Essential Financial Documents for Due Diligence

The #1 mistake first-time business buyers make is accepting financial statements at face value. Professional buyers know that proper financial due diligence requires examining multiple documents to verify the business's true financial health.

Here's your complete checklist of financial documents to request, what to look for, and what red flags to watch out for.

## Tax Documents

### 1. Business Tax Returns (Last 3 Years)

**Why You Need It:** Tax returns are the most reliable financial documents because they're filed under penalty of perjury.

**What to Look For:**
- Consistent revenue trends
- Actual profitability (not just seller's claims)
- Owner compensation and benefits
- Reconciliation with provided financial statements

**Red Flags:**
- Seller won't provide them
- Major discrepancies with other financials
- Significant losses or declining profits
- Amended returns (ask why)

### 2. Personal Tax Returns (If Relevant)

**Why You Need It:** For sole proprietorships and pass-through entities, business income flows to personal returns.

**What to Look For:**
- Schedule C (sole proprietorship) or K-1 (partnership/S-corp) income
- Other sources of income
- Verification of owner's true compensation

## Financial Statements

### 3. Profit & Loss Statements (3 Years, Monthly Detail)

**Why You Need It:** Shows revenue, expenses, and profitability trends over time.

**What to Look For:**
- Monthly trends and seasonality
- Revenue consistency or growth
- Gross margin trends
- Operating expense ratios
- One-time or unusual expenses

**Red Flags:**
- Round numbers (suggests estimates, not actuals)
- Major month-to-month swings without explanation
- Expenses that don't match business size
- "Adjusted" EBITDA without documentation

### 4. Balance Sheets (3 Years, Year-End)

**Why You Need It:** Shows what the business owns and owes at specific points in time.

**What to Look For:**
- Asset values and condition
- Debt obligations
- Accounts receivable aging
- Inventory levels
- Working capital trends

**Red Flags:**
- Negative equity
- High debt-to-equity ratio
- Growing accounts receivable
- Obsolete inventory

### 5. Cash Flow Statements (3 Years)

**Why You Need It:** Shows actual cash in and out—the true measure of business health.

**What to Look For:**
- Operating cash flow (the most important)
- Free cash flow after capital expenditures
- Financing activities
- Cash flow vs. reported profit

**Red Flags:**
- Positive profit but negative cash flow
- Heavy reliance on financing
- Unexplained cash flow discrepancies

## Banking & Cash Records

### 6. Bank Statements (Last 12 Months)

**Why You Need It:** Provides third-party verification of actual cash transactions.

**What to Look For:**
- Average daily balance
- Large deposits (do they match reported revenue?)
- Large withdrawals (owner draws? unexplained?)
- NSF fees or overdrafts
- Reconciliation with P&L

**Red Flags:**
- Cash deposits not reported as income
- Personal expenses paid from business account
- Regular overdrafts or low balances
- Frequent large transfers to/from personal accounts

### 7. Accounts Receivable Aging Report (Current)

**Why You Need It:** Shows who owes the business money and how long it's been outstanding.

**What to Look For:**
- Aging buckets (0-30, 31-60, 61-90, 90+ days)
- Percentage over 90 days old
- Major concentrations with specific customers
- Collection history

**Red Flags:**
- More than 15% over 90 days
- Large amounts from one customer
- Customers you can't contact or verify
- Growing AR balance over time

### 8. Accounts Payable Aging Report (Current)

**Why You Need It:** Shows what the business owes suppliers and vendors.

**What to Look For:**
- Current obligations
- Payment terms being honored
- Major concentrations with specific vendors
- Disputes or payment issues

**Red Flags:**
- Lots of past-due amounts
- Vendors on COD terms (sign of payment problems)
- Major disputes
- Growing AP balance

## Revenue Documentation

### 9. Sales Records by Customer (12 Months)

**Why You Need It:** Verifies revenue and shows customer concentration risk.

**What to Look For:**
- Top 10 customers by revenue
- Customer concentration percentages
- Revenue trends by customer
- New vs. repeat customer mix

**Red Flags:**
- One customer over 25% of revenue
- Top 3 customers over 50%
- Declining repeat customer rate
- Many one-time customers

### 10. Contracts & Recurring Revenue Documentation

**Why You Need It:** Verifies the stability and predictability of revenue.

**What to Look For:**
- Contract terms and expiration dates
- Cancellation clauses
- Auto-renewal terms
- Guaranteed vs. variable revenue

