Financial Due Diligence — Quality of Earnings, Net Debt and What Moves the Price

Financial due diligence is frequently described as verifying the numbers. It is not. The numbers are usually audited and usually correct. What due diligence establishes is whether the earnings will continue, what the real level of debt and working capital is, and which of the seller's obligations will become the buyer's problem after completion.

That is why a clean audit opinion tells a buyer so little. Accounts can be entirely accurate and the business still be worth substantially less than the reported profit suggests — because a third of the revenue came from a contract that has ended, because the founder has been drawing below market, because gratuity was never funded, or because creditors have been stretched for six months to make the cash position look better than it is.

N D Savla & Associates performs financial due diligence for acquirers, investors and sellers on transactions involving businesses across Mumbai, Navi Mumbai, Thane and Goa — quality of earnings, net debt, working capital, tax and contingent exposures, and the translation of findings into price and contractual protection. Where the same transaction needs a valuation, the two exercises inform each other rather than running separately.

What Does the Exercise Actually Cover?

Four workstreams carry most of the value, and they connect directly to specific clauses in the transaction documents.

The same categories recur across almost every mid-market Indian transaction, and in owner-managed businesses the aggregate adjustment is frequently larger than the reported profit.

• Proprietor and family remuneration below or above a market rate for the role actually performed
• Related party transactions on non-arm's length terms — rent paid to a promoter-owned property below market, purchases from a family entity at concessional rates, management fees with no service behind them
• Personal expenditure run through the business, and the corresponding tax effect
• One-off items presented as recurring — an insurance recovery, a favourable one-time contract, a government incentive that has ended
• Recurring items presented as one-off — restructuring costs that recur every year, bad debts written off annually and described as exceptional
• Revenue that will not continue — a customer already lost, a contract not being renewed, pull-forward of orders before completion
• Provisions taken or released to smooth results across periods
• Capitalisation of costs that should have been expensed, flattering both profit and the asset base

Each adjustment has to be evidenced rather than asserted. A seller will contest add-backs that reduce EBITDA and support those that increase it, and an unsupported adjustment does not survive the negotiation. This is the same evidentiary discipline that forensic work applies, and where the analysis suggests deliberate misstatement rather than presentation, the engagement changes character.

For most of India's corporate history there was very little to do due diligence on, because there were very few transactions.

Under the licence regime, businesses were not readily bought and sold. Industrial capacity was licensed to a named entity, foreign investment was restricted under the Foreign Exchange Regulation Act, 1973, and the Monopolies and Restrictive Trade Practices Act, 1969 constrained combinations that concentrated market power. A company acquiring another faced approvals having nothing to do with commercial logic, and the transactions that did occur were largely intra-group reorganisations. What passed for diligence was a legal title check and a look at the audited accounts.

Liberalisation from 1991 changed the volume and the counterparties. Foreign investment opened, exchange control moved from prohibition to management under the Foreign Exchange Management Act, 1999, and private equity and strategic acquirers began buying Indian businesses. These buyers arrived with a developed diligence practice from other markets and applied it — and found that Indian owner-managed accounts, prepared primarily to satisfy a statutory audit and manage tax, required considerably more adjustment than they were used to.

That produced the specifically Indian character of the discipline. Elsewhere, quality of earnings analysis largely concerns accounting judgement and non-recurring items. In India it also has to address a business run substantially for its owner — remuneration set for tax rather than economic reasons, property held personally and leased to the company, group entities transacting at whatever price suited, and personal expenditure absorbed into the profit and loss account. None of this is necessarily improper, and all of it has to be unwound before the earnings mean anything to a buyer.

Two further developments shaped the practice. The introduction of goods and services tax in 2017 created a rich transaction-level dataset that can be reconciled against reported revenue, which materially improved the ability to test completeness of sales in businesses where that had previously been difficult. And the Insolvency and Bankruptcy Code, 2016 created an entire category of distressed transactions in which diligence is performed on incomplete records, under statutory timelines, with limited access to management — a discipline quite different from a negotiated sale.

The transaction documentation matured alongside. Completion accounts mechanisms, working capital pegs, locked box structures with an effective date and leakage protection, specific indemnities for identified exposures, escrow and holdback arrangements, and warranty and indemnity insurance all became standard in the Indian mid-market over the last decade. Each of these is a mechanism for allocating a risk that diligence identified, which is why a diligence report that does not connect to the documents has done only half the work.

We reconstruct owner-managed earnings properly. In Indian mid-market businesses the adjustments frequently exceed the reported profit. Benchmarking remuneration, restating related party terms and identifying personal expenditure is slow work and it is where the price is actually determined.

Debt-like items identified, not just borrowings. Unfunded gratuity, disputed tax demands, committed capital expenditure and stretched creditors all function as debt and rarely appear on the seller's list. Each one found reduces the equity price rupee for rupee.

Revenue tested against independent data. Goods and services tax returns and income tax filings provide a check on reported revenue that did not exist a decade ago. Reconciling all three is one of the more reliable tests of completeness available.

Findings carried into the documents. A report that identifies an exposure and does not result in an indemnity has protected nobody. We work with the transaction lawyers so that each material finding lands somewhere in the agreement.

Six offices across Maharashtra and Goa. Andheri, Charni Road, Vashi, Thane, New Panvel and Panaji. Diligence means sitting with the target's finance team, visiting sites and examining records under time pressure, and being able to do that locally is what keeps a compressed timetable workable.