Financial due diligence, step by step

Financial due diligence exists to answer one question honestly: is the earnings number you offered on actually real and actually sustainable under new ownership? It is more than reading the same statements the seller already showed you during evaluation — it means reconciling those statements against independent evidence, tracing where the cash really came from, and hunting for liabilities that a summary financial statement was never going to show you on its own. This is usually where an accountant, not the buyer alone, does the bulk of the work.

Start by reconciling the books to what was actually filed

A business can show a buyer one version of its financial performance and file a different version with tax authorities, and the gap between the two — when there is one — is one of the most serious signals financial diligence can uncover. Compare the internal financial statements the seller has provided against the Notices of Assessment and tax filings actually submitted to the Canada Revenue Agency. A close match is reassuring. A material gap, or a seller reluctant to produce the filed version at all, is a reason to slow down and understand exactly why before going further, not a detail to smooth over because the rest of the deal looks promising.

Treat every add-back as a claim that needs proof

Add-backs — an above-market owner salary, a personal vehicle run through the business, a one-time repair that will not recur — are a normal and legitimate part of understanding what a business can support under new ownership. The mistake is accepting them because the seller says so rather than because there is a receipt, an invoice or some other documentation behind each one. An accountant reviewing the add-back schedule should be able to trace every item back to something concrete; anything that cannot be documented should be excluded from the normalized earnings figure you are relying on, even if the seller insists it is real.

Trace cash, not just the P&L

For any business with meaningful cash sales — a restaurant, a personal-service business, a shop that still takes cash at the till — the profit and loss statement alone is not enough. Compare reported revenue against bank deposits, point-of-sale system exports and merchant processing statements to see whether the money actually moved the way the statements say it did. A gap between what is reported and what can be independently traced through the bank is one of the more serious findings financial diligence can surface, because it raises questions about the reliability of every other number in the file, not just that one.

Check for debts the balance sheet does not show

A clean-looking balance sheet does not rule out outstanding debts to the Canada Revenue Agency, unpaid Workplace Safety and Insurance Board premiums, unremitted source deductions or sales tax, or liabilities sitting in litigation that has not been fully disclosed. These do not always appear in the financial statements themselves, which is exactly why they need to be checked separately — through CRA-debt and lien searches, an execution search, and direct questions to the seller’s accountant — rather than assumed absent just because nothing showed up on the balance sheet.

Watch for related-party transactions that flatter the numbers

A business paying below-market rent to a landlord entity the owner also controls, or receiving preferential pricing from a supplier connected to the family, can show margins that look stronger than what a genuinely arm’s-length operation would produce. Once ownership changes, those related-party arrangements often end or reset to market terms, and the earnings that looked strong on paper can compress accordingly. Identify every related-party relationship early and ask directly what happens to each one after closing, rather than discovering the answer in your first year of ownership.

Look at working capital, not just profit

A profitable business can still be starved of the cash it needs to operate day to day if its working capital is mismanaged or misrepresented. Review accounts receivable aging for anything that looks genuinely uncollectible rather than merely slow, check inventory for obsolete or overstated stock, and look at accounts payable for signs that payments were deliberately delayed near the sale to make cash flow look stronger than it normally runs. The amount of working capital the business genuinely needs to operate is a separate question from the price of the business itself, and conflating the two is a common and costly mistake.

• Two to three years of financial statements plus Notices of Assessment
• Recent bank and merchant-processing statements
• Accounts receivable and accounts payable aging reports
• General ledger detail behind any unusual or large entries
• A documented add-back schedule with supporting receipts