Key takeaway: Financial due diligence should explain how supported earnings convert to cash, what obligations remain and how the proposed terms affect the buyer. Reconcile records, challenge adjustments and turn unresolved findings into specific deal decisions.
The asking price is only one part of an acquisition. Receivable quality, replacement staffing, working-capital needs, taxes and deferred equipment spending can change the cash required after closing. Review these while terms remain negotiable.
Coordinate the review from the start
Financial, tax, legal, operational and lender diligence should inform one another. Do not postpone urgent lease, licensing, ownership, employment or regulatory review merely because the financial work is unfinished. An issue in any of those areas can change the deal’s value or feasibility.
Agree on responsibilities and scope. Financial diligence, a quality-of-earnings analysis, a valuation, a financial-statement audit or review, legal advice and lender underwriting are different deliverables. Request only the service actually needed and confirm the limitations of each report.
Request records that explain the business
| Area | Records to request | Questions to resolve |
|---|---|---|
| Earnings and revenue | Monthly statements, general ledger, invoices, contracts and customer detail | Are sales recurring, collectible and recorded in the right period? How concentrated are customers? |
| Tax reporting | Business and relevant owner returns, elections, notices and payment records | What explains book-tax differences? Are filings, deposits and classifications consistent? |
| Cash and debt | Bank statements, reconciliations, processor reports and loan agreements | Which deposits are collections, loans or capital? What debt, security interests or guarantees need resolution? |
| Operating balances | A/R and A/P aging, inventory detail, accruals and customer deposits | Are balances collectible, salable, complete and appropriately valued? |
| People and related parties | Payroll, benefits, contractor agreements, owner duties, related-party rent and services | Which costs continue, change or need replacement after closing? |
| Assets and commitments | Equipment records, leases, repair history, capital budgets and material contracts | What must be replaced, funded, transferred or approved? |
Choose the lookback period to cover relevant trends, seasonality and risks. Three to five years of annual records with recent monthly detail can be a starting request, not a universal legal requirement. Small businesses may not have audited statements; establish what reports exist and how they were prepared.
Maintain one request and issue log with the document, reviewer, reconciliation, unresolved question and required response. The IRS business recordkeeping guide explains supporting documents and accounting methods; it does not certify a seller’s figures.
Reconcile revenue, tax income and bank activity
Tax returns and management statements can differ because of cash versus accrual methods, depreciation, nondeductible costs and other tax adjustments. Obtain a bridge explaining those differences. Neither a matching total nor a filed return independently proves every transaction.
For accrual revenue, reconcile opening receivables plus credit sales, less collections and supported adjustments, to closing receivables. Identify customer advances, refunds and processor fees separately. Compare the result with deposits after excluding loans, owner contributions, transfers between bank accounts and other non-revenue receipts.
For example, assume opening A/R of $100,000, credit sales of $1,000,000 and collections of $950,000, with no other receivable adjustments. Ending A/R is $150,000. If the bank also receives a $100,000 loan, total deposits are $1,050,000, while revenue remains $1,000,000. Investigate unexplained differences after this bridge; deposits need not equal sales.
Test cutoff and subsequent collections, credit notes, unusual journal entries and customer concentration. A sudden margin increase may reflect pricing, product mix, missing costs or an accounting change; obtain evidence before accepting an explanation.
Challenge earnings adjustments and replacement costs
For every proposed add-back, obtain the source transaction, reason, amount and evidence that the cost will not recur. Personal expenses, owner bonuses or unusual refunds are not automatically valid adjustments. Consider costs that were understated or omitted as well as costs the seller wants to remove.
Suppose reported EBITDA is $200,000 after $180,000 of owner compensation. If continuing duties require replacement compensation and related costs of $150,000, the illustrative normalization is $200,000 + $180,000 − $150,000 = $230,000. Adding back all $180,000 without replacement cost would overstate this estimate by $150,000.
Review related-party rent and services against the terms available after closing. Identify required staffing, benefits, insurance, software, maintenance and transition costs. Keep buyer-specific synergies separate from the target’s supported historical earnings.
