Income statements. These show the operating health of the
company. Revenues indicate how much wealth the company is
taking in over a period. Expenses show the cost of generating
those revenues and how the assets are being consumed to run
the business. Higher revenue growth versus expense growth,
particularly compared to industry averages, is a good sign.
Industry averages. Collect financial statistics for your supplier’s
industry to allow comparison. These should be the same
statistics you are creating below for comparability.
USING THE DATA
Use the balance sheet and income statement to calculate a
few basic statistics and ratios. The following will provide a good
Profitability. Compare the profitability of the company (net
after-tax income divided by net sales revenue). If the supplier is
profitable relative to its peers, it is a good indicator that assets are
well used, meeting industry norms for performance.
Return on equity (ROE). Divide net after-tax income by net
equity. Compare this to the industry average and to the last
three years of ROE for the company. ROE is a proxy for how
well management is using the resources of the company — the
better ROE relative to the industry, the more likely management is
Working capital. Working capital is found by subtracting current
liabilities from current assets. Working capital is an indicator of the
ability to make payments on time. If a supplier has positive working
capital, it can pay its bills. Generally, a company should have at
least three months of working capital to cover its monthly bills.
If the failure of the supplier won’t harm your organization’s
immediate health, consider using just these three statistics,
reviewing them annually. If a supplier shows signs of declining
financial health, reassess the risk level and potentially find another
supply partner that is more stable.
If, however, the supplier is important to your business operations
and its failure would affect current operations, consider looking at
Free cash flow. Subtract capital expenditures for the year from
cash flow from operations for the year. This indicates how much
free cash the supplier has for investment and other purposes.
If this is negative, it could limit growth or the supplier’s ability to
respond to emergencies.
Debt-to-equity ratio. Divide total liability by owner’s equity. This
statistic will indicate the supplier’s reliance on creditors. If the ratio
appears high (for instance, if the ratio is more than 20 percent
higher than the industry average), check on the terms of the debt.
Discuss with the supplier how it plans to pay its debt over the
term of your contract.
Credit agency rating. Check the rating from Moody’s or another
rating agency. While not a guarantee of health, a credit agency
rating is a good indicator of the supplier’s ability to raise money
as required to respond to customer needs.
Audit findings. When your organization is highly dependent
upon a supplier for certain goods and services, it’s important
to obtain — and read — an audit of the supplier’s performance
completed by an independent auditor. If the supplier is a private
company, you may need to request an audit. If the supplier
pushes back, this could be a red flag, and you may need
to rethink your supply solution. The audit report should be
unqualified. Read the notes to find any issues, such as off-balance-sheet liabilities and outstanding legal concerns.
Interview with the supplier’s CFO. If the supplier is critical
to your supply chain, hire a specialized financial analyst and
consider interviewing the supplier’s CFO. The more critical the
supplier is, the more you need to know about the supplier’s
health and operating future. Any warning signs don’t necessarily
mean something’s wrong, only that the team should investigate
further to determine the nature of the risk. Call upon supply
management’s business insight to make the final contracting
Analyzing the right financial data and hiring experts when
necessary enables supply management to guide the creation
of financial risk insight as a part of assessing the future role of
a supplier. ISM
James T. Pearson, MPP, CDPM, is an instructor with the Procurement
Training Institute, which is part of the Office of Contracting and Procurement
within the government of the District of Columbia.