How Does Financial Due Diligence Work? A Step-by-Step Guide to the Process

A term sheet is on the table, the closing is scheduled for eight weeks from now, and now it’s time for financial due diligence. Financial due diligence (FDD) is the process of reviewing a company’s financial health prior to an investment or acquisition. It answers one question: Are the numbers underlying the deal accurate?

Anyone going through a financial due diligence process for the first time usually underestimates what’s involved and how much the outcome depends on thorough preparation. This guide walks you through the financial due diligence process step by step, based on over 100 financial due diligence projects we’ve supported since 2022.

Key Points at a Glance

Financial due diligence is conducted prior to an investment or acquisition to verify whether a company’s financials are sound. The process consists of five phases and typically takes two to three weeks. Depending on the deal, the scope ranges from a quick “red flag” FDD to a comprehensive “full scope” FDD. The costs depend on the number of companies to be reviewed and the complexity of the business model.

What Is Financial Due Diligence, and When Do You Need It?

Financial due diligence verifies whether a company’s reported figures are reliable before any money changes hands. The client is almost always the buyer or investor—that is, a venture capital fund, a family office, or a strategic acquirer. Unlike an audit of annual financial statements, it does not issue an audit opinion. Instead, it tests the assumptions on which the valuation is based.

The need arises in a few specific situations:

- Before a funding round, when a lead investor wants to verify the startup’s financials
- Before a corporate acquisition (M&A), when the buyer needs to verify the purchase price and assess risks (more on this in the article “The M&A Process for Startups”)
- When planning to raise debt capital, if a lender is assessing the company’s ability to repay
- As part of vendor due diligence, when the seller initiates the process to expedite the sale

The FDD typically comes into a company's life just as it is scaling up from its early stages and preparing for its first major funding round.

For Which Companies We Conduct Financial Due Diligence

We audit startups and scaleups in their growth phase, not large corporations. Our clients are primarily venture capital funds, family offices, and strategic investors who want to understand a target company before making an investment. This is precisely where we differ from the major audit firms: We specialize in the phase where financial data is still emerging and processes are still being established.

The profile of the companies audited from over 100 FDDs:

- Business Model: Just over half are B2B SaaS and software, plus services and operations, hardware and manufacturing, SaaS plus hardware, and platforms and marketplaces
- Maturity: On average, about five years old, mostly between the first Series round and the scale-up phase
- Size: Annual revenue predominantly in the low single-digit millions or below; teams typically range from 10 to 50 employees
- Sectors: Broadly diversified across HR-Tech, FinTech, HealthTech, and MedTech; PropTech; EdTech; AgTech; CleanTech; and industrial software
- Region: Focus on DACH, supplemented by neighboring European countries

If your company is in this phase, we’re already familiar with the typical patterns of your business model. This makes the audit faster and the findings more precise.

Financial Due Diligence vs. Other Types of Due Diligence

Financial due diligence is only one part of the overall due diligence process. It examines the financial figures, while other types of due diligence examine other aspects of the deal. Here’s how to categorize the due diligence review:

- Financial Due Diligence: Profitability, revenue quality, working capital, and cash. The question: Do the numbers add up?
- Commercial Due Diligence: Market, competition, and viability of the business model. The question: Can the market support growth?
- Legal Due Diligence: Contracts, corporate structure, and legal risks. The question: Are there any legal stumbling blocks?
- Tax Due Diligence: Tax risks and structures. The question: Are there any hidden tax burdens lurking?
- Tech Due Diligence: Technology, codebase, and scalability—especially for tech deals. The question: Can the technology keep up with growth?

A common misconception: Financial due diligence (FDD) is not an audit. An audit of financial statements verifies past performance according to established standards and results in an audit opinion. Financial due diligence focuses on assumptions relevant to the transaction and does not require an audit opinion. The two processes complement each other but are not interchangeable.

Red Flag, Full Scope, or Confirmatory: Which FDD Is Right for Your Deal?

Not every financial due diligence process has the same scope. The appropriate level of detail depends on the deal size, time frame, and risk appetite. In practice, we encounter four formats:

Red Flag FDD: The Quick Check. We review the numbers for critical warning signs and provide an executive summary with a list of flags (real risks) and remarks (points to follow up on). It’s not a complete financial model, but it’s done in days instead of weeks. It’s useful early in the process, when you just want to know if the deal is even worth pursuing.

