Purpose
This checklist covers the 25 financial data points that every deal team should validate before closing a middle market acquisition. It is not a substitute for a full Quality of Earnings report. It is the operating partner's field guide for knowing what to look at first and what the red flags are.
Print it. Bring it to management meetings. Use it alongside the QofE to make sure nothing falls through the cracks.
Revenue Quality (Items 1–6)
1. Revenue concentration — Top 10 customers as a percentage of total revenue. Red flag: any single customer above 15%, or top 5 above 50%.
2. Revenue trend — organic vs. acquired — Strip out acquired revenue to see the organic growth rate. Red flag: organic growth below 3% while reported growth is above 10%.
3. Revenue recognition policy — When is revenue recognized? At shipment, delivery, completion, or ratably? Red flag: aggressive recognition (bill-and-hold, percentage of completion with loose milestones).
4. Recurring vs. non-recurring revenue — What percentage of revenue is contractually recurring (subscriptions, retainers, maintenance agreements)? Red flag: management presenting project-based revenue as "recurring."
5. Backlog and pipeline quality — Signed but unrecognized revenue. Red flag: backlog declining quarter-over-quarter while management projects growth.
6. Pricing power — Average selling price trends over the past 3 years. Red flag: volumes growing but ASP declining, masking margin erosion.
Profitability (Items 7–12)
7. Adjusted EBITDA bridge — Walk from reported EBITDA to adjusted EBITDA. Every add-back needs documentation. Red flag: add-backs exceeding 30% of reported EBITDA.
8. Gross margin by product/service line — Not all revenue is created equal. Red flag: blended margin stable but highest-growth product line has the lowest margin.
9. Owner compensation and related-party expenses — Total compensation (salary, bonus, perks, personal expenses) for all owners and related parties. Red flag: combined owner comp below market rate (suggesting understated expenses) or well above (suggesting easy cost savings that may not be sustainable).
10. Customer profitability — Top 10 customers by revenue vs. by profitability. Red flag: the largest customer is unprofitable due to pricing concessions or service intensity.
11. Headcount cost per revenue dollar — Total compensation cost divided by revenue. Red flag: ratio increasing faster than revenue growth.
12. Capex vs. maintenance capex — Separate growth capex from maintenance capex. Red flag: management categorizing maintenance as growth to inflate free cash flow.
Working Capital (Items 13–18)
13. DSO trend — Days Sales Outstanding over 12+ months. Red flag: DSO increasing by more than 5 days year-over-year.
14. AR aging quality — Percentage of AR over 90 days. Red flag: 90+ day AR exceeding 10% of total, or increasing as a percentage.
15. Inventory aging — Percentage of inventory over 180 days. Red flag: slow-moving or obsolete inventory exceeding 15% of total.
16. DPO vs. payment terms — Compare actual DPO to stated payment terms. Red flag: DPO significantly exceeding terms (stretched payables masking cash flow issues).
17. Working capital seasonality — Monthly working capital over 24 months. Red flag: deal structured to close at the seasonal low point for working capital (flattering the balance sheet).
18. Working capital target vs. peg — The working capital peg in the purchase agreement vs. actual trailing working capital. Red flag: peg set at a seasonal low or excluding key items.
Cash Flow and Leverage (Items 19–25)
19. Free cash flow conversion — FCF as a percentage of EBITDA. Healthy range: 60-80%. Red flag: below 50% consistently, suggesting EBITDA overstates cash generation.
20. Capex intensity — Capex as a percentage of revenue. Compare to industry benchmarks. Red flag: below-market capex suggesting deferred maintenance or underinvestment.
21. Debt schedule completeness — All debt instruments: term loans, revolvers, equipment financing, capital leases, seller notes, earnouts. Red flag: off-balance-sheet obligations not captured.
22. Interest rate exposure — Fixed vs. variable rate mix. Red flag: 80%+ variable rate in a rising rate environment with no hedging.
23. Covenant headroom — Current covenant levels vs. actual performance. Red flag: less than 15% headroom on any financial covenant.
24. Tax exposure — Open tax years, outstanding audits, R&D credit sustainability, state nexus issues. Red flag: significant R&D credits included in adjusted EBITDA that may not be sustainable.
25. Legal and contingent liabilities — Pending litigation, warranty reserves, environmental liabilities, product liability claims. Red flag: reserves that appear understated relative to exposure.
How to Use This Checklist
Go through each item systematically during diligence. For each item, note: the current value, the trend (improving/stable/deteriorating), whether it represents a risk or an opportunity, and the dollar impact if quantifiable.
The items flagged as red flags are not deal-breakers — they are conversation starters. Every deal has issues. The question is whether the issues are priced in, manageable, and understood.
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