There are several levels of due diligence to do before buying a business. The best understood aspect is the financial part, as the numbers are factual.
At the operational level, it is important to understand when a sale is recognized. Impacts that come out of this aspect include whether there is an overcharge, which would penalize the buyer in transition. Also, whether there is work in progress, which could be false profit; and whether an amount is recognized for returns or warranties, could impact future profitability. Regarding expenses, are they well recognized according to the standards in place?
Balance sheet items have a direct link to profitability. The main aspect to validate in terms of working capital is the amount (in $) to leave for a transaction according to its valuation, to understand the cash cycle. Sometimes prepaid expenses are not recognized in the in-house financial statements, or there is a lack of provision for vacation pay, taxes and other expenses. Is the allowance for bad debts adjusted? The same goes for “special” receivables, research and development credits, taxes, advances – are these amounts adjusted and realistic? With respect to inventories, an interesting point to understand is the accounting method, their composition, and the respective age of what is on the books. In terms of assets, real estate often has an appreciated value compared to the book value.
For financial commitments, whether they be leases, supply contracts or sales of products and services, these may represent a contingent asset or liability depending on the terms. Are these contracts advantageous or not for the company. Reading the debt, lease and obligations of the company can highlight significant penalties or conditions to be met.
A well surrounded buyer will invest in the resources and skills to understand and evaluate these risks.