Financial due diligence, usually shortened to FDD, is one of the main workstreams in any serious M&A process. Newcomers often assume it means checking if the financial statements are accurate. That is part of it, but not everything. FDD is there to test the earning power, cash profile, balance sheet quality, and financial risks of a business before a buyer signs and funds a deal. In practice, it feeds directly into valuation work, SPA drafting, purchase price adjustments, and negotiations between buyer and seller.
A good way to think about FDD is this: it turns reported numbers into transaction numbers. Reported EBITDA, reported working capital, and reported liabilities may all be technically valid under accounting rules, but they may still give a weak picture of the business a buyer is actually acquiring. That is why FDD focuses so heavily on normalized earnings, working capital needs, debt-like items, and unusual exposures that could affect price or terms.
FDD sits between raw financial reporting and deal execution. It reviews historical performance, tests whether margins and cash flows are sustainable, checks whether assets and liabilities are stated in a way that reflects economic reality, and highlights areas that could change what a buyer is willing to pay. That often includes revenue recognition issues, reserve movements, non-recurring charges or credits, customer concentration, seasonality, accounting policy choices, and unusual balance sheet items.
It is also useful to be clear on what FDD is not. It is not an audit. An audit asks whether the financial statements are fairly presented under the relevant accounting framework. FDD asks a different question: what level of earnings and cash flow is likely to continue after closing, and what financial issues could affect value, price adjustment mechanics, or risk allocation in the SPA? It is also not the same as valuation. The FDD team is usually not deciding what the company is worth in isolation. It is improving the numbers that the buyer, banker, or investment committee will rely on when they do that work.
Quality of Earnings, usually written QoE or QofE, is the concept that makes FDD click for many people. The idea is simple. A buyer wants to know what level of EBITDA is maintainable, repeatable, and tied to the real trading performance of the business. That is why QoE work tries to bridge reported results to adjusted or normalized EBITDA.
This bridge exists because accounting earnings and transaction earnings are not the same thing. One source puts it neatly: reported results can be fully compliant with GAAP and still fail to reflect the sustainable run-rate of cash flows. Another makes the same point from a deal angle, noting that adjusted EBITDA in a transaction is not governed by a strict accounting or legal standard and often becomes a live point of negotiation. That is exactly why QoE adjustments attract so much attention. Each one can move the baseline EBITDA used in valuation.
The cleanest way to think about a QoE adjustment is to ask one question: does this item belong in the earnings base a buyer is paying for? If the answer is no, it is a candidate for adjustment.
In practice, most adjustments fall into a few buckets.
These are costs or credits that are real, but unlikely to repeat in the ordinary course of trade. Common examples include one-off legal fees, unusual restructuring charges, a settlement gain, a sharp bad debt hit tied to a specific event, or a temporary spike in marketing spend around a one-time launch. If the item will not recur and is not needed to sustain future earnings, buyers will often accept an adjustment, assuming the support is credible. Sources on sell-side and buy-side diligence regularly point to non-recurring charges or credits as a standard part of QoE analysis.
Private businesses often carry expenses that are not run on a market basis. Founder compensation may be above or below market. Family members may be on payroll. Personal travel or discretionary spend may sit in SG&A. A seller may also run certain items through the business that would not survive under institutional ownership. These are classic normalization items. The logic is not that the expense is fake. The logic is that it does not reflect the cost base required for the business on a go-forward basis.
Some QoE adjustments are less about one-time events and more about whether accounting treatment has distorted period earnings. Revenue may have been pulled forward. Costs may have been capitalized rather than expensed. Reserves may be too light. Accruals may be incomplete. Estimates may have changed in a way that flatters the latest period. In those cases, the adjustment is trying to fix the timing or classification so the EBITDA base better reflects economic reality. This is why QoE work often overlaps with detailed review of revenue recognition, cost capitalization, reserve levels, and consistency of accounting policies.
These are more judgment-heavy. They try to reflect the current earning base rather than the simple historical average. Examples might include annualizing a confirmed price increase, reflecting savings from an already completed headcount reduction, or showing the full-period effect of a contract that is already live. These adjustments are not all equal. Buyers tend to be more comfortable where the change is already in place and easy to evidence, and less comfortable where the add-back relies on management optimism. This is one reason QoE debates can become commercial debates very quickly.
A useful mental rule is that the closer an adjustment is to hard evidence and already visible economics, the stronger it is. The closer it is to forecast, intention, or management aspiration, the weaker it is.
Headline sales growth can hide a lot. FDD teams usually cut revenue by product, service line, geography, customer, contract type, and month. They want to see where growth is coming from, whether it is recurring or project-based, whether price or volume is driving the change, and whether margins are moving in the same direction. Reviews often test seasonality, monthly variations, pricing, quantities, product mix, customer losses, newly won projects, and shifts in margin by business line.
