Red Flags in Financial Due Diligence
The key red flags FDD analysts look for in financial due diligence: revenue manipulation, accounting irregularities, working capital risks and more.
Identifying red flags is one of the most valuable skills a Financial Due Diligence analyst can develop. Red flags are signals that something in the financial data may be misleading, unsustainable or indicative of a deeper problem. Surfacing them protects the buyer and determines whether the deal proceeds — or on what terms.
Revenue Red Flags
Customer Concentration
If the top three customers represent 70% of revenue, the loss of a single relationship can materially impair the business. Flag: review customer contracts for renewal terms, exclusivity and notice periods.
Last-Month Revenue Spikes
If revenue systematically spikes in the final month of each reporting period, management may be pulling forward orders or recognising revenue prematurely. Flag: review monthly revenue trends and reconcile to invoicing and cash receipts.
Unusual Revenue Growth Before Sale
A business showing unusual revenue acceleration in the 12–18 months before a sale should be scrutinised. Flag: compare growth against sector benchmarks and verify with customer-level data.
Related-Party Revenue
Revenue from related parties (sister companies, shareholder entities) may not be arm's length. Flag: identify all related-party transactions and assess their commercial rationale.
EBITDA Red Flags
Recurring "One-Off" Costs
If restructuring costs, legal fees or other exceptional items appear every year, they are not one-off. Flag: build a multi-year schedule of every item management has classified as non-recurring.
EBITDA Margins Far Above Industry Norms
Either the business has a genuine competitive advantage (investigate why), or costs have been suppressed artificially. Flag: benchmark against comparable companies.
Costs Capitalised Rather Than Expensed
A pattern of capitalising costs that should be expensed (development costs, maintenance costs) inflates EBITDA. Flag: review the accounting policy note and discuss with the auditors.
Working Capital Red Flags
Deteriorating DSO (Days Sales Outstanding)
Rising DSO means customers are taking longer to pay. This could indicate cash flow pressure on the customer base, or that the company is extending credit terms to boost revenue. Flag: review debtor ageing schedules.
Inventory Build
An unexpected inventory increase may indicate slow-moving or obsolete stock. Flag: review stock ageing, provisioning policies and turnover ratios.
Stretched Payables
If creditor days have increased significantly, management may be managing cash position by delaying supplier payments. This can reverse post-closing, creating a working capital outflow.
Net Debt Red Flags
Off-Balance-Sheet Financing
Factoring, invoice discounting or supplier finance arrangements may not appear clearly in the accounts. Flag: review footnotes and ask management directly about any financing facilities.
Undisclosed Liabilities
Provisions, contingent liabilities and litigation risks may be underestimated or absent from the accounts. Flag: review legal due diligence findings alongside FDD.
Conclusion
Red flag identification is not about being negative — it is about giving the buyer accurate information to negotiate price, structure warranties, or walk away when warranted. Analysts who can spot patterns and articulate their significance are among the most valued on deal teams.
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