What is Financial Due Diligence, and Why Does it Matter?
July 1, 2015 Leave a comment
In an era where people trust banks and other financial institutions less and less, the importance of due diligence is higher than ever before. But what is due diligence, exactly? And how are financial institutions incorporating it?
“Due diligence” can mean a lot of different things, depending on the industry, but at its core, it means understanding the risks and rewards involved in investing in a company. Due diligence can answer important questions and make the whole investment process go much more smoothly. Big name investment companies such as J.C. Flowers & Co. and A&M make their names in large part based on the due diligence they’re able to provide customers.
According to Investopedia, there are ten different kinds of due diligence that should be taken into account when investing in a new company:
- Total value or market capitalization. Is the company’s revenue stream diverse? Traditionally, the bigger the company is, the more avenues it has for making money. With more options for making a profit, a company is less likely to be volatile, which makes it a good investment.
- Gross revenue, margins, and return on equity trends. Some investors require the companies they work with to have a combined equity and profit margin of 50 or greater.
- Is the company considered a leader in its industry? Is the field growing or shrinking? These are important factors to keep in mind when choosing investments.
- Investors in equities measure price-to-earnings ratios and price-to-earnings growth ratios. Investors in real estate often look at how expensive it would be to replace a company’s building compared to the value of the entire property.
- Quality of management. How is the company’s management doing? Are they good leaders with a proven track record? How many of the company’s outstanding shares are owned by institutions and mutual funds, and is that number increasing or decreasing?
- Balance sheet. Can the company generate enough income to pay its debts? Is it on the NYSE or NASDAQ? Obviously, the more money a company produces, the more likely it’s a solid investment.
- Supply and demand. What was the price of the asset three months ago? Six months ago? One year ago? Does it seem likely to go up or down?
- Could the company have a second offering on the table in the future? Are any contracts coming up on expiration? Are there new markets the business could enter?
- Future expectations. This is particularly important for publicly traded companies. What does Wall Street say about the company’s future? What trends are likely to take off in terms of price and interest rates?
- Here’s the big one. What is the worst thing that could happen with this company, and how likely is it? What would investor losses look like? When investing, it’s vital to prepare ahead of time for potential losses.
Experienced teams with a solid background in their industry can offer great investment opportunities, especially if they are willing to provide thorough due diligence to their customers.