TLDR:
Financial due diligence (FDD) is the systematic review of a target company’s financial information during a transaction—typically performed by Big Four firms or specialist DD firms—to validate management’s reported financials, identify normalization adjustments, assess quality of earnings, and inform valuation. FDD findings drive purchase price negotiations, working capital targets, and identification of debt-like items.
Quality of Earnings (QoE) Analysis
The central FDD output is the Quality of Earnings (QoE) report. QoE analyzes whether reported earnings represent sustainable underlying performance by: identifying one-time items inflating earnings (asset sales, insurance recoveries, accounting changes), adjusting for non-recurring expenses (litigation, restructuring, owner compensation in excess of market), normalizing pre-tax income to a “Adjusted EBITDA” representing true operating performance, analyzing revenue quality (customer concentration, contract structure, deferred revenue patterns), and identifying potential below-the-line concerns (stock-based compensation, R&D capitalization choices).
Working Capital and Net Debt
FDD analyzes the target’s working capital trend to inform the working capital adjustment target—typically 12-month average, seasonally adjusted, with specific include/exclude treatment for cash, accounts receivable aging, inventory obsolescence, prepayments, accrued expenses, and deferred revenue. FDD also identifies “debt-like items” that should reduce equity purchase price: bonus accruals, vacation accruals, tax liabilities, environmental reserves, customer prepayments, and various other items that economically function as debt even if accounted as operating liabilities.
Specific Sub-Workstreams
Modern FDD includes specialized sub-workstreams: tax DD (separate stream typically led by tax-specialist accountants—identifying tax exposure, transfer pricing, indirect tax), HR/compensation DD (benefits liabilities, equity overhang, key employee retention), IT/operational DD (systems quality, key dependencies), and integration DD (capability mapping for synergy realization). For Turkish targets, key considerations include accounting standard differences (TFRS vs. IFRS), inflation accounting effects, deferred tax positions, and SGK and CIT exposure. Combined FDD costs typically run 0.1-0.5% of deal value, scaling with complexity.