Due diligence is not the process of understanding a company. It is the process of determining whether the company’s own understanding of itself is true.
Management presents revenue, margins, growth, cash flow and projections. The data room contains financial statements, contracts, tax returns and operational records. The management presentation is polished, internally consistent and supported by a well-constructed financial model.
The question is not whether the presentation is compelling. It is whether the numbers survive independent verification.
In Northrop Management Private Limited’s due diligence practice, every engagement begins with a principle that governs the entire methodology: trust should be an output of testing, not an input. We do not start by believing management’s numbers and looking for reasons to doubt them. We start by doubting them and look for evidence to believe them. The difference in starting position produces a fundamentally different diligence outcome.
The Seven Tests are a structured validation framework applied to every significant financial claim in the target company’s reporting. Each test addresses a specific dimension of financial integrity. Together, they determine whether the reported performance represents sustainable economic reality or a curated version of it.
Test 1: Quality of Earnings
The most consequential test in any diligence engagement. Reported profit is decomposed into its components: recurring operating earnings, non-recurring items, accounting-policy effects and below-the-line adjustments.
What we test: Revenue quality (recurring vs one-time, independent vs related-party, contracted vs unconfirmed). Cost normalisation (add back one-off costs, remove one-off benefits, adjust for accounting-policy choices that flatter the P&L). Margin sustainability (are current margins the product of operational capability or of temporary conditions that will not persist post-close?).
What we look for: One-off revenue that inflates the current period (asset sales, insurance recoveries, contract termination payments). One-off cost savings that suppress the current period’s true operating cost (deferred maintenance, reduced R&D, unfilled vacancies). Accounting choices that improve reported profit without improving economic performance (useful-life extensions, capitalisation of operating costs, provision releases).
The output: Sustainable EBITDA: the earnings the business can be expected to generate in a normalised year, stripped of everything that flatters or distorts the reported figure. The gap between reported EBITDA and sustainable EBITDA is the quality-of-earnings adjustment, and it directly affects the purchase price.
Test 2: Cash Verification
Cash is the layer where accounting claims meet economic reality. Revenue recognised in the P&L can be tested against cash received in the bank. Costs recorded in the P&L can be tested against payments disbursed. Profit claimed in the income statement can be tested against the cash flow statement and, ultimately, against bank balances.
What we test: Reconciliation of reported revenue to GST returns, to bank receipts, to customer confirmations. Reconciliation of reported operating profit to operating cash flow, adjusting for working-capital movements, non-cash items and timing differences.
What we look for: Revenue recognised in the P&L that has not been collected in cash (growing receivables without commercial explanation). Profit that consistently exceeds cash flow (the P&L reports earnings that the bank account does not reflect). Cash movements that do not correspond to reported transactions (payments to entities not in the vendor master, receipts from parties not in the customer list).
The output: Cash conversion analysis: what percentage of reported profit actually converts to cash, and is the conversion rate improving, stable or deteriorating?
Test 3: Working Capital Normalisation
Working capital is the dimension where buyers are most frequently surprised post-close. The closing-date working capital may be materially different from the working capital the business actually requires to operate normally across a full cycle.
What we test: Trailing 12-month average working capital versus the closing-date position. Receivable ageing and collectability by counterparty. Inventory composition (active vs slow-moving vs obsolete) and realisable value. Payable sustainability (are current terms achievable post-close, or were they temporarily extended for the transaction?). Customer advances and their delivery obligations.
What we look for: Closing-date compression (receivables collected aggressively, inventory drawn down, payables stretched in the weeks before closing). Overdue receivables included in the “current” category without adequate provision. Inventory at cost that exceeds realisable value. One-off working-capital improvements (factoring, unusual advances, supplier concessions) that will not repeat.
The output: Normalised net working capital: the amount the business requires in steady state. The gap between normalised and closing-date working capital is the working-capital trap, and it directly affects how much cash the buyer actually inherits.
Test 4: Accounting Policy Assessment
Two companies with identical economics can report materially different financial results based on their accounting-policy choices. The due diligence must identify which policies the target has adopted, where those policies sit within the range of acceptable treatments and how the choice affects the reported numbers.
What we test: Revenue recognition (timing, method, treatment of variable consideration). Capitalisation (what is capitalised vs expensed, and how does it compare to industry practice?). Depreciation (useful lives, methods, recent changes). Provisioning (expected credit losses, warranties, litigation, restructuring). Lease treatment. Consolidation scope.
What we look for: Policies at the aggressive end of the acceptable range (longer useful lives than peers, lower provision rates than history supports, revenue recognition earlier than delivery). Recent policy changes that improved reported results (useful-life extensions, capitalisation of previously expensed items, provision methodology changes). Policies that differ from the buyer’s own policies (which will require harmonisation post-close, with potential P&L impact).
