Mergers and Acquisitions: Why Due Diligence is More Important Today Than Ever

The Croatian mergers and acquisitions (M&A) market has experienced strong momentum in recent years. The number of transactions is growing at double-digit rates – from acquisitions of promising technology companies to consolidation in the tourism and manufacturing sectors. According to a recent report, in 2024, more than 1200 M&A transactions were recorded in Central and Southeast Europe, reaching the highest level of activity since 2018. In this regional context, Croatia stands out both in volume and dynamics, with over 90 completed transactions in 2024, making it one of the most active M&A markets in the region. Domestic companies are increasingly seeking growth opportunities through acquisitions – whether by purchasing competitors, entering new market segments, or partnering with investors who bring capital and management expertise.

This surge is part of a broader trend in Central and Southeast Europe, where investors are looking for stable markets with consolidation potential. Despite geopolitical and inflationary challenges, the market shows resilience, and a key change is that the real cost of capital is rising, meaning that investment decisions are made with greater caution and a need for more detailed checks. However, in such an environment, every mistake has financial consequences. Buying a company with a blindfold on – without a detailed insight into its true state – can turn into an expensive guessing game. Therefore, due diligence (due diligence) is not a mere formality, but a crucial basis for understanding what is truly being purchased and with what risks. Thorough due diligence enables informed decision-making and prevents inheriting someone else’s problem with the acquisition, instead of creating new value. In practice, the quality of the due diligence report is often a decisive factor for the continuation of negotiations.

Financial Check: Behind the Numbers

Although due diligence is often simplified as a review of financial statements, its purpose is much broader and deeper. The goal is to comprehensively understand how a company creates value, how sustainable that value is, and what factors affect it in the long term. Well-conducted due diligence provides a complete insight into the target company – from finance and taxes to market and operations, as well as technology and regulatory compliance. Financial due diligence analyzes key financial aspects in detail: the quality of revenue and profit, profitability by segments, cost structure, investments, working capital status, and indebtedness.

However, the numbers in the balance sheet and income statement alone are not enough; it is crucial to understand the story behind the numbers. Questions such as: Which products or markets generate the largest share of revenue? What are the margins and trends? Is the growth organic or a result of acquisitions? Does the company have hidden debts or off-balance-sheet obligations (e.g., guarantees, lawsuits, loans to related parties)? Financial due diligence attempts to uncover such elements to ensure that the picture of the business is realistic and not embellished. This analysis ensures that the buyer bases their valuation on real, not inflated data.

Tax Check: Is There a Burden?

Tax due diligence is conducted concurrently with financial due diligence. Tax documentation and history are reviewed to identify potential tax exposures or irregularities. It is checked whether all obligations to the state have been settled, whether there are open tax audits or disputes, and whether the company complies with tax regulations (e.g., transfer pricing within the group, VAT records, etc.). Tax findings can also influence the decision on whether the acquisition will be conducted as an asset deal instead of a share deal, in order to avoid inheriting historical tax burdens.

Commercial Check: Market Analysis

Commercial due diligence focuses on the market position and strategy of the target company. The size and growth of the market, market share, trends in customer habits, competitive environment, and potential threats (e.g., entry of new competitors) are analyzed. This is crucial for assessing the sustainability of revenue – the buyer must know whether they are entering a growing sector or a declining one and whether the target company has a competitive advantage (e.g., a recognizable brand, patent, more efficient distribution) that will allow it to maintain market share. Without quality commercial due diligence, financial forecasts are unfounded. Due diligence is a multidisciplinary process that brings together financial experts, tax advisors, lawyers, IT, and security experts.

Quality of Earnings: Sustainability of Profit

The concept of quality of earnings (quality of earnings – QoE) is crucial for distinguishing repeatable and sustainable earnings (EBITDA or operating profit) from those that are temporary, one-off, or the result of creative accounting treatment. QoE analysis answers the question of whether the financial statements reflect the actual, enduring earnings of the company or are currently embellished by one-off effects.

Examples of items that can inflate profits without reflecting a permanent improvement in business include: one-off asset sales, government subsidies and incentives, and extraordinary gains. On the other hand, there may also be hidden costs that are deferred or unrecorded – for example, deferred maintenance of equipment (which reduces current costs but will require greater investments later) or excessive ownership costs that are not reflected through creative accounting. QoE analysis normalizes EBITDA by removing those items that are reasonably expected not to recur or that are not part of regular operations. This leads to a realistic, sustainable level of earnings on which valuation can be based. Without such analysis, the buyer risks overpaying for the company, paying for profitability that will not be repeatable after the acquisition.

The Real Picture of Liquidity

Working capital is the lifeblood of daily operations. A thorough understanding of working capital movements is crucial to gain the right picture of liquidity and operational needs. Due diligence analyzes seasonality, trends, and working capital management policies to identify anomalies. The buyer may inherit a company that immediately needs additional cash if the seller artificially reduced working capital before the transaction – accelerated receivables collection, delayed payments to suppliers, and reduced inventory. The buyer thus inherits a situation where they must invest fresh money in the first weeks: pay old obligations and replenish inventory.

To prevent this, contracts define the target level of working capital (target working capital). On the closing date (closing), working capital is recalculated. If the actual working capital is less than the target, the purchase price is reduced (in favor of the buyer), and if it is higher, the price is increased (in favor of the seller). This mechanism protects both parties and ensures that the buyer receives a ‘normally’ functioning company. Careful determination of what to include in the definition of working capital and identifying seasonal fluctuations is necessary.

Net Debt: Detailed Check

The concept of net debt is crucial because, in M&A transactions, the equity value is usually adjusted for the amount of net debt. Net debt is defined as the total financial debt of the company minus cash and cash equivalents. According to standard M&A practice, the seller retains cash and assumes the obligation to repay financial debt. The due diligence team thoroughly checks all components of net debt: long-term and short-term loans, leases, promissory notes, and potential off-balance-sheet obligations. It is essential to precisely define what is considered debt for the purposes of the transaction.

Sometimes, non-functional items, such as unpaid VAT or restructuring costs, are temporarily treated as debt (debt-like items) to reflect them in the final price paid by the buyer. The analysis ensures that the value of the company is adequately reduced by the amount of assumed financial obligations, thus preventing overpayment for the target. The acquisition agreement is the culmination of the due diligence process, a document that ensures that risks are managed and not left to chance.

Condition for a Good Purchase and Sale

The Croatian M&A market is maturing – investors are becoming increasingly demanding and expect high standards in every aspect of the transaction. The quality of due diligence is becoming a key differentiator between deals that create value and those that create problems. Timely and detailed analysis of the sustainability of the business model ensures long-term success of the acquisition. Well-conducted due diligence is not there to ‘kill’ the transaction, but to ensure that it achieves its goal. It enables understanding of the entire business model and the real picture of risks and potential of the company. Every unchecked corner can hide a cost that erases the profit of the acquisition.

Therefore, investing in thorough due diligence pays off multiple times: whether due to a better price, more favorable contractual terms, or simply a more peaceful sleep for management and owners. In an environment of rising capital costs, reducing risk through due diligence is not only desirable but financially necessary. Proper due diligence enables risk management, not its inheritance. In a time when the pace of business is faster and there is less room for error, this philosophy is the foundation of responsible and sustainable acquisition. One should enter an acquisition with eyes wide open, armed with facts, checks, and analyses, aware of both risks and opportunities.

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