Due Diligence

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Due diligence entails the process of a detailed and sufficient research before taking any decision or action to make sure the risks are minimal. Diligence is an important working trait that requires being extra vigilant, cautious, and well-acquainted so that mistakes can be avoided.

Definition:

“Due Diligence involves taking all the necessary steps and conducting a comprehensive research to reduce the risks when making an uninformed decision.”

More particularly, due diligence is often also defined as,

“A detailed thorough appraisal of an entity or a business conducted by a potential buyer, specifically to take over its assets and liabilities or to estimate its commercial value.”

Simply put, due diligence is the precaution that must be exercised before any action is taken. It is the investigation, audit, or review that must be performed to validate the facts.

At an organizational level, these actions usually refer to the decisions taken by the top management. It is the necessary investigation or care expected from a business or a prudent person before a substantial decision is taken.

Examples:

  1. Before buying a property, it is important to visit it and inspect it yourself. Take note of the site and the environment around it. Also, analyze the market rates and the trend of the real estate industry to reach a better negotiation with the seller. Taking all these steps is ‘Due Diligence’.
  2. Checking your bank account, e-statements, all the inflows and outflows from your bank account regularly ensures that no unusual activity has taken place. Performing this exercise is Due Diligence.
  3. Before you order yourself a product from Amazon, carefully read its product description, understand its features and compare them to the features of other similar brands. Also, read the consumer reviews to have a better idea of the product performance. Conducting all these steps before product purchase entails Due Diligence.

Understanding Due Diligence:

Due Diligence emerged as a common practice and an important element in the USA with the evolution of the Securities Act 1993. This law demanded all the security dealers and brokers to fully disclose all the relevant and material information about the instruments they were trading. As per this law, any failure to disclose this information or negligence triggered a serious criminal prosecution against the responsible person.

Soon it was realized that this requirement by law left the brokers and the dealers unfairly prosecuted for non-disclosure of the information that did not have or could not have fetched. Therefore, the act came up with a legal defense; due diligence. 

After this change of law, all the dealers and brokers who exercised ‘due diligence’ during the investigation of the instruments, stocks, equities, or securities that they were trading, couldn’t be held liable for the non-disclosure of any other information not discovered and eventually disclosed.

Kinds of Due Diligence:

Due Diligence can be and should be performed by every person in his every decision. However, within the corporate world, due diligence is ought to be exercised by the following:

  • Companies planning to acquire or merge with other companies. 
  • Fund managers and equity research analysts must base their decisions on a diligent research.
  • Individual investors are not obliged by law to conduct a thorough investigation for all of their trading; however, they might voluntarily want to exercise due diligence. 
  • Brokers and dealers, however, are legally obliged to conduct a thorough research and investigation for any instrument before dealing with it.

Due Diligence – Steps to be taken:

Following are some of the most important research procedures that must be adopted before investing in any instrument.

Most of these steps are best suited to the trading of stocks. However, these can also be applied when trading other kinds of instruments; bonds, securities, real estate, etc.

All the information that is needed is mostly readily available through the company’s quarterly, semi-annual and annual financial statements, on discount brokerage portals and other financial new websites. To keep diligence intact all the research must be conducted through the publicly available data. However, the confidentiality of any information should never be hurt without the owner’s consent.

  1. Study the Company’s Capitalization:

Before any kind of investment in a company, it is important to study the nature of its capitalization. Companies can be financed by their owners or they can borrow money from creditors. The leverage ratio of a company; what portion of the company’s capital is financed by debt and what by the owners, is very important.

The company’s capitalization indicates the volatility of the stock price, the grandeur of the business, and the potential size of a company’s business. All this true information can help the investors to make better decisions.

‘Large-cap’ and ‘Mega-cap’ companies have a stable revenue stream and a large investor base with diverse investors. This helps to keep the stock price maintained. On the contrary, ‘Small-cap’ and ‘Mid-cap’ companies undergo a higher instability in their share prices and revenue streams.

  1. Revenue Trends:

The next most important thing to analyze is the revenue trends. The profit and loss statements of a company show the company’s revenues and other expenses. Before investing in any company, it is important to analyze the trends in their revenue, operating, and other expenses.

Comparing the profit margins of a company over the period and also with other competitors within the same industry is a good way to exercise due diligence.

  1. Industry Competitors:

The performance of a company can be very well gauged when compared with the performance of other competitors in the market. It is important to analyze the profit margins of two or three competitors of the potential investment company. Is the company a market leader or is it growing?

Due Diligence involves conducting research not only on the target company but also on its competitors. This provides an enormous insight into the subject company and the industry’s performance.

  1. Valuation Metrics:

Financial ratios are an excellent way to gauge a company’s performance in comparison to others and also over the years. These ratios fetch the key figures from the financial statements of the company which are then used to evaluate the company’s performance.

