Due Diligence Red Flags: What Transaction Due Diligence Teams Need to Address Before an M&A Deal Closes
- Kyle Croxford
- Jan 12
- 9 min read
Mergers and acquisitions can accelerate growth, unlock synergies, and create long-term shareholder value. But they can also expose organizations to hidden risks that only emerge after completion—when remediation is costly and leverage is lost.
Transaction due diligence should not be a box-checking exercise. It's a risk discovery and value protection process designed to identify issues that could materially affect valuation, deal structure, financing, or post-transaction performance.
Below are the most common red flags in M&A transactions—along with recommended audit and diligence procedures used to identify and manage these risks.
Note: This list highlights common risk areas observed in merger and acquisition transactions but doesn't represent a complete or comprehensive assessment of all potential risks. Additional issues may arise depending on the transaction structure, regulatory environment, financial complexity, and operating model of the target business.
Financial Red Flags: When the Numbers Don't Tell the Full Story
Risk Indicators
Weak financial discipline is often the earliest warning sign in a troubled transaction. Inconsistent reporting, unexplained adjustments, or frequent changes in accounting policies may indicate poor internal controls—or deliberate earnings management.
Aggressive revenue recognition is another frequent concern. Revenue spikes at period-end, significant manual journal entries, or receivables growing faster than revenue may inflate earnings and valuation.
Strong reported profits combined with weak operating cash flow often signal poor earnings quality or working capital strain.
Recommended Audit & Due Diligence Procedures
Perform a quality of earnings (QoE) analysis to separate sustainable earnings from one-off or non-recurring items. A QoE analysis adjusts reported earnings to remove non-recurring, non-operational, or owner-specific items to determine the business's sustainable, repeatable earnings base.
Reconcile management accounts to audited financial statements and underlying ledgers. Reported management results are traced back to audited statements and general ledger data to confirm consistency, accuracy, and completeness.
Review revenue recognition policies against applicable accounting standards and test a sample of contracts and invoices. A sample of customer contracts, invoices, and delivery evidence is reviewed to confirm revenue is recognized in line with accounting standards and contractual obligations.
Analyze trends in revenue, margins, receivables, and write-offs over multiple periods. Historical financial data is analyzed to identify unusual movements, margin volatility, or disconnects between revenue growth and cash collection.
Perform cash flow bridge analysis comparing EBITDA to operating cash flows. Reported EBITDA is reconciled to operating cash flow to identify working capital movements, non-cash items, and cash leakage.
Working Capital and Liquidity Risks
Risk Indicators
Many transactions underestimate the true cash required to operate the business post-acquisition. A company may appear profitable while quietly consuming cash through inventory build-ups, extended customer credit terms, or seasonal funding gaps.
Customer or supplier concentration further amplifies liquidity risk. The loss of a single major counterparty can materially disrupt cash flow and covenant compliance.
Recommended Audit & Due Diligence Procedures
Conduct a normalized working capital analysis to determine sustainable operating levels. Historical working capital levels are analyzed to determine the level required to operate the business on a steady-state basis post-transaction.
Review historical monthly working capital movements and seasonality trends. Monthly balance sheet data is reviewed to identify seasonal funding needs, volatility, or structural cash shortfalls.
Assess customer and supplier concentration ratios and dependency risk. Revenue and procurement data is analyzed to quantify reliance on key counterparties and assess exposure if relationships deteriorate.
Test receivables agings, bad debt provisions, and inventory valuation. Aging reports, write-off history, and valuation methodologies are reviewed to assess collectability and inventory obsolescence risk.
Model downside cash flow scenarios assuming customer or supplier attrition. Cash flow forecasts are modeled under adverse scenarios such as revenue loss, margin compression, or delayed collections.
Legal and Regulatory Red Flags
Risk Indicators
Undisclosed litigation, regulatory investigations, or unresolved tax disputes can result in significant future cash outflows. Even when disclosed, provisions may be understated or poorly supported.
Contractual risks are equally common. Missing, informal, or poorly drafted contracts—especially those with change-of-control clauses—can undermine deal economics overnight.
Recommended Audit & Due Diligence Procedures
Obtain and review a legal claims and litigation register with external legal counsel confirmation. Management representations are corroborated through legal confirmations and documentation to identify current, pending, or potential legal claims.
Assess adequacy of provisions and contingent liability disclosures. Recorded provisions are evaluated against legal advice, historical outcomes, and probability assessments to determine adequacy.
Review material customer, supplier, financing, and employment contracts. Key contracts are reviewed to identify enforceability, termination rights, and economic risks.
Identify change-of-control, termination, or repricing clauses. Contracts are specifically examined for clauses that may trigger termination, repricing, or consent requirements upon acquisition.
Perform regulatory compliance gap analysis relevant to the industry. Business practices are assessed against relevant regulatory frameworks to identify non-compliance risks or remediation requirements.
