A statutory audit answers whether the accounts were prepared in accordance with the standards. Financial due diligence answers a different question: whether the earnings being valued will still be there under a new owner.
The output is not a report in the ordinary sense. It is four numbers and a list — a normalised EBITDA, a net debt figure, a working capital peg, and the specific items that have to be settled in the transaction documents.
Four areas decide those numbers. This series takes each one in turn: what to test, and what to ask for.
The series
1. Revenue — is it repeatable?
The three-way reconciliation of shipped, invoiced and recognised; contract terms that move revenue; sell-in versus sell-through; customer concentration; price realisation; and matching revenue to bank receipts.
2. Related party transactions — what survives the closing?
Four tests — pricing, substance, survival and substitutability; where the exposure actually sits; and why not every related party arrangement is a deduction.
3. Cost of sales — is the gross margin real?
The margin bridge rather than the margin ratio; purchase price benchmarking; supplier concentration and payment terms; cost completeness; and inventory at cost.
4. Operating expenses — is the cost base complete?
The four-way payroll reconciliation; selling expenses; capitalised development costs; owner-related and shared costs in both directions; and non-recurring items.
How the four come together
| Output | What it is |
|---|---|
| Normalised EBITDA | Reported EBITDA, adjusted for revenue that does not survive, costs that are incomplete, and income that is not recurring |
| Net debt | Interest-bearing debt less cash, with a defined position on restricted cash, pledged deposits and notes discounted with recourse |
| Working capital peg | A normalised level, built from trading history rather than from the last reported balance sheet |
| Risk register | Each finding, its quantified impact, and the mechanism that addresses it |
Findings then become transaction mechanics. An item that affects the earnings base belongs in the price. An item that is a one-off exposure belongs in a condition precedent or a specific indemnity. The distinction matters commercially: buyers who negotiate every finding into the price tend to lose deals that were worth doing.
The purpose of due diligence is not to produce a list of problems. It is to produce a number you can defend, and a short list of things that must be fixed or priced.
In most China processes, the binding constraint is scheduling rather than analysis: whether the source records — payroll, bank statements, tax filings and contracts — can be produced before exclusivity expires, and in a form that ties to the ledger. Settling that in the first week is worth more than any single test.
Common questions
How is financial due diligence different from a statutory audit?
A statutory audit tests whether the accounts comply with the applicable standards for a given period. Financial due diligence tests whether the earnings being valued will still be there under a new owner, which means adjusting for revenue that does not transfer, costs that are incomplete and income that is not recurring.
What does financial due diligence produce?
Four numbers and a list: a normalised EBITDA, a net debt figure, a working capital peg, and the specific items that have to be settled in the transaction documents. Findings that affect the earnings base go into the price; one-off exposures go into a condition or an indemnity.
This series describes a general approach. It is not accounting, tax, or legal advice for a specific transaction. Views are my own and do not represent any firm.