Due Diligence

What is a Due Diligence Report of a Company?

Due Diligence is a process of risk assessment and analysis of an impending business transaction. The findings of the process are summarized in a report known as the Due Diligence Report of a company. The purpose of Due Diligence report is to understand the risks or the red flags in an investment and determine the conditions in which an investment can be undertaken. Due Diligence report helps in ascertaining the state of affairs of the business which further helps in determining the future performance of the business. Due Diligence is conducted either by a company’s internal due diligence team or by an external team hired by the company to conduct due Diligence on their behalf.

What is Due Diligence?

Due Diligence in general terms means a pre-investment review. It is something which is performed by every person almost every day. It is a part of normal human behaviour. Before buying a product or investing amount into something, every person analyzes the risks, estimates and benefits involved in it. Similarly, every company performs due Diligence before undertaking any business transaction to assess and analyze the risk involved in it. The kind of business transactions for which due Diligence is conducted are Mergers & Acquisitions, Amalgamation, Takeovers, Joint Ventures and De-mergers.

 Due Diligence involves the exchange, review and appraisal of confidential, legal and financial information by the parties involved in the proposed business transaction prior to undertaking the transaction. In the statutes, if it is stated that Due Diligence is mandatory then it should be conducted. For e.g. transactions such as Initial Public Offers, Takeover and buybacks which require mandatory due Diligence. In cases which do not require mandatory conduct of due Diligence, the company may skip due Diligence. This makes Due Diligence optional for companies. However, companies prefer to conduct Due Diligence even if it is not prescribed in the statutes. As it provides insights into the company’s financial health & credibility and operational status of the company.

The main intention of performing due Diligence is to make investment decision by comprehending the risks associated and favourable conditions available for the investment to proceed. Experts in the field are hired to gather information and records of the target business with whom the transaction is proposed to be made. On the basis of all the information gathered, a Due Diligence Report is prepared. The report provides for a SWOT Analysis^[1]. The Strengths and Opportunities help in deciding whether or not to undertake the transaction and the Weaknesses and Threats help in improving the bargaining power of the company. The Due Diligence report also helps bridge the gap between the existing status and the expected status of the target business. Due Diligence report helps the executive team take a well informed decision and arrive at the the conditions under which the investment can be made. Basically, a due diligence report is the end product of the due diligence process. The due diligence report contains a compilation of various types of due Diligence conducted by the investor company.

Types of Due Diligence

1. Financial Due Diligence

Financial Due Diligence analyzes all the financial records, standing operations and market estimates. Accounting and audit practices along with the tax compliances of a company are analyzed.

• Legal Due Diligence

Legal Due Diligence analyzes the legal aspects of the transaction and verifies whether all regulatory compliance have been undertaken. Both inter-corporate and intra-corporate transactions are covered. This includes assessing whether there is any pending litigation and ensuring that there is no irregularity in their intellectual property rights.

• Business Due Diligence

Business Due Diligence analyzes the profile of parties  involved in the transaction, the business structure and other business aspects like the company’s market share, its competitive position, growth and future prospects. It also reviews the background of key managerial personnel to ensure integrity.

Contents of a Due Diligence Report

The contents of a Due Diligence Report may vary from company to company. However, it mainly consists of the following:

1. Brief about the business into consideration.
2. Profile of promoters and key managerial personnel of the business.
3. Business Profile which consists of the projects, operations and industries in which the business is involved.
4. Financial Performance of the business determined on the basis of the financial records, profitability, and the cost structure.
5. Legal Background of the company determined on the basis of pending litigation, intellectual property holding, compliance of all regulatory and legal requirements.
6. Strength, Weakness, Opportunity and Threat involved in the proposed business transaction.
7. Key Findings.

Benefits

The following are the benefits of Due Diligence Report:

1. It provides a summary of all the significant aspects of the business under consideration.
2. It shows the genuineness of the business under consideration.
3. It helps the company to get a clear picture of the way forward after undertaking the business transaction.
4.  The investing company gains confidence that the business concern is financially capable and its corporate governance process is well defined.
5. As the due diligence report provides an in-depth analysis of the daily functioning of the business and internal controls, it becomes easy to understand the operational efficiency of the business.
6.  It protects the company from loss or significant misfortune by making a wrong investment.

Limitations of Due Diligence Report

Following are the limitations of Due Diligence Report:

1. Due Diligence Report only provides a superficial view of the business concern. The risk of business not succeeding still remains.
2. Due Diligence Report fails to provide a view on the competency of the workforce and the work culture. Only an idea can be formed based on the performance of the business in consideration.

Due Diligence and Audit: The Confusion, The Similarity and The Differences

Sometimes due Diligence is confused with audit and assurance however, both are completely different concepts. The ground on which the confusion arises is that both due Diligence, as well as audit and assurance, involve checking and inspection of financial records. However, due Diligence is a completely separate concept where not just the financial records but other legal and business records are also inspected. Due Diligence is an occasional event which is only undertaken by a company when it is thinking of investing in another business whereas audit is a recurring event which takes place after the expiry of every financial year. Where Due Diligence is the pre-mortem analysis or future analysis, Audit is a post-mortem analysis. Both historical events, as well as future events, are considered while conducting due Diligence. However, only historical events are considered in an Audit. The purpose of due Diligence is to identify the risks or the red flags before finalizing the transaction; however, the purpose of an audit is to provide a true and fair view of the financial statements. Thus, making Due Diligence and Audit similar yet different concept altogether.

Conclusion

From the above discussion, it is clear that the term Due Diligence may apply to many situations, but it is mainly used for business transactions. It is as significant as the proposed business transaction itself. It is used to minimize risk, take informed decisions and make a business transaction workable. 

Also Read: Legal Due Diligence – Everything You Need to Know