This is where the monthly view becomes so useful. Annual numbers can smooth out a weak second half, hide pull-forward revenue, or make a customer loss look smaller than it really is. Monthly reporting packages and monthly trend analysis often show what the annual audited statements do not: lumpiness, margin slippage, changes in mix, and performance support from unusual period-end activity. That is one reason QoE work is often built from monthly management accounts, audit statements, and tax filings rather than from annual statements alone.
One of the biggest jumps for people new to FDD is working capital. On paper it looks simple: current assets minus current liabilities. In transactions, it is much more than that. The buyer and seller usually agree a working capital peg, meaning the level of normalized working capital expected to be left in the business at closing. If actual working capital delivered is above the peg, the seller often gets a dollar-for-dollar increase in price. If it comes in below, price is typically reduced dollar-for-dollar.
The peg is usually based on a normalized period such as the trailing twelve months, although shorter periods may be used if they better reflect current trading. Seasonality, closing timing, shifts in business mix, and changes in purchasing or inventory policy all need to be considered. Good FDD work tries to build a peg that is neutral, meaning enough working capital is left in the business for normal operations on day one after close.
This is where many deal disputes begin. Cash, financing items, accrued interest, unusual accruals, one-off balances, and changes in methodology can all affect the peg. One source usefully splits working capital adjustments into three categories: definitional adjustments, due diligence adjustments, and pro forma adjustments. That is a helpful framework because it shows how much of the fight is about what belongs in the peg versus what should sit elsewhere in the purchase price mechanism.
The phrase “debt-like items” confuses people at first because many of these balances are not labelled debt in the accounts. If the buyer is paying for the business on a cash-free, debt-free basis, then any obligation that behaves like pre-close indebtedness or reduces value in a financing-like way may need to be treated separately from working capital.
Examples often include unpaid bonuses, deferred compensation, accrued commissions, unusual warranty claims, customer or contract liabilities in some fact patterns, tax exposures, derivatives, environmental liabilities, and other obligations identified during diligence. Tax items can be especially messy. Accrued income taxes, deferred taxes, sales and use tax exposures, and unclaimed property can all create debate over whether the seller should bear the item through a debt-like adjustment or whether it should sit in normalized working capital.
A good practical distinction is this: working capital should reflect the normal operating funding needed to run the business. Debt-like items usually relate to obligations that a buyer does not want to fund through enterprise value because they are pre-close burdens, financing-like claims, or exposures that will crystalize into cash outflow without supporting normal post-close trading. That is why the border between working capital and debt-like items is one of the most negotiated parts of many SPAs.
Another useful lesson in FDD is that balance sheet review can change a deal as fast as earnings review. Receivables may not be collectible. Inventory may be slow-moving or overstated. Accruals may be incomplete. Capex needs may be underappreciated. Cash may be trapped, restricted, or needed to support operations. Sell-side diligence guidance routinely points to quality of assets, completeness of liabilities, contingent obligations, and capex sufficiency as areas that can affect both price and buyer appetite.
Deferred revenue is a good example of why this area needs care. It can look attractive because the business has taken in cash before delivering the service, but it also creates a post-close delivery obligation and can have tax consequences that are easy to miss. One tax note on acquisitions with material deferred revenue highlights that the issue is not limited to earnings timing. It can affect post-close tax liability, valuation of tax attributes, and the timing of deal mechanics.
FDD output does not sit in a report and disappear. It usually feeds straight into negotiation. If QoE is weak, the buyer may challenge EBITDA and cut price. If working capital has been flattered by stretching payables or running inventory down, the peg may be revised. If debt-like items emerge late, the SPA schedules and adjustment mechanics may need to change. If data quality is poor, management credibility can take a hit and buyers may demand more protection. Financial diligence providers describe these findings explicitly as inputs into valuation, price adjustment mechanisms, and negotiation terms.
This is also why sell-side QoE has become common. A seller that has already cleaned up the bridge to adjusted EBITDA, built support for the peg, and identified awkward liabilities is in a much stronger position. Pre-sale diligence can help control the narrative, reduce surprises, streamline buyer review, and support stronger offers earlier in the process.
If you want one simple way to frame financial due diligence, use this: FDD is the process of converting accounting history into deal-ready economics. It takes reported performance and tests what is real, what is recurring, what is temporary, what needs reclassification, and what could reduce value after closing. That is why QoE, working capital, debt-like items, and balance sheet review all sit so close together. They are different ways of answering the same buyer question: what am I really paying for, and what am I really taking on?
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