What it means
A buyer considers purchasing a distributor, and management presents strong profit figures, but the buyer needs to understand earnings quality, working capital and key contracts, so specialist teams review material and report what they can support. PwC and EY describe due diligence across financial, commercial, tax, operational and technology areas, though a specific engagement may cover only some of these, and it should never be assumed that a financial report also cleared legal, cyber or employment issues.
The report should state the transaction context and scope by identifying the entities, time periods, documents examined and work not performed, since a report based on three years of accounts cannot claim to have verified every customer relationship. An executive summary can help decision makers see the biggest findings, but readers should follow each material issue to its evidence and limitation, because a short red-flag list is not a substitute for understanding the underlying contract or calculation.
Financial diligence may adjust reported earnings for one-off or non-recurring items, and a proposed EBITDA adjustment needs support and a reason, so buyers should test whether a supposedly one-off cost will really disappear after the deal. Working capital and debt-like items can affect what cash the buyer must provide at closing, as a report may identify aged receivables, unpaid taxes or customer deposits, while the purchase agreement determines the actual price mechanics.
Legal diligence can find change-of-control clauses, ownership questions or litigation, and a contract that requires consent before assignment may threaten expected revenue, so the commercial team should assess how likely the customer is to consent. Tax diligence can identify unpaid amounts, filing gaps or uncertain positions, and a risk estimate is not always a confirmed liability, so an amount already assessed by an authority should be distinguished from a possible future exposure.
Commercial work may test customer concentration, market assumptions and churn, since a growth forecast built on one large customer deserves more scrutiny than one supported by many signed renewals, with interviews and data weighed carefully. Operational diligence asks whether the business can deliver the plan, because a profitable product may depend on one supplier, ageing equipment or a founder who intends to leave, and a spreadsheet margin cannot show all delivery risks.
Cyber and data diligence may matter in a digital business, so system ownership, access, known incidents and legal obligations should be checked, since a vendor's general security certificate does not establish that the target has no undisclosed issue. Findings should lead to actions, as a buyer may ask for a price adjustment, warranty, indemnity or closing condition or decide not to proceed, and not every issue is solved by reducing price.
Avoid one formula for price adjustments, because adding a liability to an earnings adjustment multiplied by a valuation multiple can double count an item or miss the agreed enterprise-to-equity bridge, and the deal's valuation and contract mechanics must be modelled separately. For illustration, a verified $1 million debt-like item may reduce equity proceeds by $1 million under a cash-free, debt-free deal, while a separate $0.5 million sustainable earnings reduction at a six-times multiple might indicate $3 million of enterprise-value pressure.
Whether those effects are additive depends on overlap and negotiation. The report should distinguish facts from management claims and adviser judgement, so if access to a major contract was denied the gap should be flagged rather than writing that no problem was found, and timing matters because a report prepared months before closing can go stale.
Key facts such as cash, litigation, customer cancellations and tax notices should be updated near signing or completion when the transaction requires it. For owners, a due diligence report supports an informed decision under uncertainty, so read the scope and main evidence, assign each material finding an owner and carry it into price, terms or the post-deal plan.
In practice
Real-world examples.
Example
A buyer's financial diligence team tests whether a claimed $600,000 one-off consulting cost should really be added back to earnings. The team finds that similar fees appeared in two of the last three years. It reduces the proposed add-back to the part it can support.
Example
Legal diligence on a software company flags that its largest customer contract requires consent after a change of control. The commercial team interviews the customer and rates the risk of non-renewal. The buyer makes consent a condition of closing.
Example
Tax diligence on a manufacturer distinguishes a $300,000 liability that a tax authority has already assessed from a possible $200,000 exposure still under review. The buyer asks for a specific indemnity on the second item. The first is treated as a debt-like item in the price discussion.
Formula
Calculation
No universal price-adjustment formula applies. Enterprise value (EV) illustration = sustainable EBITDA x multiple, and equity value = EV - net debt - verified debt-like items.
Worked example. A seller's reported EBITDA is $4 million and the agreed multiple is 6x, so the initial EV is $4 million x 6 = $24 million. Diligence finds that $0.5 million of the earnings is not sustainable, so sustainable EBITDA is $3.5 million and EV becomes $3.5 million x 6 = $21 million, which is $3 million of enterprise-value pressure. With net debt of $5 million, the original equity value would be $24 million - $5 million = $19 million.
A verified $1 million debt-like item (for example, unpaid taxes) then reduces equity further. The adjusted equity value is $21 million - $5 million - $1 million = $15 million, which is $4 million below the original $19 million. This treats the effects as additive; if the same $1 million cost also caused part of the earnings reduction, adding both would double count, so the overlap must be checked.Case study
Seen in the real world.
This entirely fictional example follows Palm Industries, an invented buyer. Its report identified a possible tax exposure and a key supplier contract requiring consent. The buyer asked for more records, negotiated a specific contractual protection and set a closing task. The story does not claim the exposure became payable or that an indemnity guaranteed recovery.
Palm also assigned an owner to each finding in a short action table, with a due date before closing. Two items moved into the purchase agreement as warranties, one became a closing condition and one was passed to the integration team for the first 100 days. Palm refreshed its cash and litigation checks a week before completion.
Watch out
Common mistakes.
- Reading only the executive summary while ignoring scope limits and evidence.
- Treating a possible exposure as a confirmed debt or adding overlapping adjustments twice.
- Failing to translate material findings into deal terms or a post-close owner.
Questions
People also ask.
What is a due diligence report?
A scoped written account of findings from reviewing a target before a major transaction.
What does it cover?
It can cover finance, tax, legal, commercial, operations and technology, depending on the engagement.
How is it used?
To decide whether to proceed and how findings affect price, protections, conditions and integration.
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