Understand the importance of Due Diligence?
Due diligence is a deep and careful check of a business before making a big decision. It helps to find any hidden risks or problems before you buy, invest, or form a partnership.
Think of it like buying a second-hand car. You wouldn’t just take the seller’s word that it’s in great condition. You would check the engine, test-drive it, and look at its service history. Due diligence does the same for businesses—it helps you know exactly what you’re getting into.
Why is Due Diligence Important?
Without due diligence, you could end up with a bad deal, legal trouble, or big financial losses. Here’s why it matters:
1. Prevents Costly Mistakes
Sometimes a business looks successful on the outside but has problems beneath the surface.
A company might be losing money, have big debts, or be involved in legal trouble, which you might not see unless you check properly.
Due diligence helps you avoid buying a business that looks good but is actually in trouble.
Example: Imagine buying a restaurant, but after the purchase, you find out the rent is going up, and suppliers haven’t been paid. If you had done due diligence, you would have known this before buying.
2. Gives You Power in Negotiations
When buying a business, you want to pay a fair price. Due diligence helps you check if the price matches the actual value.
If you find risks, you can use that information to negotiate a lower price or ask the seller to fix the issues before selling.
If you’re selling a business, doing due diligence in advance helps you fix any problems before buyers find them. This makes your business more attractive to buyers.
Example: A company is selling a clothing store for R1 000 000. Due diligence reveals that the store owes R200 000 to suppliers. As a buyer, you can now negotiate a lower price or ask the seller to settle the debt first.
3. Ensures Legal Compliance
Many businesses have contracts, licenses, and legal agreements that must be followed.
If a business isn’t following the law, the new owner might be responsible for fines or lawsuits.
Checking legal documents protects you from future legal trouble.
Example: A trucking company for sale claims to have all necessary transport permits. Due diligence reveals that some permits have expired. If you buy the business without knowing this, you could face fines or even be forced to stop operations.
4. Verifies Financial Health
A company’s financial statements tell the true story of its profits, losses, and debts.
Due diligence checks that the numbers are real and accurate, not just what the seller wants you to see.
It also checks cash flow (how much money is coming in and going out) to ensure the business can keep running smoothly.
Example: A bakery claims to make R50 000 profit per month, but financial due diligence shows that the real profit is only R10 000 after expenses. Without checking, you might have overpaid for the business.
Types of Due Diligence
There are three main types of due diligence, and each one helps in a different way.
1. Financial Due Diligence
What it does: Checks the company’s income, expenses, debts, and taxes.
Why it’s important: It confirms if the company is really making money or if there are hidden financial problems.
What it looks at:
Profit and loss statements (to see if the business is making a profit).
Bank statements (to check cash flow).
Debts and loans (to see if the company owes money).
Tax records (to make sure all taxes are paid).
Example: A gym is for sale. Financial due diligence finds that many customers have unpaid memberships, which means the gym is actually losing money.
2. Legal Due Diligence
What it does: Checks all contracts, agreements, licenses, and legal risks.
Why it’s important: It protects you from lawsuits, fines, or broken contracts.
What it looks at:
Contracts with suppliers, landlords, and customers (to see if they are fair).
Business registration and ownership documents (to confirm the seller is the real owner).
Lawsuits or legal disputes (to check if the company is being sued).
Licenses and permits (to make sure the business is legally allowed to operate).
Example: A hotel is being sold, but legal due diligence reveals that it is involved in a court case with a supplier. Without checking, the buyer would have been responsible for the legal battle.
3. Operational Due Diligence
What it does: Examines how the company runs daily, including employees, suppliers, and processes.
Why it’s important: A business might look successful but have serious operational problems.
What it looks at:
Suppliers and inventory (to check if supplies are reliable).
Staff and management (to see if employees are well-trained and staying with the company).
Technology and equipment (to ensure systems are modern and working properly).
Customer satisfaction (to find out if customers are happy or leaving for competitors).
Example: A delivery company is being sold. Due diligence finds that half of the delivery vans are old and need expensive repairs. This would increase future costs for the buyer.
What Happens if You Skip Due Diligence?
Skipping due diligence can be a disaster. Here are some real dangers:
1. Overpaying for a Business
If you don’t check financials, you might pay too much for a company that isn’t making real profits.
Some sellers inflate profits by hiding costs or debts.
Example: A small coffee shop is sold for R 2 000 000, but the buyer later finds out it actually makes almost no profit. If they had done due diligence, they could have offered a lower price or avoided the deal.
2. Discovering Hidden Debts
Some businesses have unpaid loans, unpaid supplier bills, or even tax debts.
If you buy a business without checking, you could inherit those debts and have to pay them yourself.
Example: A furniture store is sold, but the buyer later learns it owes R150 000 in unpaid supplier invoices. Now, the new owner must find the money to pay.
3. Legal Trouble
A business might have illegal contracts, unpaid employee wages, or government fines.
Without checking, you could end up in court or facing penalties.
Example: A warehouse is sold, but later, the new owner is fined for not having a fire safety permit. Due diligence would have caught this issue before the purchase.
4. Operational Failures
A company might have bad suppliers, unhappy customers, or broken equipment.
Without checking, you might end up with a failing business.
Example: A taxi company is sold, but the buyer later finds out most of the cars are in bad condition. Fixing them costs more than the price of the business itself.
Final Thoughts
Due diligence is a must before making any big business decision. Whether you are buying, selling, or investing, checking financial, legal, and operational details can save you from expensive mistakes.
Access the Introduction to Business Valuations and Due Diligence CPD here.
🔎 Unlock the Power of Business Valuations & Due Diligence 📊
Are you confident in assessing the value of a business? Do you know the key risks to look out for before a sale, merger, or investment?
Join CIBA’s exclusive webinar on from 21 January 2025 onwards and gain the skills to:
✅ Understand business valuation methods and when to use them
✅ Perform effective due diligence to identify risks and opportunities
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📅 Date: Available from 21 January 2025
💡 Earn 2 CPD Units | Category: Financial Reporting and Operator
Presenter: Leana van der Merwe – A seasoned expert with 18+ years in accounting and corporate governance.
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