Due diligence – What is due diligence?
Due diligence is an investigation that should be carried out before finalising important business decisions.
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Due diligence is usually associated with large-scale investments, the restructuring of a company, or mergers and acquisitions (M&A).
The aim of due diligence is to check the valuation of assets and liabilities, assess the risks within a business, and identify areas for further investigation; this enables an investor or purchaser to make informed investment decisions.
What does the due diligence process involve?
Due diligence is an extensive process that covers many aspects of a business – from financial statements and accounting records, to key staff members and contracts. The aspects of a company covered by due diligence usually fall within five broad areas: finances, commercial performance, legal compliance, operations, and environmental impact.
As there are no official guidelines for what must be covered by the due diligence process, it is usually tailored to each specific transaction. Some types of due diligence are more important in some industries than in others, and the length, depth, and scope of the investigation usually depends on:
- The nature of the transaction
- The purchasing or investing company’s needs and interests
- The perceived level of risk.
Financial due diligence
Financial due diligence is perhaps the most common and well-known form of due diligence; it involves an analysis of financial data, including historical statutory accounts, performance forecasts, outstanding debts, and any funding requirements.
Commercial due diligence
Before a company makes a purchase or investment, it needs to fully understand the target company’s current and projected commercial performance.
Commercial due diligence helps an investor assess whether a target company is commercially viable; it addresses factors such as competitor analysis, EBIT projections, the target company’s reputation, market conditions, and customer satisfaction.
Operational due diligence
A target company’s daily operations could indicate whether it would be a good match for a merger, or whether its proposed business plan is achievable. The day-to-day running of a business can therefore be a major concern for potential investors or buyers, and is investigated through operational due diligence.
Operational due diligence covers area such as staffing levels, the performance of senior management, pension plans, human resource activities, or insurance policies held by the target company.
Legal due diligence
Legal due diligence involves identifying and analysing potential legal risks associated with the target company. This could include legal ownership of assets, any legal claims made against the target company, or unsettled employment disputes.
Data protection is also covered by the legal due diligence process. With the roll out of GDPR, investors will want to thoroughly understand how a target company stores and processes data.
Environmental due diligence
Recent trends in corporate social responsibility, ethical trading, and sustainability have driven an increased focus on the environment. Environmental due diligence might include checking the target company’s carbon footprint, emissions, and compliance with industry environmental standards.
Environmental due diligence is particularly relevant if a company’s activity could create environmental risks or hazards. It is also more common in industries with tightly controlled environmental regulations.
What’s the difference between due diligence and an audit?
Although there is some overlap between audits and due diligence, the concepts are quite different in terms of:
- Objectives: an audit assesses whether a company’s financial statements provide a fair overview of its financial performance, whereas due diligence is designed to inform potential investors before finalising important business decisions.
- Scope: an audit typically covers financial reports at the end of an accounting year; although due diligence also involves the checking and analysing of financial statements, it addresses many other areas of a business. The information provided by an audit might be used within due diligence, but it is only one small part of its scope.
- Who is involved: audits are usually carried out by professional auditors or accountants – although an accountant with expertise in M&A might be involved with due diligence, it is usually carried out by specialist consultancy organisations, representatives from the purchasing or investing company, or even by staff within the target business.
- Cost: the cost of an audit is relatively fixed compared to the cost of due diligence. This is because the scope of due diligence can vary quite drastically, which results in a significant variation in cost.