Operational and Integration Risks
Risk Indicators
Operational weaknesses often surface post-acquisition, when integration begins. Over-reliance on a small number of key individuals, undocumented processes, or outdated systems increases execution risk and integration costs.
Poor data integrity and manual processes can also delay reporting, disrupt controls, and erode management confidence.
Recommended Audit & Due Diligence Procedures
Perform key person dependency analysis and review retention and incentive arrangements. Organizational structures and revenue drivers are analyzed to identify individuals whose departure would materially impact operations or earnings.
Assess organizational structure, succession planning, and role concentration. Employment contracts, incentive schemes, and retention plans are reviewed to assess continuity risk post-transaction.
Review core operational processes and internal control documentation. Core operational and financial processes are reviewed to identify control gaps, manual workarounds, and scalability limitations.
Evaluate IT systems, ERP capabilities, and data integrity controls. ERP systems, data flows, and reporting outputs are assessed to determine reliability, integration complexity, and upgrade requirements.
Identify integration complexity and estimate post-deal remediation costs. Identified operational gaps are quantified to estimate post-acquisition remediation costs, timelines, and execution risk.
Tax and Structuring Risks
Risk Indicators
Tax risks often crystallize after completion. Aggressive tax positions, unclear transfer pricing arrangements, or unresolved disputes with tax authorities can result in unexpected liabilities.
Complex or opaque group structures may hide trapped cash, inefficient tax outcomes, or legal risks that affect post-deal flexibility.
Recommended Audit & Due Diligence Procedures
Review historical tax filings, correspondence, and audit outcomes. Tax returns and correspondence with tax authorities are reviewed to identify compliance issues, disputes, or audit exposure.
Assess uncertain tax positions and adequacy of tax provisions. Judgment-based tax treatments are evaluated to determine whether they're sustainable or likely to result in future liabilities.
Review group legal structure, inter-company agreements, and transfer pricing policies. Inter-company pricing policies and agreements are reviewed for compliance and exposure to tax authority challenge.
Insolvency and Going Concern Warning Signs
Risk Indicators
Upcoming debt maturities, restrictive banking covenants, or reliance on short-term funding may signal financial distress. Overstated asset values—particularly goodwill, inventory, or receivables—can mask solvency risks.
Management over-optimism, unsupported forecasts, or resistance to stress testing are often late-stage warning signs.
Recommended Audit & Due Diligence Procedures
Review debt agreements, covenants, maturity timelines, and refinancing plans. Loan agreements are reviewed to understand covenant requirements, default triggers, and restrictions on operations or distributions.
Perform going concern and solvency analysis under realistic, challenging scenarios. Cash flow forecasts are analyzed to assess whether the business can meet its obligations as they fall due over the forecast period.
Stress test cash flow forecasts and covenant restrictions. Key assets such as receivables, inventory, and goodwill are tested to assess whether carrying values are supported by cash generation.
Test asset recoverability and impairment assumptions. Management forecasts are independently reviewed by testing assumptions against historical performance and market conditions.
Culture and Governance Risks (Often Overlooked)
Risk Indicators
Weak governance, poor tone from the top, or ineffective internal controls can undermine even the strongest financial case. Cultural misalignment frequently erodes value through execution failures rather than financial misstatement.
Recommended Audit & Due Diligence Procedures
Review board composition, governance frameworks, and reporting lines. Board structures, delegations of authority, and reporting frameworks are assessed for effectiveness and transparency.
Assess internal control environment and risk management practices. Financial controls are evaluated to identify weaknesses that could result in misstatement, fraud, or operational failure.
Evaluate management incentive structures and alignment with performance. Management incentives are analyzed to assess whether they encourage sustainable performance or short-term risk taking.
Conduct cultural and leadership alignment assessments. Leadership behaviors, decision-making styles, and risk tolerance are assessed to identify potential post-merger friction.
Identify control gaps requiring post-acquisition remediation. Identified governance and control gaps are translated into a prioritized remediation roadmap with estimated costs and timelines.
Accounts Receivable & Allowance for Doubtful Accounts
Risk Indicators
Accounts receivable balances are frequently overstated in M&A transactions, particularly where management is incentivized to maximize short-term earnings or valuation. An inadequate allowance for doubtful accounts can inflate profits and working capital while masking collectability issues.
Red flags include growing receivables without corresponding revenue growth, long-outstanding balances, manual overrides to credit limits, or consistently low bad debt provisions relative to historical write-offs.
Recommended Audit & Due Diligence Procedures
Receivables aging and trend analysis. Receivables are analyzed by aging category and compared across periods to identify deterioration in collection patterns or increasing exposure to older balances.
Historical write-off vs provision analysis. Actual bad debt write-offs are compared to historical provisions to assess whether the allowance methodology has been consistently underestimating credit losses.
Customer-level collectability testing. Individual customer balances are reviewed, focusing on overdue accounts, disputed invoices, and post-period cash receipts to assess recoverability.
Credit policy and override review. Credit approval processes, limits, and override practices are reviewed to identify control weaknesses or aggressive credit extension.
