What is Due Diligence?

By Michael Thorburn

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Due diligence refers to the examination of financial records prior to entering into a proposed transaction with another party.

In wider terms, due diligence is the act of performing a review or audit for the purpose of confirming facts or details of a matter under consideration.

How due diligence works

The practice of conducting due diligence became commonplace in the US with the passing of the Securities Act of 1933. The passing of this law meant securities dealers and brokers were responsible for disclosing full material information about the instruments they were selling. Failure to do so could leave them liable for criminal prosecution.

Investors can conduct due diligence on any stock by using available public information to help minimise risk from investment decisions. Thorough due diligence involves analyzing a company’s financial records to compare them over specified periods of time and benchmarking them against similar companies.

There are ten steps investors can take to conduct thorough due diligence, these are:

Make more informed investment decisions

Undertaking thorough due diligence can help investors make better informed investment decisions. It provides a clearer overview of not only the company but the industry as a whole, to determine whether it is a sound investment opportunity.

Mitigate risk

While it is impossible to entirely remove all risks, due diligence can go a long way to mitigating risks. It can help investors understand any risks associated with the company or the industry before they decide to invest.

Drawbacks of due diligence

Can be complex

For investors new to the world of investments, conducting due diligence can be complex. Understanding how to read a balance sheet or analyze financial reports can take a special set of skills.

Investors may miss opportunities

Performing due diligence can be time-consuming, especially if you are not experienced in doing it. Taking time to do due diligence can lead investors to miss out on opportunities that require a quick decision.

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Author: Michael Thorburn

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.