Red Flags in Financial Due Diligence
The key red flags to identify in a Financial Due Diligence: revenue risks, margin deterioration, working capital issues, balance sheet risks and governance concerns.
Identifying red flags is one of the core skills tested in a Transaction Services interview. It's also one of the most valuable skills in the job itself. Here's a structured guide to the red flags that matter most.
Revenue red flags
Customer concentration: a single customer accounting for 20%+ of revenue is a material risk. If the top three customers represent over 50% of revenue, the business's resilience to churn is limited.
End-of-period revenue spikes: consistently high revenue in the last month of the financial year — particularly in the months before a transaction — can signal pulled-forward sales, aggressive invoicing or revenue recognition manipulation.
Growing receivables without growing sales: if trade receivables increase faster than revenue over multiple periods, collections may be deteriorating or revenue recognition may be aggressive.
No written contracts: revenue from key customers based on informal arrangements is at risk post-transaction when the seller's relationship is removed.
Margin red flags
Sustained gross margin compression: a gradual decline in gross margin over 2-3 years signals pricing pressure or rising input costs not being passed through to customers.
Volatile EBITDA margins: significant unexplained quarterly or annual swings in EBITDA margins warrant investigation.
EBITDA to cash conversion gap: if EBITDA is strong but operating cash flow is consistently low, working capital or hidden charges are absorbing the earnings.
Working capital red flags
DSO trend increasing: rising days sales outstanding signals collection difficulty, weakening customer financial health, or aggressive invoicing near period-end.
DPO trend increasing sharply pre-sale: sellers often stretch payables in the months before a transaction to present a favourable NWC at closing. This will need to normalise post-closing.
Inventory build: increasing inventory without corresponding sales growth can signal demand weakness, obsolescence risk or production management issues.
Balance sheet red flags
Underprovided receivables: significant overdue receivables without adequate bad debt provisions suggest overstated assets.
Recurring capitalisation of costs: if development or maintenance costs are consistently capitalised, EBITDA may be structurally overstated.
Large unrecognised pension deficits: in industrial businesses, unfunded defined benefit obligations can be material debt-like items hiding in the notes.
Governance and management red flags
High management turnover: multiple CFO changes in recent years is a significant warning sign. Financial management instability affects the reliability of reporting.
Frequent related-party transactions: transactions with entities linked to the shareholders require careful scrutiny for arm's-length pricing and economic justification.
Changes in accounting policies: policy changes that flatter near-term results without strong justification should be investigated.
Presenting red flags in an interview
When asked "what red flags do you look for in FDD?", structure your answer by category: revenue, margins, working capital, balance sheet, governance. Give two concrete examples in each. Show that you understand not just what the red flag is, but why it matters for the buyer's decision.
The programme's case studies embed real red flags for you to identify — simulating exactly the kind of analytical challenge you'll face in interview and on the job.