Financial Due Diligence: Quality of Earnings and What the Numbers Hide

Financial due diligence (FDD) is often misunderstood as accounting verification — confirming that the numbers add up. This is a small part of what FDD does. The primary purpose of a quality financial due diligence is to understand: are the reported earnings real, sustainable, and fairly presented? Is the working capital requirement normal or has it been managed to look better than it is? Are there liabilities that are not on the balance sheet? The answers to these questions are what drive the final price.

Quality of Earnings Analysis

Quality of Earnings (QoE) is the central analytical framework for financial due diligence. It answers the question: of the reported EBITDA, how much is reliably recurring and how much is the result of one-off items, aggressive accounting, or unusual circumstances?

Normalised EBITDA. The starting point is identifying the reported EBITDA and then adjusting it for items that a new owner would not expect to recur. These adjustments go both ways — some increase the EBITDA (add-backs), some reduce it.

Legitimate add-backs typically include:

• Owner-director's salary above market rate for a hired manager
• Personal expenses (car, phone, travel, club memberships) running through the company
• One-off professional fees (legal costs for a dispute, transaction advisory fees)
• One-off losses (write-off of a specific bad debt, one-time inventory impairment)
• Costs relating to a business activity that has since ceased

Items that should reduce reported EBITDA (often not disclosed by sellers):

• Revenue recognised in advance that belongs to a future period
• Expenses deferred from prior periods that properly belong to the current period
• Below-market rent paid to a related-party landlord (should be normalised to market rate)
• Absence of a cost that will be necessary post-completion (e.g., the owner did not draw market-rate management fees, but a hired replacement will cost more than what was charged)

Identifying Aggressive Revenue Recognition

Revenue recognition under MFRS (Malaysian Financial Reporting Standards) is based on when performance obligations are satisfied — when the goods or services are delivered, not when cash is received or invoiced. Common patterns of aggressive revenue recognition to look for:

Bill-and-hold arrangements. Goods invoiced and recognised as revenue before they have been delivered to the customer. Common in manufacturing or trading businesses at year-end.

Percentage-of-completion manipulation. For long-term contracts, revenue is recognised based on estimated completion percentage. Manipulating the completion percentage — overstating how much work has been done — accelerates revenue recognition. This is common in construction, IT project companies, and professional services.

Channel stuffing. Shipping goods to distributors or customers in excess of their requirements near period-end, recognising revenue, then accepting returns in the next period. Watch for an unusually high accounts receivable balance at year-end that reverses in January.

Related-party sales. Sales to related parties (associated companies, family businesses) at prices above market or in volumes that would not be possible with arm's-length counterparties.

Cross-reference the revenue figure to: bank statement credits (does cash collected reconcile to recognised revenue?); delivery records; customer contracts with payment terms; and the accounts receivable aging schedule.

Working Capital Analysis

Working capital — the net of current assets (receivables, inventory, cash) less current liabilities (payables, accruals) — is one of the most manipulable elements of a business's financial position. The QoE analysis must include a working capital assessment.

Normalised working capital is the level of working capital the business requires to operate at its current revenue level under normal conditions. This becomes the basis for the working capital mechanism in the SPA — the price adjusts if actual working capital at completion is above or below the normalised reference point.

Key metrics to establish:

Debtor days (Days Sales Outstanding): How many days of revenue are sitting in receivables at the balance sheet date? If the business normally has 45-day debtor days and the year-end balance sheet shows 70 days, something has been deferred — either collections have slowed, or invoices have been issued late to push revenue into the next period.

Creditor days: How long is the business taking to pay its suppliers? If creditor days are unusually long at period-end, the business may be deferring payments to improve its cash position at the reporting date — a common working capital manipulation. A new owner will need to normalise these payables, which reduces the effective cash position.

Inventory: For product-based businesses, examine inventory levels vs the prior year and vs days of cost of goods sold. An unusual build-up of inventory that is not explained by a specific contract or seasonal pattern may indicate obsolete stock that has not been written down.

Capital Expenditure Assessment

Distinguish between maintenance capex (spending required to keep the business operating at its current capacity) and growth capex (spending to expand capacity or capability). In a QoE analysis, maintenance capex is often treated as a charge against sustainable earnings — it is a recurring cost of keeping the business in operating condition.

A seller who has deferred maintenance capex in the years before sale can temporarily inflate EBITDA. The buyer then inherits a business that requires immediate significant capex to maintain operations. Always ask: what is the total maintenance capex requirement annually, and how does that compare to what was actually spent in each of the last three years?

Off-Balance Sheet Liabilities

These are the items that can most significantly affect the price paid or the post-completion experience:

Contingent tax liabilities. LHDN (Inland Revenue Board) assessments that have been raised but disputed, or positions taken in tax returns that are not compliant and could be challenged in a future audit.

Employment claims. Pending or potential Industrial Court claims from former employees. These can be material in businesses with high turnover or recent redundancies.

Lease obligations. Under MFRS 16, leases are capitalised on the balance sheet — but only for leases of 12 months or more. Short-term leases (cafes, kiosks, temporary premises) may not be on the balance sheet.

Personal guarantees. Owner-directors often provide personal guarantees for company borrowings. Post-sale, the bank may require the new owner to provide equivalent guarantees and release the seller — confirm this process in advance.

Environmental liabilities. For manufacturing, agriculture, or processing businesses, historical environmental breaches (waste discharge, chemical use, land contamination) can create remediation liabilities that are not provisioned.

Malaysian Accounting Standards Context

Malaysian public companies follow MFRS, which is aligned with IFRS. Private companies (Sdn Bhd) may use MPERS (Malaysian Private Entities Reporting Standard), a simplified framework. The choice of accounting standard affects how revenue is recognised, leases are treated, and certain financial instruments are measured. When reviewing accounts, confirm which standard is applied and whether it has been consistently applied.