Full Scope FDD: The comprehensive review. It includes a detailed financial analysis (income statement, cash flow statement, balance sheet), an assessment of the quality of earnings, and a description of financial processes. This is the standard format for investments involving a substantial amount. About half of our reports fall into this category.

Confirmatory FDD: The confirmatory due diligence. It specifically verifies individual assumptions when the deal is already well underway and only residual uncertainties remain.

Hybrid Format (QoE / Revenue Sanity Check): A focused snapshot, such as a review of revenue or ARR alone, without the full process descriptions. This is appropriate when the client wants to clarify exactly one specific question.

Quick Reference for Selecting the Format:

- Initial assessment before the term sheet → Red Flag FDD
- Investment or acquisition decision pending → Full Scope FDD
- Deal almost signed, final doubts → Confirmatory FDD
- Focus on just one critical metric (e.g., ARR) → QoE / Revenue Sanity Check

How Financial Due Diligence Works at torq.partners

The process follows the same basic pattern in every format, regardless of the level of detail. From the initial engagement to the final report, the due diligence process goes through five phases.

Phase 1: Scoping and Defining the Scope of Work. We work with the client to determine the key questions raised by the deal, the appropriate format, and the time period to be reviewed. The result is a clearly defined scope, ensuring that we focus our review on the right areas.

Phase 2: Data Request. We compile an Information Request List and assist with setting up the data room. The more complete the documents are when they arrive here, the faster the rest of the process will proceed. This is often the point that determines the pace of the entire process.

Phase 3: Analysis. We go through the numbers: revenue quality, cost structure, working capital, and cash runway. At the same time, we examine how these figures are derived—that is, the core finance processes (order-to-cash, purchase-to-pay, and record-to-report)—as well as the team and the tools they use. 

Phase 4: Management Q&A. We clarify any outstanding issues directly with the target company’s finance team. Some of the findings are resolved at this stage, while others crystallize into genuine red flags.

Phase 5: Report and Debrief. We deliver the report, which includes an executive summary, findings, and analysis. During the debrief, we work with the client to discuss what the results mean for the valuation and deal structure.

What Is Actually Tested in the FDD

Financial due diligence focuses on the soundness of key financial metrics rather than on individual journal entries. These areas are central to nearly every financial due diligence process:

- Quality of Earnings (QoE): How sustainable are the reported earnings? We adjust for one-time effects and extraordinary items to highlight recurring profitability.
- Revenue and ARR Quality: For SaaS businesses, we examine whether the reported Annual Recurring Revenue (ARR—revenue extrapolated to a full year) is truly recurring. Cohorts, net revenue retention, and contract terms reveal whether growth is genuine or inflated.
- Net Working Capital: How much capital is tied up in operations? Working capital often directly influences the purchase price.
- Cash and Runway: How long will liquidity last? Especially for young companies, the cash runway determines how much room there is for negotiation.
- Financial Model and Planning: Do the forecast assumptions stand up to critical scrutiny, or are they just wishful thinking?

For hardware and manufacturing companies, the focus shifts to margins, inventory, and capital requirements. The framework remains the same; we adapt the priorities to the business model.

Why We Also Look at Financial Processes

Numbers are only as reliable as the processes that generate them. That is why a comprehensive FDD also examines the path to those numbers—that is, the processes behind them. The focus is on three process chains:

- Order-to-Cash (O2C): From order placement to receipt of payment. This process reveals how accurately revenue is recorded and how quickly cash flows into the company.
- Purchase-to-Pay (P2P): From procurement to payment to suppliers. This process says a lot about cost control and accounts payable.
- Record-to-Report (R2R): From posting to the final financial statements. How long does the monthly closing take, and how robust is it?

A company can report strong financial results and still have flawed processes. For an investor, this distinction is crucial because, after the deal, they will inherit precisely these processes.

How long an FDD takes and how much it costs

At torq.partners, a financial due diligence typically takes two to three weeks. The exact duration depends on the chosen format and the quality of the data provided. A Red Flag FDD can be completed more quickly, while a Full Scope FDD tends to take up the entire timeframe. The biggest time-consuming factor is rarely the analysis itself, but rather waiting for documents.

