Red-flag reports: the 5 issues we look for first.
Our FDD practice, in detail.
1. Why the first 5 days matter.
The deal economics turn on a small number of findings. In the first week of a buy-side FDD, before the detailed work-streams begin, the team runs five quick checks that have historically produced the most material findings. If any of the five surfaces an issue, the rest of the diligence is shaped around it. If all five come up clean, the team can focus on the deeper, sector-specific work without the foundational concerns.
2. Revenue recognition cut-off.
The most common source of EBITDA distortion in a deal year is revenue cut-off at year-end or LTM-end. Indicators we test for in week 1:
- Last-week sales spike. Compare the last week of the period to the average weekly sales of the prior 11 weeks. A spike of 2x or more invites investigation.
- Bill-and-hold transactions. Sales invoiced where the goods are still in the seller's warehouse. Confirm the transfer-of-control criteria are met.
- Long-term contracts. Revenue recognised on percentage-of-completion without independent verification of the underlying progress measure.
- Advance recognition on annual licences. Licences sold late in the year with full revenue recognised upfront rather than ratably.
- Bonus invoices to channel partners. Sell-in to distributors without sell-through verification, with channel inventory levels at unusual highs.
Where any of these are present, the QoE typically includes a revenue normalisation adjustment.
3. Related-party leakage.
Related-party transactions are a structural feature of many promoter-led businesses and are not in themselves a problem. Leakage occurs when RPTs are at non-market terms, are not approved through the proper governance, or are not disclosed transparently. We test for:
- RPT volume vs disclosure. Map all transactions with directors, KMP, their relatives and group entities. Compare the total to the related-party disclosure in the financials.
- Pricing benchmarks. For RPT purchases and sales, compare against arm's-length benchmarks. Discounts or premiums beyond market are flagged.
- Approval evidence. Section 188 of the Companies Act, 2013 requires audit-committee approval for RPTs above the threshold. Verify minutes and resolutions for each transaction.
- Recurring RPT services with intangible deliverables. Management fees, consulting fees, royalties between group entities are scrutinised for substance.
4. Capex vs opex classification.
Aggressive capitalisation inflates EBITDA by moving costs above the line. Conservative capitalisation does the opposite. In an FDD context, we test for misclassification in either direction, with particular attention to:
- Repairs and maintenance. Items capitalised as "improvements" that look like routine maintenance. Conversely, large overhauls expensed as repairs.
- Software costs. Implementation, customisation and configuration costs split between capitalised application development and expensed training / support.
- Inventory of consumables. Items capitalised as fixed assets that are economically consumables (small tools, low-value items with short lives).
- Allocations of overheads. Allocation of indirect costs to projects under construction, inflating capitalised cost and pre-operative expenses.
5. Unprovided contingent liabilities.
Contingent liabilities sit below the line. They can be the largest debt-like items in the deal. We catch up:
- Income-tax disputes. Status of pending assessments, CIT(A) and ITAT appeals. Probability assessment with reference to legal opinions where available.
- Indirect-tax disputes. GST, customs duty, service tax legacy matters at any stage.
- Labour litigation. Industrial disputes, wrongful termination claims, PF / ESI exposures.
- Customer / supplier disputes. Pending arbitration, contractual claims.
- Environmental and regulatory penalties. Notices from pollution-control boards, factory inspectors, drug regulators.
- Bank guarantees and performance bonds. Issued to third parties.
For each, the FDD assesses probability and quantum, and places the probability-weighted exposure in the debt-like items schedule.
6. Working-capital window-dressing.
Sellers naturally manage working capital tightly in the months before a sale. The FDD looks for indications of unsustainable contraction:
- Receivables push. An unusual collection drive in the LTM-end months, with receivables at multi-year lows.
- Payables stretch. Payment terms extended beyond historical patterns, with vendor complaints picking up.
- Inventory reduction. Pre-sale inventory clearance below operating minimums; risk of stock-outs post-closing.
- Capex deferral. Capex spending pushed out past the closing date to inflate cash and reduce debt.
Where any of these appear, the working-capital target is adjusted upward and the buyer is protected from inheriting the contracted position.
Frequently asked
How long does the first-5-days red flag exercise take?
It runs alongside the data-foundation work in week 1 of the FDD. By end of week 1, the team has a preliminary view on each of the five reds and can shape the remaining work-streams accordingly. A full red-flag report is finalised in week 4 alongside the FDD report.
What if there are no red flags?
Genuinely clean targets exist and the FDD should say so. A 'no major reds' finding is itself a useful signal to the acquirer and informs the SPA's reps and warranties (a clean diligence supports tighter reps; an issue-laden diligence usually leads to broader indemnities).
Are the five reds the same across sectors?
The structure is the same; the specifics adapt to the sector. For services companies, revenue cut-off and pro-forma assumptions are higher priority. For manufacturers, inventory and capex classification matter more. For PE-backed targets, working-capital window-dressing gets extra scrutiny.
Does the FDD also look for fraud?
FDD is not a forensic exercise and does not opine on fraud, but it surfaces indicators that warrant forensic follow-up (unusual vendor concentrations, round-number patterns, transactions at limits of authority, sudden changes in management). Where indicators appear, the FDD scope is sometimes extended to a focused forensic review.
How is the red-flag report different from the main FDD report?
The red-flag report is short (10 to 20 pages), ordered by severity, and focused on issues that change the deal. The main FDD report is the full document with QoE, working capital, net debt, detailed findings and supporting analysis. The red-flag report is typically read first by the deal team and the main FDD by the wider acquirer organisation.
