The term due diligence, from a financial aspect, refers to the process of investigating and analyzing records and facets of an entity before any transaction or agreement takes place between another entity.
How Does Due Diligence Work?
The term and practice of undertaking due diligence has been around for close to 100 years. The Securities Act of 1993 in the US implemented a requirement whereby all brokers have to disclose pertinent information relating to the security being sold. The act states that any individual or entity that does not provide transparent information is accountable and can be punished by law. (1)Govinfo.gov."Securities Act of 1933."
This law might well have led to a number of sellers of companies coming under fire due to a small financial oversight which could not have been known as the time of a sale. For this reason, the act states that any entity that does its “due diligence” when assessing the company of the underlying security, will not be held liable. Since then, due diligence has become an important activity which is conducted by a number of individuals.
These include the likes of hedge fund managers, brokers, analysts tasked with doing financial research, investors themselves, and entire companies that are looking to buy another entity. If you, as a retail trader or professional investor, wish to do due diligence, you are more than welcome to. However, it is not mandatory as is the case with brokers who are looking to sell the underlying financial asset.
Due Diligence FAQs
Below, our experts have run through a number of frequently asked questions pertaining to due diligence in the financial sense.
What does due diligence mean?
Due diligence refers to an activity which is undertaken to assess any financial information pertaining to a company before any sort of tangible decision is made. Simply, it’s been put in place so that entities can assess the risks involved with the sale of securities or even the purchase of a company.
This includes looking at various financial ratios, annual statements, and performance indicators. Moreover, it also includes using these stats to compare and contrast the performance against competitors in the market so as to identify the viability of the asset or company moving forward.
Why does due diligence exist?
Due diligence exists so as to remove the element of risk as much as possible. It also enables all parties involved to be fully-aware of the details, and potential downsides, of an agreement or transaction before it takes place. In terms of online trading, a broker provides any potential trader with a report outlining the due diligence findings so that the broker is in the clear and the trader fully-informed.
Is there a criteria for due diligence oversight?
Yes, those who do due diligence follow an organized guideline. This outlines exactly which aspects need to be assessed; including the operational procedures and policies, the various department performances and ethos, the financial assets and overall ownership, as well as the actual financial ratios which speak to the financial viability of the company in question.
Different Types of Due Diligence in 2023
There are a number of different forms of due diligence:
Legal: This includes making sure that a company meets all legal requirements while being compliant and ensuring regulatory procedures are upheld. Legal due diligence includes assessing whether the company followed the correct corporation to the intellectual property rights, and more.
Commercial: This assessment looks at a company’s market share and analyzes the financial viability of the company – past and future performance included. Commercial due diligence can include analyzing everything from the various company departments to the contribution and focus of R&D and the relationships of customers and suppliers.
Tax: This includes assessing the tax obligations of the company and whether there are any tax burdens. Due diligence in this area also assesses how the company can reduce its tax obligations moving forward.
Financial: Due diligence which includes a comprehensive assessment of a company’s financial records to ensure all is above board and that there are no skeletons in the closet – so to speak.
Mergers and Acquisitions Due Diligence
Any company that wishes to acquire another will certainly do its due diligence and this is known as M&A due diligence. Although due diligence looks at the past performance of a company, it also assesses the potential future growth of a company. Companies that wish to acquire another are well within their rights to conduct in-depth research and analysis.
Conventionally-speaking, this type of due diligence has focused on the financial state of a company while assessing the risk and getting to know more about existing assets and liabilities that will affect the acquisition decision-making process. Interestingly, in recent years this due diligence has evolved to include less tangible assessments of the company culture and management.
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