Getting the financials ready for due diligence: what it takes and how long it runs

Readiness depends on where your books start

Getting financials ready for due diligence can take a few weeks for a company with clean monthly closes, reconciled accounts and a working forecast, and many months for one with inconsistent books, mixed personal and business expenses or missing records. The work follows the same phases either way: clean and reconcile the history, standardize the monthly reporting, build a defensible forecast, and assemble the documents a buyer or investor will request. The single best thing you can do is start before anyone asks.

I have led pre-transaction preparation, financial due diligence and post-merger integrations, and guided finance teams through business sales, acquisitions and liquidations. As a partner at ECFO, I work with companies in Dallas and elsewhere on audit and transaction readiness. The pattern I see most is an owner who receives an offer or a term sheet and then discovers that the numbers that have run the business for years will not survive a stranger's questions.

What the other side will actually examine

Diligence is the buyer, lender or investor testing whether the story you have told them is supported by the numbers. The U.S. Small Business Administration notes that lenders typically expect an established business to provide income statements, balance sheets and cash flow statements for the last three to five years, and that venture investors review the management team, market, products, governance documents and financial statements during due diligence. Buyers of a business go further, because they are paying for future earnings and want to understand exactly what produces them.

• Historical statements, monthly as well as annual, and whether they reconcile to tax returns.
• Quality of earnings: which profits are recurring and which were one-time.
• Revenue by customer, product and location, including concentration risk.
• Working capital: receivables, inventory and payables, and how they move through the year.
• Debt, leases, guarantees and any liabilities not obvious on the balance sheet.
• Owner compensation and personal expenses run through the business.
• The forecast and the assumptions behind it.

Phase one: clean up and reconcile the history

Every account on the balance sheet should reconcile to something outside the books: bank statements, loan statements, customer and vendor balances, physical inventory counts. Revenue should be recorded in the month it was earned, using the same method every year. Expenses should be categorized consistently, so that a line labeled marketing means the same thing in every period.

This is also when owner and personal expenses need to be identified and documented. Many private companies run some personal costs through the business. That is not unusual, but in diligence each item needs to be explained and supported, because buyers will add back legitimate owner expenses to earnings only if you can prove them. Unsupported add-backs are among the fastest ways to lose a buyer's confidence.

• Reconcile every balance sheet account at each month-end.
• Correct revenue timing and make the recognition method consistent.
• Recategorize expenses so each line means the same thing across years.
• Document owner compensation and any personal or one-time costs.
• Tie the books to the filed tax returns and explain the differences.

Phase two: monthly reporting that holds up

Buyers and investors look at trends, not just annual totals. They want monthly statements prepared the same way every month, closed promptly and consistent with the year-end figures. If your monthly numbers are adjusted heavily at year-end, expect hard questions about which version is real.

This phase is where systems often need attention. If month-end depends on spreadsheets and manual journal entries, now is the time to fix the process, and sometimes the system itself; my guide on outgrowing QuickBooks covers when that is worth doing. The goal is a routine that produces a reliable monthly package without heroics, because once diligence starts the team will be answering questions and the business still has to run.

Phase three: a forecast you can defend line by line

A buyer is paying for the future, and the forecast is where the value argument lives. It has to tie to the historical results, rest on assumptions you can explain, and reflect the business as it actually operates. Growth assumptions should connect to specific drivers such as signed contracts, pipeline, pricing changes or capacity, not to a percentage that sounds reasonable.

Expect the other side to test every assumption. Where does this revenue come from? What happens to margin if the largest customer leaves? Why does working capital stay flat while sales grow? A forecast that has been built with those questions in mind shortens diligence and supports the price. One that falls apart under questioning invites the buyer to substitute their own, less generous numbers.

Working capital: the figure that quietly moves the price

Owners focus on the headline price and on earnings, and many are surprised late in the process by a negotiation over working capital. In many deals the buyer expects the business to be delivered with a normal level of receivables, inventory and payables, so that it can keep operating the day after closing. If the working capital delivered falls short of the agreed target, the price can be adjusted down; if it is above, sometimes up.

That makes it important to understand your own working capital pattern before the buyer does. Seasonal businesses swing a great deal through the year, and a target set at the wrong point in the cycle can cost real money. Twelve or more months of clean monthly balance sheets let you show what normal actually looks like, and argue for a target based on evidence rather than the buyer's estimate.

Phase four: the data room

The final phase is assembling the documents in an organized, secure place so that requests can be answered quickly. Speed and organization matter more than owners expect; slow, incomplete answers create doubt even when the underlying business is sound. Your attorney will handle the legal documents, but finance owns a large share of the list.

Assign one person to track every request, who is answering it and when it was sent. Diligence requests arrive in waves and overlap, and without a log the same question gets answered twice in two different ways, which is exactly the kind of inconsistency that makes a buyer dig deeper. Review each answer before it goes out to make sure it agrees with what has already been provided.

Keep in mind that historical records must remain available long after the deal. The IRS generally expects records supporting a tax return to be kept for at least three years, with longer periods in certain situations, and employment tax records for at least four years after the tax is due or paid, whichever is later. A clean archive helps both now and after closing.

• Monthly and annual financial statements and tax returns.
• Bank, loan and lease statements, with reconciliations.
• Aged receivables and payables, and inventory records.
• Customer and supplier contracts and revenue by customer.
• Payroll records and owner compensation details.
• The forecast model with written assumptions.

What decides whether this takes weeks or months

The biggest factor is the starting condition of the books. A company with a disciplined monthly close, reconciled accounts and consistent categories may only need to assemble and explain. A company with years of inconsistent accounting needs the cleanup done first, and that cannot be rushed without creating new errors.

Other factors are the number of entities and locations, whether there is inventory, any international operations or related-party transactions, and whether the other side will require audited statements. If audited financials are part of the request, an auditor explains what that involves in what to expect when the bank asks for audited financial statements. Audit timing depends on the audit firm's schedule as well as your readiness, so raise it early.

The mistakes that cost owners the most in diligence

Valuation is set before diligence and defended during it. The SBA describes three common approaches to valuing a business, based on income, comparable sales and assets, and it warns sellers not to leave out any assets or liabilities, because that can create problems even after the sale is final. In my experience, most value lost in diligence is lost to surprises the seller could have found and explained first.

If you have received an approach before any of this work is done, a business broker's guide on what to do when someone offers to buy your business covers how to respond without rushing. And because the finance work continues after closing, my guide to the finance mistakes companies make after an acquisition is worth reading whether you are the buyer or the seller staying on.

• Starting preparation only after a letter of intent is signed.
• Unsupported add-backs and undocumented owner expenses.
• Monthly numbers that do not match year-end statements.
• A forecast with growth that is not tied to identifiable drivers.
• Slow or incomplete responses to information requests.

Where I fit in the preparation

My role in a sale or raise is to lead the finance side: clean and reconcile the history, standardize reporting, build the forecast, prepare the data room and sit in the room when the other side asks questions. I work alongside your attorney, CPA and any broker or banker, and I coordinate cross-border issues when there are operations overseas.

If a sale, raise or major loan could be on the horizon in the next year or two, the best time to talk is now, while there is room to fix things calmly. I work with companies across the Dallas–Fort Worth area and remotely. The first conversation is about where your books stand today and what the transaction will demand.

Questions people ask me