The output: Accounting-policy adjustment: the financial impact of restating the target’s results under a neutral or conservative policy set. This adjustment reveals how much of the reported performance is operational and how much is presentational.
Test 5: Concentration Analysis
Revenue, customer, supplier, geographic and product concentration are dimensions that directly affect enterprise value even when the P&L looks healthy.
What we test: Customer concentration (top 1, 5, 10 by revenue contribution). Supplier concentration (top 1, 3, 5 by procurement value). Geographic concentration (revenue by state or country). Product concentration (revenue by product line or service category). Key-person concentration (which individuals hold which critical relationships, knowledge or capabilities).
What we look for: Any single customer above 15% of revenue. Any three customers above 40%. Any single supplier providing more than 50% of a critical input. Any geography contributing more than 60% of revenue. Any product line contributing more than 50%. Any individual whose departure would disrupt operations, client relationships or regulatory standing.
The output: Concentration discount: the reduction in enterprise value attributable to the fragility of the earnings base. The discount is applied to the valuation, whether the seller acknowledges it or not, because it reflects the risk that the reported earnings are contingent on dependencies the company does not control.
Test 6: Debt and Capital Structure Assessment
The target’s debt position affects the buyer’s post-close capital structure, covenant obligations, refinancing requirements and financial flexibility.
What we test: Total debt (including off-balance-sheet obligations, guarantees, leases and deferred consideration). Debt maturity profile. Covenant headroom. Change-of-control provisions. Refinancing requirements. Cost of debt versus market rates.
What we look for: Debt classified as non-current that is economically current (covenant breach risk, bullet maturities within 18 months, working-capital facilities that may not be renewed post-close). Change-of-control provisions that accelerate debt repayment upon acquisition. Guarantees extended to group entities that transfer the group’s credit risk to the target. Off-balance-sheet obligations (operating leases under old standards, uncommitted facilities, informal guarantees).
The output: Adjusted net debt: the total financial obligations the buyer inherits, including those not visible on the balance sheet.
Test 7: Contingent Liability and Off-Balance-Sheet Assessment
The final test examines the obligations that the financial statements disclose but do not recognise, and the obligations that may not be disclosed at all.
What we test: Contingent liabilities (litigation, tax disputes, regulatory proceedings, warranty claims, environmental obligations). Related-party arrangements (loans, guarantees, trading relationships, shared assets). Pending assessments (tax, regulatory, labour). Contractual commitments (minimum purchase obligations, exclusivity arrangements, penalty clauses).
What we look for: Contingent liabilities that are classified as “possible” (not recognised on the balance sheet) but that the evidence suggests are “probable” (should be recognised). Related-party arrangements that transfer value or risk to or from the target. Pending tax assessments where the exposure significantly exceeds the provision. Contractual commitments that constrain the buyer’s post-close flexibility.
The output: Adjusted contingent exposure: a risk-weighted estimate of the obligations that the balance sheet does not reflect but that the buyer may ultimately bear.
The Northrop Integration
In Northrop Management Private Limited’s due diligence practice, the Seven Tests are applied sequentially but evaluated as an integrated assessment. The findings from each test inform the others: a quality-of-earnings adjustment may reveal an accounting-policy issue, which may connect to a working-capital manipulation, which may trace to a concentration dependency.
The integrated output is a single document that answers the buyer’s fundamental question: what is this business actually worth, net of everything the management presentation did not say?
Ashish Chaudhary, frames the diligence discipline directly: “Trust should be an output of testing, not an input. We do not start by believing management’s numbers and looking for reasons to doubt them. We start with evidence and determine what the evidence supports. The difference produces a diligence outcome that protects the buyer from the surprises that management’s presentation was not designed to reveal.”
Questions for the Boardroom
- For our most recent acquisition, did we apply all seven tests, or did we focus primarily on earnings and debt?
- What was the gap between reported EBITDA and sustainable EBITDA after quality-of-earnings adjustment?
- Did our working-capital analysis use the trailing 12-month average or the closing-date balance?
- Did we assess the target’s accounting policies against our own policies and quantify the harmonisation impact?
- What contingent liabilities or off-balance-sheet obligations surfaced during diligence that were not disclosed in the management presentation?
Closing Implication
The Seven Tests do not assume that management is dishonest. They assume that management’s presentation is curated, that accounting choices are directional, that working capital is manageable, that concentrations are de-emphasised, that debt is optimistically classified and that contingencies are conservatively disclosed. Each assumption is tested against evidence. Where the evidence confirms, trust is earned. Where it does not, the adjustment protects the buyer.
A diligence process that applies all seven tests will not prevent every bad acquisition. But it will ensure that the buyer enters the transaction knowing what they are buying, at what price and with what risks, rather than discovering those facts in the months after close.