**Red Flags:**
- Major contracts expiring soon
- Easy cancellation terms
- No long-term commitments
- Revenue depends on one contract

## Expense Documentation

### 11. Payroll Records (12 Months)

**Why You Need It:** Verifies one of the largest expense categories.

**What to Look For:**
- Total payroll cost including taxes and benefits
- Employee count and compensation
- Payroll tax compliance
- Benefits costs

**Red Flags:**
- Payroll not matching reported expenses
- Payroll tax issues
- Misclassified employees (IRS risk)
- Off-the-books workers

### 12. Major Expense Receipts & Invoices

**Why You Need It:** Verifies that reported expenses are real and business-related.

**What to Look For:**
- Supporting documentation for major expenses
- Business purpose
- Proper categorization
- Arms-length transactions

**Red Flags:**
- Personal expenses in business
- Related-party transactions at non-market rates
- Missing documentation
- Unusual or unexplained expenses

## Debt & Obligations

### 13. Debt Schedules & Loan Documents

**Why You Need It:** Shows all business debt obligations you'll inherit or need to pay off.

**What to Look For:**
- Loan balances and terms
- Monthly payments
- Interest rates
- Collateral pledged
- Personal guarantees

**Red Flags:**
- Hidden debt not disclosed
- Balloon payments coming due
- High interest rates (financial distress?)
- Cross-default provisions

### 14. Equipment Leases & Other Obligations

**Why You Need It:** Identifies ongoing obligations and their terms.

**What to Look For:**
- Lease terms and expiration dates
- Monthly costs
- Purchase options
- Assignment restrictions

**Red Flags:**
- Above-market lease rates
- Leases expiring soon with no renewal option
- Personal guarantees you'll have to replace
- Cannot be assigned/transferred

## Tax Compliance

### 15. Sales Tax Returns & Payroll Tax Filings

**Why You Need It:** Verifies tax compliance and identifies potential liability.

**What to Look For:**
- All required filings current
- No outstanding tax liabilities
- Consistent with reported revenue/payroll
- No penalties or interest

**Red Flags:**
- Missing or late filings
- Outstanding tax liens
- Penalties and interest
- Major discrepancies with financial statements

## How to Organize Your Document Request

### Phase 1: Initial Package (Week 1)
- Last 3 years tax returns
- Last 3 years P&L and balance sheets
- Last 12 months bank statements
- Current AR/AP aging

### Phase 2: Detailed Review (Week 2-3)
- Monthly P&L detail
- Customer sales data
- Payroll records
- Major contracts

### Phase 3: Final Verification (Week 4)
- Supporting invoices and receipts
- Debt documentation
- Lease agreements
- Tax compliance records

## What to Do With All This Information

1. **Cross-Reference Everything:** Tax returns should match P&L should match bank deposits
2. **Calculate Key Ratios:** Gross margin, operating margin, debt-to-equity, current ratio
3. **Trend Analysis:** Look at 3-year trends for all key metrics
4. **Compare to Industry Benchmarks:** Is this business performing above or below average?
5. **Identify Adjustments:** Add back owner salary, remove one-time expenses, adjust for market-rate compensation

## Red Flag Patterns to Watch

Multiple red flags in the same area suggest serious problems:
- **Cash flow issues:** Bank overdrafts + growing AP + high AR aging
- **Revenue problems:** Declining revenue + customer concentration + contract expirations
- **Hidden liabilities:** Missing tax filings + high debt + vendor payment issues

## Get Professional Help

Even with all these documents, you should hire:
- **Accountant/CPA:** To review financials and calculate adjusted EBITDA
- **Tax Professional:** To identify tax liabilities and compliance issues
- **Attorney:** To review contracts and legal documents

**Cost:** $2,000-$5,000 for professional review
**Value:** Could save you hundreds of thousands in avoided mistakes

## Your Next Steps

1. **Download Our Document Request Template:** Pre-formatted request list you can send to the seller
2. **Use Our Financial Analysis Template:** Organize and analyze all these documents systematically
3. **Get Our Complete Guide:** Step-by-step instructions for evaluating every document

Don't let a seller's "trust me" override your need for documentation. Professional buyers verify everything.

**Remember:** If a seller won't provide these documents, walk away. Transparency is non-negotiable in business buying.