What financial due diligence on a small business acquisition actually involves

Most buyers of small and mid-sized businesses believe they have done due diligence. They have read the information memorandum, looked at three years of profit and loss statements, asked the vendor some questions, and had their accountant cast an eye over the numbers. None of that is financial due diligence. It is a review of documents the vendor chose to provide, prepared by advisers the vendor pays, presenting the picture the vendor wants presented.

Real due diligence starts from a different place: the vendor's accounts are a claim, not a fact. The job is to test that claim against records the vendor cannot easily dress up. Bank statements. BAS lodgements. The general ledger. Payroll data. You rebuild the earnings picture from those sources, and then compare it to the story you were sold. When the two match, you buy with confidence. When they don't, you have just found your negotiation, or your exit.

The three reconciliations that do most of the work

The core of any decent engagement is reconciliation. In plain terms, that means tying what the accounts say to what independent records show. Three matter most.

First, revenue to BAS and bank. Sales in the profit and loss should line up, within explainable differences, with the GST turnover reported to the ATO and with deposits actually landing in the business bank account. The BAS comparison catches revenue that only exists in the accounts. The banking comparison catches timing games and money moving in circles between related parties. If the vendor's stated revenue sits well above what they told the ATO, one of those two documents is wrong. Both answers are a problem.

Second, wages to payroll and superannuation records. Understated labour is the most common way small-business earnings get inflated. Family members working unpaid. The owner drawing dividends instead of a wage. Penalty rates not provisioned. Super in arrears. Every one of these overstates the profit you will actually collect, because you will be paying for that labour at market rates.

Third, the balance sheet to reality. Plant registers get checked against what is physically there and what is financed. PPSR searches surface security interests the vendor never mentioned. Employee entitlements get compared to what the contract says transfers. This is where completion adjustments come from, and completion adjustments are routinely worth more than the diligence fee.

What a real engagement finds

The table below is the summary page from a recent verification engagement, anonymised and materially altered. The target was priced on a vendor-adjusted profit of a little over $600,000. Here is what the same business looked like after reconciliation.

Every line in that table moved the sustainable earnings down, and none of it showed in the information memorandum. The revenue story was true. Sales really were growing at 27%. It was also beside the point, because costs were growing faster, the margin was shrinking every year, and the adjusted profit had been built by leaving expenses out rather than adjusting them. A buyer relying on the vendor's paperwork would have paid a multiple of earnings that did not exist.

Working capital: the finding nobody prices

Earnings get all the attention, but working capital quietly decides whether your first year is comfortable or desperate. A business can be genuinely profitable and still strip you of cash at settlement. The vendor collects the debtors and runs down the stock in the months before completion, and you inherit a business that needs an immediate cash injection just to trade normally. Buy a seasonal business at the wrong point in the cycle and you will need far more cash than the last balance sheet suggests.

Good due diligence looks at the working capital cycle across at least twelve months, works out what a normal level looks like, and recommends a completion adjustment mechanism. That is a peg the actual position at settlement gets trued up against. In owner-managed deals this one recommendation routinely pays for the whole engagement, because standard contracts at this end of the market often contain no working capital protection at all.

When in the deal to do it

The right time is after price and structure are agreed in principle, and before your due diligence condition expires. Any earlier and you are paying to analyse a deal that may never be agreed. Any later and your negotiating leverage is gone. The practical point: the due diligence period written into the contract matters. Two to three weeks is workable for a scoped engagement if the vendor's records are ready, and the information request should go out the day the contract is signed.

Findings then land while they can still change the outcome. A quantified issue discovered inside the diligence period becomes a price adjustment, a warranty, a retention, or a walk-away. The same issue discovered after settlement becomes a legal question, which is a slower and much more expensive way to learn the same fact.

What due diligence is not

It is not an audit. An audit expresses an assurance opinion over financial statements under auditing standards. Due diligence is a commercial review that answers a buyer's question: what does this business actually earn, and what should I do about the difference? It is not a formal business valuation, not legal due diligence on the contract, and not tax advice either. A good report tells you exactly which of those you need and what to ask the specialist.

It is also not a folder of documents. The deliverable that matters is the findings report. Each issue evidenced, quantified where the records allow, and turned into a recommendation: a price adjustment, a completion mechanism, a warranty to demand, a question the vendor must answer in writing, or advice not to proceed.

Scale the work to the transaction

Not every acquisition needs the full treatment. A fast financial verification covers revenue reconciled to BAS and bank, expense trends, every add-back reviewed, and a red-flag memorandum. That costs a few thousand dollars, takes under a week, and is enough to kill a bad deal early or justify going deeper. A scoped engagement adds the normalisation bridge, working capital, balance sheet and entitlements work. A full earnings analysis adds proof-of-cash testing, monthly analysis across 24 to 36 months and downside modelling, built for material transactions and lender reliance.

The discipline is the same at every level. The fee is fixed, the scope is written down before the engagement starts, and the fee does not depend on what the analysis concludes.