase” of M&A.

Speaking of the role of financial due diligence in the success of the deal, BPM’s Craig Hamm notes:

“The uptick in deal preparation activity is telling. With M&A volume projected to rise in 2025, thorough financial due diligence will be what distinguishes successful transactions from troubled ones.“

Without due diligence, buyers might overpay or face big problems after the deal. Investors also feel more confident when proper checks are done. It protects both sides from surprises later.

Financial due diligence vs. audit: What’s the difference?

Both FDD and audit examine financial data. However, these processes serve entirely different purposes. Audit confirms that financial statements are accurate and comply with GAAP and IFRS accounting standards. It checks historical financial statements, looking for errors, fraud, or misstatements in past reporting. The result of an audit is a standardized opinion, like “clean” or “qualified” for regulators, lenders, or shareholders.

Unlike an audit, financial due diligence is forward-looking. It tests the sustainability of earnings, working capital needs, and hidden risks. Due diligence provides actionable insights, like “EBITDA is overstated by 20% due to owner add-backs”.

Overall, both FDD and Audit are important aspects of the M&A process. Audits ensure the numbers are correct, and FDD explains what they mean for the deal.

Key objectives of financial due diligence

During a financial due diligence investigation, buyers and potential investors want to:

• Verify revenue & costs
• Check if earnings are sustainable
• Spot inflated profits or hidden expenses
• Analyze working capital
• Review cash flow cycles (AR/AP, inventory)
• Identify liquidity risks
• Uncover hidden liabilities
• Find undisclosed debt or legal risks
• Check tax compliance issues
• Assess financial controls
• Detect weak processes or fraud risks
• Ensure accurate reporting
• Test future projections
• Validate growth assumptions
• Stress-test cash flow forecasts

Who performs financial due diligence and when?

Financial due diligence is usually done by the buyer or investor, with help from both their own team and outside experts. The internal team, often professionals from finance or legal, understands the buyer’s goals and can see if the deal fits those plans. But sometimes, they need extra help from specialists who bring a fresh, detailed perspective to make sure nothing gets missed.

That’s where external advisors come in. These can be investment banks, consulting firms, or accounting experts. They bring specialized knowledge and experience. They review the target company’s financial statements, tax records, income statements, debts, and other details. External advisors are independent, so they give an unbiased view of the risks.

Financial due diligence happens after initial interest but before signing the final deal. It starts once both sides agree to go ahead, often after a letter of intent (LOI) is signed. This way, the buyer can confirm the company’s true value and find out any problems before committing to the purchase.

Financial due diligence process: Step-by-step

The financial due diligence process is complex and consists of several key steps, each aimed at identifying the financial performance of the target company. Here is how it happens:

Step 1: Define scope & assemble team

Define the focus areas and align stakeholders:

• Sign an engagement letter. This is a formal agreement on deliverables, timeline, and fees.
• Finalize due diligence scope and identify focus areas, such as revenue quality, debt review, and tax risks.
• Assemble a team: financial analysts, tax experts, and industry specialists.

Step 2: Collect financial documents

Collect and organize financial documents for review:

• Request documents: P&L statements, balance sheets, cash flow reports, tax filings, and contracts.
• Set up a safe data room for secure and efficient document sharing.
• Review initial data for completeness and red flags.

Step 3: Analyze financial health

Validate financial performance and identify trends:

• Investigate P&L: revenue recognition, EBITDA adjustments, cost structure.
• Review the balance sheet, check for asset quality, debt obligations, and contingent liabilities.
• Benchmark KPIs: compare margins, growth rates, and efficiency ratios vs. industry peers.

Step 4: Pinpoint risks and red flags

Highlight financial, operational, and compliance risks:

• Review debt & liquidity documents for covenant breaches and refinancing risks.
• Check tax & legal compliance for pending audits, transfer pricing risks.
• Assess working capital to identify short-term liquidity gaps.

Step 5: Deliver findings and advise the next steps

Summarize findings and guide decision-making:

• Draft due diligence report that covers key risks, normalized earnings, and valuation adjustments.
• Arrange a management discussion to present findings to investors/board.
• Adjust deal terms based on findings (for example, price reduction, escrow).

Financial due diligence checklist

This financial due diligence checklist is a must-have for:

• Private equity firms that evaluate portfolio companies
• Corporate development teams executing acquisitions
• Investment bankers who prepare sell-side materials
• Business owners who are getting ready for exit or fundraising

Tools used during financial due diligence

To efficiently analyze a company’s financial health, professionals rely on specialized tools, such as data rooms for due diligence, accounting software, analytics tools, and more.

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Financial due diligence in investment banking

During investment banking deals, financial due diligence helps to avoid potential risks and deal failures. Before a company buys another business, goes public, or takes on private equity investors, someone has to check the numbers.

For deal underwriting, banks dig into the company’s finances to see if the deal makes sense and if it’s worth the risk. Private equity firms also use due diligence to check if the business can actually make the money it claims it will.

In Australia, boutique banks handle a lot of this work, especially for smaller deals. They review financials, check tax records, and make sure the company follows ASIC regulations. It’s their job to spot red flags before anyone signs on the dotted line.

