It’s a proactive assessment or detailed feasibility study of the potential investment opportunity. The due diligence needs to consider financial and operational aspects to avoid any possible surprises. In other words, it’s an evaluation of the deal’s commercial potential to ensure an informed decision is made, considering the strengths/weaknesses of the investment to be made.

Due diligence can be viewed as review, investigation, audit, analysis, feasibility, and understanding to ensure that a potential deal or investment has merits to be considered.

Expectations from due diligence

Following are the expected outcomes of the due diligence practice.

1. Risk assessment—The due diligence report is expected to explain the potential risk of the investment decision. The risk assessment needs to be made in terms of business operations, business strength, market competence, unique selling points, financial challenges, regulatory compliance, product positioning, and so on. The prime purpose of this section is to communicate the level of risk exposure the investment opportunity is expected to bring.  
2. Evaluate your existing compatibility—This is about evaluating your existing competence/resources with the potential investment. This due diligence area is expected to evaluate your ability/competence in terms of executing operations and fulfilling customer demands/expectations. It helps to understand if you are equipped with the resources required to tackle coming challenges because of the new expansion/investment.
3. Identify concealed business strength—Sometimes, selling businesses are window-dressed in terms of inflated revenue/profit and undue support from related parties. The due diligence exercise is expected to identify sources/related parties providing undue support. For instance, there may be interest-free borrowing available for the business the investor is considering acquiring.  
4. Understand expansion—The idea is to determine whether expansion is related to or unrelated to current business operations. In the case of unrelated expansion, due consideration needs to be made to mitigate the risk because of lack of experience.
5. Analyze numbers and financial statements as a whole—Financial analysis involves analyzing balance movement, fluctuation, ratios, trends, and seasonal variations. Unjustified balance movement may reflect financial performance better than reality. Hence, risky financial spots must be identified and considered in financial risk assessment.
6. Avoid surprises—A detailed due diligence report is expected to provide a detailed risk assessment. The assessment needs to include finance, operations, and compliance. Hence, a good due diligence report helps avoid potential surprises after investing.  

It’s important to note that due diligence is not limited to business expansion but includes any investment. Let’s examine situations requiring due diligence practice.

Examples of due diligence

Following are some situations where due diligence can be a good idea.

1. Buying equipment– Perform due diligence in terms of production output and financial impact of equipment addition.
2. Buying the new business– Consider business potential regarding earning potential and expected synergy.
3. Investing in the information system – Assess for expected results to implement the information system.
4. Securing the loan: Review the loan terms, such as interest, payment terms, applicable covenants, mortgages, and other terms and conditions.
5. Acquiring intellectual property- Understand cost structure, expected benefits, and related aspects of the acquisition.

Due diligence standard process

Following is the standard approach to conduct due diligence.

1. Define engagement goals for due diligence—The first step is to define the expected diligence outcome. For instance, risk assessment and feasibility study can be goals of diligence engagement.  
2. Allocate responsibilities—Different sections of the report can be allocated to different staff. However, the work can be allocated in any appropriate manner.
3. Ensure appropriate documentation– The diligence documentation needs to be comprehensive, adequate, sorted, and to the point.  
4. Assess risk management– A complete section needs to reflect risky investment areas. In other words, challenging aspects related to business and finance controls are identified and mitigated.
5. Report on the due diligence—The due diligence report needs to be concise, summarized, highly relevant, to the point, and add significant value to the investing decision.

Types of due diligence

The following are the main types of due diligence.

Financial due diligence refers to the assessment/examination of financial transactions, balances, numbers, analysis, trending, and overall movement. It includes but is not limited to ratio analysis, trend analysis, competition analysis, market size, market share, competition, and financial challenges related to numbers and movement.

Operational due diligence—Operational diligence is about evaluating operational efficiency and effectiveness. This diligence can include synergy, compatibility, competence, resources, and overall operational business aspects.

Legal due diligence—Legal due diligence refers to the minimum standard of compliance required to continue the business. The compliance benchmark/checklist is extracted via regulatory requirements. All checks in the list need to be marked to ensure satisfactory operations and data management.

Tax due diligence refers to taxation compliance. The checklist for this is extracted from tax regulation. This compliance is mandatory to ensure that risk-related potential penalties are appropriately mitigated.

Compliance due diligence—Compliance diligence is a general term. The compliance benchmark can be extracted using any applicable regulatory framework. For instance, compliance with a company’s internal policies, regulatory mechanisms, industrial norms/regulations, and any other applicable regulations can be assessed via diligence.

Conclusion

Due diligence refers to the proactive assessment/examination of facts and figures related to a potential investment opportunity. It’s about understanding the financial, operational, and technical aspects of the investment decision.

The expectations from due diligence include but are not limited to, risk assessment, evaluation of existing resources/compatibility, identification of concealed business strengths, understanding of expansion, and appropriate explanation in terms of investment decision.

Examples of investment situations requiring due diligence include buying equipment, starting a business, implementing an information system, and acquiring intellectual properties.

There are different types of due diligence, such as financial due diligence, operational due diligence, legal due diligence, tax due diligence, and compliance due diligence etc.