Adjusted EBITDA is not cash available for debt service or distributions. Build a separate bridge for taxes, working-capital changes, capital spending, interest, principal payments and other cash items, including any noncash adjustments needed to reconcile the starting measure. Test recurring maintenance spending as well as expansion projects.
Define deal working capital in the agreement
Accounting working capital generally means current assets minus current liabilities. A purchase agreement’s working-capital measure is negotiated and may exclude cash, debt, income taxes, transaction costs or other accounts. Define included balances, exclusions, reserves, accounting policies, the target, closing calculation and dispute process.
Use comparable historical periods and account for seasonality. Test overdue receivables, obsolete inventory, unpaid bills, accrued payroll, customer deposits and deferred revenue. Do not put the same obligation in working capital, debt and a separate price adjustment without considering double counting.
The closing target is distinct from the buyer’s actual cash requirement. Budget payroll, supplier payments, debt service, taxes and transition costs even when the seller delivers the agreed working capital.
Review acquisition taxes and continuing obligations
Identify the legal assets or interests being acquired and their federal tax treatment. Buying a disregarded LLC interest can be treated as an asset acquisition for federal income tax; purchasing corporate stock generally does not itself reset the corporation’s asset basis. Other elections and partnership adjustments require separate analysis.
For applicable business-asset acquisitions, buyer and seller generally allocate consideration under the residual method and report required information on Form 8594. Inventory, depreciable property, goodwill and other assets can have different tax effects. See the IRS business-sale guidance and Form 8594 instructions.
Review sales, payroll and income taxes, open notices, audits and unpaid balances. Florida DOR warns that a buyer can face liability related to the acquired business and describes certificates and transferee-liability audits. A point-in-time account-status letter is not a universal guarantee against future assessments. Coordinate the appropriate procedure, any escrow and purchase-money withholding before closing. See Florida DOR acquisition and tax-clearance guidance.
Establish the post-close classification and owner-pay rules
An LLC is a legal form. A domestic single-member LLC generally is disregarded for income tax, while a domestic multi-member LLC generally is a partnership, unless an election changes treatment. Separate employment and excise-tax rules can still apply. See the IRS LLC classification rules.
A sole proprietor generally takes draws rather than wages from their own business. Partners generally are not employees of their partnership. Corporate owners who perform services may need payroll, including reasonable-compensation analysis for S corporation shareholder-employees. Review IRS owner-pay guidance and document the actual classification before configuring the books.
Convert findings into closing actions
Resolve each issue by obtaining support, adjusting forecasts or terms, setting a closing condition, arranging a remedy with counsel, reserving cash or deciding the risk is unacceptable. Define opening balances and responsibility for historical corrections, tax filings, payroll and the first monthly close.
CPA Firm South Florida’s tax advisory page describes transaction planning, classifications and projections. Confirm the exact acquisition analysis and report scope before engaging the firm. Use its contact page to discuss the transaction, proposed timetable and available records.
Frequently asked questions
Should financial diligence finish before legal diligence begins?
Coordinate them. Financial findings affect deal terms, while legal, licensing, lease, employment and regulatory issues can change the economics or stop a transaction early. Set priorities around the actual risks and deadlines rather than using one universal sequence.
Must bank deposits equal reported revenue?
No. Accrual revenue can precede collections, and deposits can include loans, owner contributions or customer advances. Reconcile timing, receivables, liabilities, fees, refunds and non-revenue deposits before deciding whether the reported figures are supported.
Can I add back all of the seller’s compensation?
Not automatically. Determine which duties continue and the realistic cost of replacing them, including benefits and payroll costs. A compensation add-back without necessary replacement costs can materially overstate sustainable earnings.
Does an asset purchase eliminate old tax liabilities?
No. Contractual allocations do not necessarily prevent statutory successor liability. In Florida, review sales-tax transferee-liability procedures and the appropriate certificate or audit with the advisers handling the acquisition.
What is the working-capital target in a purchase agreement?
It is a negotiated measure defined by the agreement’s included accounts, exclusions, accounting policies, target period and closing-adjustment mechanics. It may exclude cash, debt, income taxes and other items. Apply the agreed definition consistently and separately budget actual operating cash.