What is Due Diligence?

“Due diligence” is a term that has been used since at least the 15thcentury and came into broader usage with the passage of the United States’ Securities Act of 1933.

A section of the act known as the “Due Diligence” defense held that as long as broker-dealers exercised due diligence when investigating businesses, and revealed their findings to potential investors, that they wouldn’t be held liable for failing to disclose a material fact they didn’t know at the time of the sale of an equity.  

The term quickly grew in popularity and became a standard practice among broker-dealers handling stocks. Today, the term has grown to mean the research and analysis of an investment or company conducted in advance of a transaction. This process typically involves research into the investment or company and a review of financial records, among other strategies.  

Why is Due Diligence Important?

Due diligence is important for an investor to avoid an unexpected outcome in his or her investment that may have been avoided with a more thorough investigation into the various factors controlling an investment’s future.

Generally, an individual investor will undergo the due diligence process by studying Securities and Exchange Commission (SEC) filings, reviewing annual reports and other information about a business. The purpose is to determine whether the investment is a good match for the investors’ anticipated returns, income needs and risk tolerance.

By taking these steps, an investor can find out how well the company is performing financially, how volatile it is from an economic standpoint, its value and the best time to make the purchase. 

Due Diligence Tips for Chinese Investors

Weighing the pros and cons of an investment via the due diligence process is an important and necessary step in today’s marketplace, especially for foreign investors. Coincidentally, there is a growing need for Chinese investors to gain a better understanding of due diligence methods for U.S. investments, as the amount of Chinese investment in the U.S. is at unparalleled levels.

In making a logical and rational decision, the following due diligence tips will help you gain the necessary information you need to vet a potential investment.

Revenues and Profits

For businesses, one of the first things to examine is the revenue, profit and margin trends. Both Yahoo! Finance and Google Finance offer net income and finance trends over the last two years, along with quarterly and annual reports. In addition, a check of the price-to-earnings (P/E) ratio and the price-to-sales (P/S) ratio will reveal if revenue growth is steady or haphazard.

Management

It’s also a good idea to examine the management of the company. In particular, are the founders still running the business, or has the board brought in new blood to oversee the operation? Generally, more involvement by the company’s founding members is considered advantageous because they have a greater stake in the success of the business. It’s also important to review the bios of top management on the company’s website or through SEC filings. A simple Google Search can reveal quite a bit, and records regarding bankruptcies, previous businesses and similar information are available via a search of court records, legal statements and business information.

Competitors

While investigating a potential investment in a company, it’s important to take a close look at the competitors and how the business fares in the overall industry. Compare the profit margins of several competitors. This type of information can be gleaned from company profiles found on most major research websites.

The Business Plan

Another key document is the business plan. A review of this report provides an opportunity to spot red flags, but it’s important to keep in mind that businesses often tend to be overly-optimistic in these documents. Nevertheless, the business plan offers good background about a business, and is useful in drafting questions to ask if you decide to take a tour of the business or investment property.

Take a Tour

You can only learn so much combing through financial and other documents. Often, the best way to learn about a potential investment or company is to take a tour. A tour of a seller’s facility or investment property can give the potential buyer a broader picture about the condition of the property. A tour also provides an opportunity to ask managers and employees questions—gleaning valuable information seldom available in various documents.

Conclusion

By taking these steps, potential investors should have enough information to make an educated decision about a potential investment. If you’re having trouble reaching that point, it may be advisable to hire a licensed financial professional to aid in continued due diligence that may help alleviate any apprehensions.

In the event things should go south, does the business have a plan in place to address this contingency? What steps has the company taken to prevent this worst-case scenario? Finally, is the company’s business model evergreen? What are its financial prospects over the next three, five or even 10 years?

As you do your due diligence, inevitably other questions will arise, but these guidelines should provide a roadmap for the journey ahead.

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