Due Diligence: Definition, Types, Importance, and Disadvantages

Definition:

Due diligence is defined as reviewing and audit financial documents, assets, and any other thing under consideration for a particular purpose. Due diligence is usually done in the business world before a company buys another company or enters into some kind of deal with it.

The financial world is riddled with fraud. That is why it is so much important to do due diligence. Due diligence helps the company protects itself from fraudulent companies and deals.

For public companies, due diligence is a given as any deal needs approval from the board. The main reason is that due diligence helps the board makes informed decisions.

For example, Company A wants to buy Company B, but it does not know about the true financial conditions or position of Company B. So it hires somebody to do the due diligence on its behalf.

It comes out that Company B has been lying and it is not in great financial condition. So, the due diligence protected company A from making a very bad decision.

Types of Due Diligences

There are six main types of due diligences based on their classification. The six types of Due Diligences are shown in figure 1.

Figure 1: Type of Due Diligence

These are administrative, human resource, financial, environmental, asset, and taxes. All six types are explained in details below:

Administrative Due Diligence

This type of due diligence is done for administrative resources. These include office space, working facilities, and workspace. The purpose of Administrative due Diligence is to find out the truth about all the facilities listed by the company.

See also  Types of Underwriters: 4 Types with Detail Explanation

 It also helps if the administrative facilities are listed in the financial documents. This also helps in understanding the operational costs of the company and whether these are listed in the financial documents. Some companies hide the operational costs to improve their profit outlook.

Human Resource due diligence

This is one of the most detailed forms of due diligence. It includes a number of things that are analyzed. This is due to the fact that human resource, people, is the most important component of a company. Following are some of the things that are analyzed in the H.R Due diligence.

  1. The analysis of companies total employees, pay scale, retirees, vacancies.
  2. Analyzing bonuses, salary scale, and method of payments.
  3. Employees contracts: non-competes, non-disclosure agreements, non-solicitation. This helps the buyer analyze if there are any legal issues that may be faced by them as they buy the company.
  4. H.R Policies: How the company resolves issues between its employees.
  5. A list of benefits, insurance, and any other Employee Benefits policy.

Financial Due Diligence

This type of due diligence covers the financials of the company. It is one of the most important types of due diligence. It helps in understanding the financial health of the company and whether the company is in great health or bad health.

The financial due diligence helps accurately accessing whether the financial disclosure provided by the company is true or not.

The financial due diligence covers the audited and unaudited receipts, customers’ payment, Capital expenditure, write-downs, schedule of inventory, debts, etc.

The customers’ accounts are also checked in detail. This is a very detailed analysis of a company’s finances.

See also  What Is the Replaceable Value? Definition and Analysis

Environment Due Diligence

Environment due diligence has recently gained extreme importance. This is due to the rise of (Environment, sustainability, and governance) ESG investing. The companies are expected to follow environmentally sustainable production methods.

This type of due diligence is also traditionally important for companies involved in the manufacturing industry such as chemicals, metals, and auto production.

There are strict regulations around these industries enforced by the EPA in the U.S.A. If a company is found to be damaging its environment, it would have to pay fines and in a worst-case scenario, the whole plant may be shut down.

This will cause severe financial distress to the purchaser, so it is always a good idea to perform Environmental due diligence.

Assets Due Diligence

This is, as the name implies, asset evaluation that the company possesses. In this type of due diligence, the notional value of the assets possessed by the company is evaluated.

The assets are real estate, capital equipment, inventory, financial assets such as shares and securities.

The quality of assets is also monitored. For example, capital equipment that is five years old is worth less than capital equipment that has been recently bought by the company.

The Assets due diligence also involves lease agreements for various pieces of equipment, permits, mortgage evaluation, and utility bill.

The assets Due Diligence helps the purchases understand how to value a company and also whether the Assets possessed by the company are of high quality.

Taxes Due Diligence

The taxes due diligence protects the buyer from any sudden surprises. The evaluator learns about the tax liabilities, tax credits, and any other tax-related benefit or issue that may arise in the future or as a result of this purchase.

See also  8 Characteristics & Feature of Financial Intermediaries

It is also important to protect the purchaser from any issues that will arise if the company is under-reporting its taxes.

 The documentation of all taxes is collected and can go as back as five years. This helps match the taxes from different years and helps in evaluating whether the company’s tax liabilities have fallen, risen, or remained the same.

Main Advantages of Due Diligence

There are numerous benefits of carrying out due diligence on a company. Some of the biggest advantages of performing due diligence are:

  • Protection from unhealthy companies and assets.
  • Knowing the true value of a company
  • Protection from any bad surprise after purchase of the company.

Main Disadvantages of Due Diligence

It is always a good practice to do due diligence. There are not any cons associated with Due Diligence.

Conclusion

Due diligence is a great practice that helps to protect the investors. There are many types of due diligence, you should know what type of due diligence suits your needs.

Scroll to Top