Financial Due Diligence

1. Financial Statement Mastery

Every consultant must read and interpret the three core financial statements. They tell different but interconnected stories about a business.

Income Statement (P&L)

Shows profitability over a period (quarter, year). Think of it as a movie—showing the flow of revenues and expenses.

Revenue (Sales)                          $100M
 - Cost of Goods Sold (COGS)              -60M
 ─────────────────────────────────────────────
= Gross Profit                            $40M     (Gross Margin = 40%)

 - Operating Expenses (SG&A, R&D)         -25M
 ─────────────────────────────────────────────
= Operating Income (EBIT)                 $15M     (Operating Margin = 15%)

 - Interest Expense                        -2M
 - Taxes                                   -3M
 ─────────────────────────────────────────────
= Net Income                              $10M     (Net Margin = 10%)

Balance Sheet

Shows financial position at a point in time. Think of it as a photograph—a snapshot of what the company owns and owes.

Cash Flow Statement

Shows cash movement over a period. Critical insight: Profit ≠ Cash. A company can be profitable but cash-poor.

2. Profitability Analysis

Margin Analysis

Margins reveal efficiency at each level of the P&L:

EBITDA & Operating Leverage

EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) is the most common metric in consulting and PE:

Net Income                   $10M
 + Interest Expense           +2M
 + Taxes                      +3M
 + Depreciation               +4M
 + Amortization               +1M
 ─────────────────────────────────
= EBITDA                     $20M

Unit Economics

Unit economics answers: "Is the core business model profitable at the individual customer or transaction level?"

3. Revenue Quality Assessment

Not all revenue is equal. High-quality revenue is predictable, sticky, and growing.

Recurring vs One-Time Revenue

Customer Concentration Risk

Customer concentration is a major risk factor in due diligence:

Pricing Power

Pricing power indicates competitive moat and margin sustainability:

• Strong pricing power: Can raise prices without losing customers (Apple, luxury brands)
• Weak pricing power: Must match competitors or lose share (commodities, undifferentiated products)

4. Cost Structure Analysis

Fixed vs Variable Costs

Cost Drivers

Understand what drives costs to identify improvement opportunities:

Benchmarking Opportunities

Compare cost metrics against industry benchmarks to identify improvement potential:

Cost Drivers

Understand what drives costs to identify improvement opportunities:

Benchmarking Opportunities

Compare cost metrics against industry benchmarks to identify improvement potential:

5. Business Valuation Basics

Valuation determines what a company is worth. Three primary methods are used, often in combination ("triangulation").

DCF Analysis (Discounted Cash Flow)

DCF values a company based on its future cash flows, discounted to present value. It's the most theoretically pure but most assumption-sensitive method.

Enterprise Value = Σ [ FCF(t) / (1 + WACC)^t ] + Terminal Value / (1 + WACC)^n

Where:
  FCF(t)         = Free Cash Flow in year t
  WACC           = Weighted Average Cost of Capital (typically 8-12%)
  Terminal Value = FCF(n+1) / (WACC - g), where g = perpetual growth rate (2-3%)

Comparable Company Multiples

Values a company based on trading multiples of similar public companies.

Precedent Transactions

Values a company based on multiples paid in recent M&A deals for similar companies.

6. Due Diligence Types

Comprehensive due diligence covers multiple workstreams, each answering different questions.

Commercial Due Diligence

Validates the market opportunity and competitive position.

Financial Due Diligence

Validates the quality of earnings and financial projections.

Operational & Technology DD

7. Red Flags Consultants Look For

Warning Signs

Hidden Liabilities

Things that might not appear on the balance sheet:

• Off-balance sheet leases: Operating leases (pre-IFRS 16)
• Pension obligations: Underfunded pension plans
• Litigation: Pending lawsuits, product liability
• Environmental: Cleanup costs, compliance requirements
• Tax: Transfer pricing disputes, uncertain tax positions
• Warranty/guarantees: Product warranties, customer guarantees

8. Private Equity Case Style Thinking

PE investors have a specific way of evaluating deals. Understanding their framework helps consultants add value.

Investment Thesis

Every PE deal starts with an investment thesis—a clear statement of why this deal will create value:

1. MARKET OPPORTUNITY
   "We believe [market] will grow at [X]% because [drivers]..."

2. COMPANY'S POSITION
   "Target has [competitive advantages] that will allow it to [win]..."

3. VALUE CREATION PATH
   "We will create value through [specific initiatives] resulting in [outcomes]..."

4. DOWNSIDE PROTECTION
   "Key risks include [risks]; mitigated by [protections]..."

5. EXIT POTENTIAL
   "We expect to exit via [path] at [multiple] in [years] for [IRR]..."

Value Creation Levers

Exit Strategy Planning

9. Conclusion & Next Steps

You now have a solid foundation in financial due diligence:

• Financial statements: Income statement, balance sheet, and cash flow analysis
• Profitability: Margins, EBITDA, unit economics
• Revenue quality: Recurring vs one-time, concentration, pricing power
• Cost structure: Fixed vs variable, drivers, benchmarking
• Valuation: DCF, comparables, precedent transactions
• DD types: Commercial, financial, operational
• Red flags: Warning signs and hidden liabilities
• PE thinking: Investment thesis and value creation