Risks of skipping or rushing due diligence

What would happen if a company decides to skip financial due diligence or rush through the process? Here are a few hidden risks to keep in mind:

1. Overvaluation

Without verifying financials, buyers may overpay for inflated earnings or unsustainable growth. Consequences:

• EBITDA adjustments reveal true earnings are 20-30% lower than claimed.
• Post-acquisition write-downs destroy shareholder value.
• Failed ROI: The deal never delivers promised synergies.

2. Hidden liabilities

Undisclosed obligations can sink cash flow or trigger lawsuits. Consequences:

• Debt covenants breached post-close, forcing emergency refinancing.
• Unrecorded liabilities (pensions, warranties) demand sudden cash injections.
• Legal claims from suppliers, employees, or regulators emerge.

3. Fraud exposure

Inadequate checks fail to catch cooked books or embezzlement. Consequences:

• Revenue recognition fraud (fake invoices, round-tripping).
• Asset misappropriation (inventory “missing” after closing).
• Legal liability if fraud is later traced to pre-acquisition periods.

4. Fines & forced restructuring

Non-compliance with tax, labor, or industry laws transfers to the buyer. Consequences:

• IRS audits uncover unpaid payroll taxes + penalties.
• Antitrust violations force divestitures or kill the deal entirely.
• GDPR/FCPA fines for historic breaches become the buyer’s problem.

5. Operational chaos

Blind spots in working capital, IT systems, or culture derail synergies. Consequences:

• Cash flow crises from unplanned working capital needs.
• Tech incompatibility costs millions to fix (ERP mismatches).
• Employee exodus due to culture clashes or uncovered benefit cuts.

Red flags to watch during financial due diligence

Financial due diligence helps uncover hidden risks before a deal, but some warning signs should make you pause, dig deeper, or walk away. Here are the most critical red flags:

1. Weird jumps or drops in revenue. If sales suddenly spike or fall with no good reason, it could mean the numbers are being stretched, customers are leaving, or they had a one-time boost that won’t last.

2. Strange debt or hidden loans. If you find loans that weren’t mentioned or complicated debt off the books, it could hurt cash flow once you buy the company.

3. Messy or missing financial records. If audits are missing, accounts don’t add up, or reports are late, it could mean the company’s financial controls are weak or worse, there might be fraud.

4. Profits don’t match cash flow. If a company shows big profits on paper but doesn’t have the cash to back it up, it might be selling to customers who don’t pay.

5. Too many deals with the owner or insiders. If the business is paying for personal expenses or making special deals with friends or family, the real profits could be smaller than they seem.

6. Relying too much on one customer. If one client makes up a big chunk of sales, the company is at risk if that customer leaves.

7. Overly hopeful financial forecasts. Super optimistic predictions that don’t line up with past performance or market realities could be a red flag.

8. Frequent changes in auditors or finance leaders. If the CFO or auditors keep changing, it might mean they’re fighting over the numbers.

9. Tax troubles. Unpaid taxes or ongoing tax audits can lead to costly fines later.

10. Poor financial controls. If there’s no clear system for checks and balances, like manual spreadsheets or no audits, mistakes and fraud can easily happen.

Importance of financial due diligence for companies in Australia

Financial due diligence often depends on local rules, regulations, and market practices. For companies that operate in Australia, financial due diligence involves regional compliance checks.

There are two main regulatory bodies in Australia: ASIC and FIRB. ASIC (Australian Securities and Investments Commission) reviews company financial reports. FIRB (Foreign Investment Review Board) approval may be required if there are foreign investors involved.

During financial due diligence, Australian companies review tax records, debts, cash flow, key employee entitlements, and industry-specific regulations. Buyers also check for audited financial statements, hidden liabilities, or legal risks that can impact the value of the deal.

Australia has strict rules and a strong focus on transparency. That’s why financial due diligence is a must. It helps companies avoid overpaying, deal with surprise penalties, or take on hidden financial problems.

Financial due diligence services in Australia

In Australia, companies usually don’t have to handle financial due diligence on their own. They can easily outsource it. Plenty of consulting firms offer this as a service, so businesses can bring in experts to dig through the numbers and flag any risks.

Big consulting firms like PwC, Deloitte, or EY can help to evaluate the target company’s financial performance. They’ve got large teams, global experience, and can handle complex deals.

On the other hand, smaller, boutique firms offer a more personal touch. They know the local market well and are great for small to mid-size deals. They move faster, often cost less, and still provide solid advice. The right partner depends on the size of your deal and how much support you need.

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Key takeaways

Companies that are thinking about buying a business, investing, or going public should take financial due diligence seriously. It is how they protect themselves from financial and reputational losses. FDD helps businesses spot hidden risks, check the real value of a company, and avoid expensive mistakes.

We covered how due diligence works, who’s involved, and why it’s so important in the Australian market. With strict rules from ASIC and FIRB, having the right experts and secure tools on your side makes all the difference.

That’s why businesses now rely on data rooms. A secure, well-organized data storage where all the key documents are in one place can make due diligence faster, smoother, and far less stressful for everyone involved.

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