I think your flow chart is pretty good. It basically, in my mind, boils down to how much you're willing to risk damaging the engine by running to determine the problem. Thinking about it, here's what I would do:
1. Pull the valve cover. Check for damaged and/or loose parts, etc. The valve springs compress very easily compared to what you'll be used to on a car engine, I discovered. Apparently that's normal. But I'd pull the rocker arms one at a time and check for bent pushrods and stuff. If nothing shows up, put the cover back on, even fingertight, so you don't spray oil all over the engine bay and shop floor.
2. Activate the compression release, then wire it open, and crank it over. While this is happening, you should be able to (since you wired the release open and have a spare hand) test the hydraulics. If you get any activity at all then you know that's good. Meanwhile, listen/feel for heavy clunking or whatever. Piston slap is higher pitched than bearing knock.
(By doing it this way, you don't have to run the engine at all, and it's not seeing any compression, hopefully minimizing any damage to the cylinders and/or the lower end.)
3. At this point decide if you want to risk running it or not. I would, but that doesn't mean it's a good idea. From my perspective, if I have to tear into the internals of the engine, I'm going to replace all the worn or near lower-limit parts anyway.
Option A: Fire it up, then check for blowby. After you know it will start, I would shut it down, then remove one of the injector lines, and try it again. If it won't start, put it back on, and move to the next one, and so forth. When I did mine, I just removed the line altogether where it attaches to the injector. I ran it into a small bottle so I wouldn't spill any fuel and make a mess. Easiest, but involves running the engine the most.
Option B: Pull the exhaust manifold. Insert ear plugs (My YM240 wasn't that much louder, but it's really noisy anyway). Fire it up, see which cylinder blows smoke, and what color it is, check for blowby, etc. It may not blow unusual smoke at all, or very little. You may end up having to loosen the injector lines anyway to isolate the dead cylinder. It will depend on what else you find.
If it's a broken ring or piston, there should be compression passing into the crankcase, and significant blowby should be evident. If blowby is minimal, then it's not passing compression, and the trouble is elsewhere. The good news is that likely means there isn't anything wrong with major components, just the fuel system.
For peace of mind, if you want, try pulling the pan and wiggling the rods and main bearings. I've never even seen a 1610D, so have no clue how tough that would be; it's going to be easier than on a car though! A bearing alone shouldn't give you smoking.
You may have to pull the head. Has the motor ever seen ether? With the head off, you can see if a valve is chipped, piston cracked, or rings broken/missing. I expect, though, that you'll have a good indication before you have to get to that point, of what the issue(s) is(are).
They do make compression testers for these. They replace the injectors and are bolted down with the retaining hardware as the injector would be. You can't hold them by hand pressure: Compression PSI on these is several times more than a regular gasoline engine. If it's bleeding past the rings or piston, I think it should be obvious. Compression testing may be viable, if you can get the parts. Hoye sells and rents them here:
Yanmar tractor tools
Good luck with it; I hope you're able to figure things out. Keep us in the loop.