AFDA methodology assessment. Management's allowance calculation methodology is reviewed for consistency, supportability, and alignment with historical loss experience and current risk profiles.
Fixed Asset Valuation & Impairment Risk
Risk Indicators
Fixed assets may be overstated where depreciation policies are aggressive, assets are underutilized, or impairment indicators haven't been appropriately considered. This risk is elevated in capital-intensive businesses, turnaround situations, or where recent performance has deteriorated.
Common red flags include assets carried at cost despite declining cash flows, extended useful lives, limited maintenance spend, or poor fixed asset register integrity.
Recommended Audit & Due Diligence Procedures
Fixed asset register integrity review. The fixed asset register is reviewed for completeness, accuracy, duplicate entries, and alignment with the general ledger.
Physical asset existence and condition assessment. A sample of assets is physically inspected (or supported by documentation) to confirm existence, operational condition, and ongoing usefulness.
Depreciation policy review. Useful lives, residual values, and depreciation methods are assessed for consistency with industry norms and actual asset usage.
Impairment indicator assessment. Financial performance, utilization rates, and market conditions are evaluated to identify triggering events requiring impairment testing.
Impairment testing and recoverability analysis. Where indicators exist, asset recoverability is assessed by comparing carrying values to expected future cash flows or fair value estimates.
Transaction Due Diligence as a Value Protection Tool
For CEOs and CFOs, transaction due diligence isn't about finding reasons to abandon a deal. It's about understanding risk well enough to price it correctly, structure around it, or mitigate it effectively.
Red flags don't automatically kill deals—but failing to identify them almost always destroys value. The most successful acquirers approach transaction due diligence with skepticism, discipline, and a willingness to challenge assumptions before capital is committed.
M&A Due Diligence Checklist for CEOs and CFOs
Purpose: To identify material financial, legal, operational, and solvency risks before signing or closing an acquisition or merger.
Financial Performance & Earnings Quality
☐ Are historical financial statements complete, accurate, and consistent?
☐ Have earnings been normalized for one-off, non-recurring, or owner-related items?
☐ Are revenue recognition policies compliant and consistently applied?
☐ Do reported profits convert into operating cash flow?
☐ Are there unexplained journal entries or management adjustments?
Working Capital & Cash Flow
☐ Is normalized working capital sufficient to sustain operations post-transaction?
☐ Are receivables aging, inventory levels, and provisions appropriate?
☐ Is the business exposed to seasonal or structural cash flow volatility?
☐ Are key customers or suppliers overly concentrated?
☐ Has downside cash flow been stress tested?
Legal, Regulatory & Contractual Matters
☐ Are all litigation, claims, and contingent liabilities fully disclosed and provisioned?
☐ Do material contracts exist, and are they enforceable?
☐ Are there change-of-control clauses that could trigger termination or repricing?
☐ Is the business compliant with applicable laws and industry regulations?
☐ Are employment, IP, and data protection risks clearly understood?
Tax & Transaction Structuring
☐ Are historical tax filings complete and free of unresolved disputes?
☐ Are there uncertain or aggressive tax positions?
☐ Is the proposed transaction structure tax-efficient?
☐ Are there transfer pricing or inter-company risks?
☐ Is there trapped cash or post-deal restructuring risk?
Operational & Integration Readiness
☐ Is the business overly reliant on key individuals?
☐ Are systems, processes, and controls scalable post-acquisition?
☐ Is data reliable, timely, and decision-useful?
☐ Are integration costs and timelines clearly identified?
☐ Are operational synergies realistic and executable?
Solvency, Debt & Going Concern
☐ Are debt terms, covenants, and maturities clearly understood?
☐ Is there sufficient covenant headroom under downside scenarios?
☐ Are asset values (inventory, receivables, goodwill) recoverable?
☐ Is the business dependent on short-term funding or refinancing?
☐ Have going-concern risks been independently assessed?
Governance, Culture & Risk Management
☐ Is the governance framework effective and transparent?
☐ Are financial controls and risk management practices robust?
☐ Are incentives aligned with sustainable performance?
☐ Is there cultural alignment between buyer and target?
☐ Are post-acquisition control improvements identified and costed?
Executive Decision Check
☐ Are identified risks quantified and reflected in valuation?
☐ Can risks be mitigated through deal structure, warranties, or price adjustment?
☐ Are there unresolved red flags that materially threaten deal success?
Bottom Line: If key risks can't be explained, quantified, or mitigated, the issue isn't diligence—it's deal discipline.
Whether you're evaluating a strategic acquisition, preparing your business for sale, or seeking an independent assessment of transaction risks, Pursuit Advisory Group brings deep transaction due diligence expertise to help you protect value and make informed decisions. Our team guides mid-market and Fortune 1000 companies through complex M&A transactions, identifying material risks before they become costly surprises. We invite you to schedule a confidential consultation to discuss how our CFO advisory and transaction support services can meet your specific needs at https://www.pursuit-advisory.com.
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