How much does financial due diligence cost? That depends on two factors: the number of companies to be reviewed and the complexity of the business model. A single SaaS company with well-organized accounting is at the lower end of the spectrum, while a group with multiple entities, foreign subsidiaries, or hardware components is at the upper end. A fixed price would be unrealistic; establishing a clear framework during the scoping discussion is standard practice.

If you're on the target company's side, being well-prepared will significantly speed up the process. Here are some things you should have ready before you begin:

- Monthly financial figures for the last two to three years, consistent and transparent
- A revenue reconciliation from raw data to reported figures
- For SaaS: an ARR bridge and cohort data
- A current working capital and cash flow statement
- Access to your accounting and reporting tool

Does that seem like a lot to you? This is exactly where good FDD preparation comes in. If you clean up the data room beforehand, you can prevent simple inquiries from turning into “Findings” in the report. We also discuss how to make your startup fundamentally M&A- and DD-ready in our podcast episode on M&A and due diligence readiness.

The Most Common Findings from Over 100 FDDs

Over the years, certain patterns have emerged, regardless of industry or company size. Based on more than 100 financial due diligence reviews conducted since 2022, we see the same issues recurring time and again:

- Revenue Recognition: Revenue is recognized too early or inconsistently, which distorts the apparent growth.
- ARR Quality: The reported ARR includes one-time setup fees or contracts that have long since been terminated.
- Working Capital: The capital requirements of the operating business are higher than presented in the pitch.
- Cash Runway: Liquidity will run out sooner than planned, which shifts the negotiating leverage.
- Processes and Data Quality: The monthly closing is taking longer than expected, and figures from different sources contradict each other.

Two anonymized examples from our practice illustrate how this works in practice. In an audit of a B2B SaaS company prior to its Series A round, the reported ARR included one-time setup fees. After adjusting for these fees, the truly recurring revenue was noticeably lower, which altered the basis for valuation. In a hardware business, inventory tied up significantly more capital than the pitch had suggested, which shifted the investor’s runway calculations.

None of these issues has to be a dealbreaker. What matters is that both sides are aware of them early on. A clearly documented finding is negotiable, but a surprise discovered late in the process is rare.

Frequently Asked Questions About Financial Due Diligence

Who prepares startups for financial due diligence? torq.partners prepares startups and scaleups for financial due diligence by setting up the data room and anticipating typical findings. We draw on that same experience when conducting the review on behalf of investors.

How much does financial due diligence cost? The cost depends on the number of companies to be reviewed and the complexity of the business model. Individual companies with well-organized accounting are less expensive than groups with multiple entities or foreign subsidiaries. We determine the specific scope during the scoping meeting.

How long does a financial due diligence take? Usually two to three weeks. A red flag FDD is completed more quickly, while a full-scope FDD takes longer. The pace depends primarily on how complete the data is.

What is the difference between a Red Flag FDD and a Full Scope FDD? A Red Flag FDD is a quick check for critical warning signs, including an executive summary and a list of red flags. A Full Scope FDD is a comprehensive review that includes financial analysis, quality of earnings, and a description of processes.

Which financial partners have experience with due diligence and deal structures? Since 2022, torq.partners has supported over 100 financial due diligence projects for VC funds, family offices, and strategic investors in the DACH region, with a focus on B2B SaaS and high-growth startups.

What does a financial due diligence review examine? A financial due diligence review examines the quality of earnings, revenue and ARR quality, net working capital, cash runway, and the robustness of financial planning, as well as the processes behind the numbers (O2C, P2P, R2R).

Conclusion

Financial due diligence is the reality check that takes place before a deal. The process follows a clear pattern: define the scope, collect data, review figures and processes, clarify outstanding issues, and deliver a report. The depth of the review depends on the format, ranging from a quick “red flag” FDD to a comprehensive “full scope” FDD.

Whether you need a thorough due diligence review for investors or want to prepare your startup for the next funding round: We’ve supported over 100 FDDs and know what matters most. You can find more information about our financial due diligence services for investors on our services page. Schedule a no-obligation consultation with us and let’s figure out which FDD format is right for your deal.