Some very important financial ratios include:

  • Earnings per share:

Earnings per share is the portion of a company’s profit allocated to each share. This shows how much is the company roughly earning against each share’s investment. EPS is sometimes also known as the proxy of the company’s financial health.

A higher EPS means that a company earns enough profits to pay out its shareholders more. Therefore, a higher EPS means a better company performance. EPS is calculated by dividing the net income of a company by the number of outstanding shares.

  • Price-Earnings to Growth Ratio:

The Price to Earnings Growth Ratio indicates the expectations of the investors regarding the earnings of the company in the future. These earnings are then compared with the current earnings. A company’s whose PEG ratio is almost one (<1) is considered as fairly valued.

  • Debt to Equity Ratio:

The debt to equity ratio is the metric of a company’s financial leverage. It is calculated by dividing a company’s debt to its shareholders capital. This shows how much a company is financed by debt and how much by the owners.

Debt-financing is not bad; however, a highly leveraged (debt-financed) company has fewer opportunities to borrow more funds in case of need. Also, it must be liquid enough to pay off its debts in time.

  • Liquidity Ratio:

This ratio depicts the ability of a company to finance its needs using cash. This ratio is primarily important to make sure the company remains solvent. A higher liquidity ratio represents a higher capability of the company to run its operations and pays off its short-term obligations.

  1. Balance Sheet:

The balance sheet of a company shows its assets, liabilities, and the available cash. If these figures have fluctuated substantially over the period, then this must be critically analyzed.

The company might be going through a financial crisis, it might have business expansion plans in the future, or it might be planning for business restructuring. Scrutinizing the footnotes and other disclosures along with the financial statements can provide the investor with a deep insight into the company’s affairs.

Mergers & Takeovers:

The concept of due diligence has a massive application when it comes to mergers and takeovers. Acquiring another company, subsidiary or a unit even requires a lot of research, analysis, forecasting, and diligence. Generally, it involves gathering all the necessary information about a company before the merger or takeover.

The objective of such due diligence exercise is to gather all the necessary information regarding a target company including its financial performance, financial position, affairs, and other prospects. Such detailed research must acquaint the merging company of the following,

  • Determine if the merger or takeover is desirable i.e. would it benefit the company.
  • If that is the case, whether the offered cost and all other direct expenses are reasonable enough.
  • The insights i.e. strengths and weaknesses of the merging company and how to deal with them.

The Merger & Acquisition exercise involves the following two kinds of ‘Due Diligence’:

Hard Due Diligence:

In a conventional merger or acquisition, the acquiring firm recruits risk analysts and other professionals who perform due diligence by analyzing the costs, revenues, structures, benefits, assets, and liabilities of the potential entity to be acquired. This exercise is known as hard due diligence.

During a merger, takeover or acquisition, hard due diligence is all about lawyers, negotiators, professional valuers, and accountants. It mainly focuses on earnings, interest, taxes, profit before tax, receivables, liquidity etc.

Examples:

Some hard due diligence activities include:

  • Scrutinization and audit of the financial statements
  • Future performance projection
  • Customer market analysis
  • Third part relationship analysis
  • Review of potential earning opportunities

Soft Due Diligence:

Hard due diligence involves the use of mathematics and logistics which can sometimes be susceptible to manipulation and window dressing. When numbers are manipulated or exaggerated, soft due diligence comes in for the counterbalance.

There are many other drivers of business performance that cannot be entirely captured by numbers. For example, the internal organizational culture, employee relationships, corporate culture, leadership etc.

The study of a company’s culture, employee relationships, management, and other human elements is known as Soft Due diligence. Soft due diligence is not a science; it only focuses on how well a new workforce can integrate with the existing culture of the acquiring entity.

Below are some of the ways how soft due diligence can be performed:

  • Gauge the employee motivation and skills
  • Employee Compensation Packages
  • Assess if new incentive plans are successfully implemented
  • Evaluate the organizational culture of an entity

Conclusion:

  • Due Diligence refers to audit, investigation, or research of any matter before taking any decision, under any given circumstances.
  • Due Diligence must be enacted by any rational or prudent person in all kinds of situations and before taking any kind of decision.
  • It has a massive application in investment decisions (investing in stocks, bonds, securities of any kind of instrument) and mergers and acquisitions (merging of two companies or the acquisition of one company by another).
  • Brokers and dealers are obliged by law to conduct thorough research and perform due diligence, whereas individuals can perform due diligence voluntarily.
  • Some important steps that must be taken to ensure due diligence before investing in stocks and other instruments include analyzing a company’s capitalization, revenue trends, industry competitors, financial statements, and other valuation metrics and financial ratios.
  • Within Mergers and acquisitions, performing due diligence is essential as well as legally required. The Due Diligence required for M&A is a delineation between soft and hard due diligence – both the company statistics and human element needs to be evaluated.