Monday, March 21, 2011

Financial Analysis of Suppliers

The financial health of a Supplier is important to any procurement situation. The larger the contract, the more critical the purchase, or the longer term of the agreement, the more important it becomes.  The reasons for that are simple. The better the Supplier’s financial health, the more likely you will be able to reduce cost.  Financially stable Suppliers will provide committed or improved performance, and have predictable deliveries and performance.  You have to invest significantly less time and effort managing the relationship with financially stable suppliers and using stable supplier should need fewer requirements to manage against performance risks. For example, with a Supplier that is financially unstable, as protection you might need to negotiate licenses and escrow in the event the Supplier starts to fail financially.  You might dual source the item which will cost more because volumes are not maximized and because instead of having to manage one Supplier you need to manage two.

The best Suppliers will be profitable and will have sound fiscal management.  By reviewing the Suppliers financial statements it allows you to ask questions or learn information that will also be useful in the negotiation. So like other aspect of prequalification you need to not just look at whether or not they will be qualified but you should also be considering the impact to your cost and be looking for information that you can use in your negotiation. For example a high “days sales in accounts receivable ratio” can mean one of two things: either customers are not paying them on time possibly because they are encountering problems with the product or service or the Supplier is extending longer credit terms to get sales. You should find out why.

To analyze the financial health of a Supplier requires several steps.
  1. Get and review the Suppliers financial statements
  2. Calculate the 14 business ratios* and compare them against the best in their industry and location.
  3. Do a credit check on the Supplier using a company similar to Dunn & Bradstreet.

For financial statements here is what you might request
1.     A fully audited, unqualified financial statement as of the end of the last fiscal year, CPA prepared.
2.     Unaudited interim financial statements
3.     The opinion letter from the CPA.
4.     Balance Sheet
5.     Income statement (P&L)
6.     Notes to the financial statement
Exhibits referred to in the financial statement such as sources and use of funds, any noted change in financial position,  major work in progress may also be helpful

You want the financial statements to be audited. The external auditor
1.     provides safeguards that they were done by a professional CPA,
2.     provide an external view of the company
3.     they will do enough of an audit of the financial statements that were prepared by Company management to determine the fairness of the financial statements as accurately representing the company
4.     will provide a report that is fair and consistent.
The auditors opinion can disclose certain things that may have an impact on the financial stability of the Supplier such as a change in the method of accounting.

If you don’t know your way around financial statements one on the best things to read is a booklet prepared by Merrill Lynch entitled “How To Read a Financial Statement”.  That can be found on-line at:
Most financial statements of publically traded companies can be found on line at the Supplier’s websites. U.S. Corporations also file much more robust financial reports called 10-K’s with the Security Exchange Commission and many of them will post their 10-K’s as part of their financials on their website.

The 14 key ratios look at three things, solvency, efficiency, and profitability. What is considered to be strong ratios will vary based upon the specific commodity being purchased and geographical location of the Supplier. Dunn & Bradstreet annually publishes “Industry Norms and Key Business Ratios” for one hundred and twenty five lines of Business, but you could also compare the rations of the Supplier you are qualifying against the ratios of a strong supplier in the same commodity and geography to see how they rate. For Suppliers located outside of the US you should work with any local finance people you have in those locations as the industry norms may vary from country to country

For training on the 14 Key Business ratios you can go to the Dunn & Bradstreet site where all of the business ratios are explained at:

Here’s a quick summary of the ratios and how you may use them.

  1. The quick ratio (cash and accounts receivable ÷ total current liabilities) show the dollars of liquid assets available to cover current liabilities. A ration of 1 or less means the Supplier has a need for cash.

  1. The current ratio (total current assets ÷ current liabilities) shows how much safety they have in meeting current liabilities. A ratio of one or less means the Supplier has a need for cash.

  1. The current liabilities to net worth ratio ( total current liabilities ÷ net worth) measures the net worth of the company. The small the net worth and the larger the liabilities the greater the risk in dealing with the Supplier.

  1. The current liabilities to inventory ratio ( total current liabilities ÷ inventory) tells how much a company relies on sales of inventory to meet debt. The more they need to sell inventory to meet their debt, the more they should need your business which provides leverage in the negotiation.

  1. The total liabilities to net worth ratio (total liabilities ÷  net worth) is a sign if the indebtedness in comparison to what was invested in the company by its owners. The higher the ratio the less the owners have at risk.

  1. The fixed assets to net worth ration (fixed assets  ÷  net worth) describe how capital intense a Business is. If a Supplier has a lower ratio that the best in class Supplier you would want to understand why. If much of the work outsourced? If their equipment old and depreciated? Do they lease rather than own their property?

  1. The inventory turnover ratio (sales ÷ inventory) shows how quickly inventory is being sold. The worse the ratio means one of two things. Either they have inventory that they need to sell, which provides leverage for the negotiation, or they have significant excess or obsolete inventory that they have not written down.  Find out which.

  1. The assets to sales ratio (Total assets ÷ sales) shows how much in assets were required to generate sales. The higher this ratio the more their price will be heavily influenced by the need to depreciate those assets which are fixed costs.

  1. The sales to net working capital ratio looks at the efficiency of being able to use the working capital (Current Assets less Current Liabilities) to generate sales. ( sales ÷  net working capital).  The more efficient a supplier is in doing this the less likely they may be to rush to discount to make the sale as they may not need the cash to support current liabilities.

  1. The accounts payable to sales ratio (accounts payable ÷ sales) measures how much of the money to generate sales is through suppliers.  If you multiply the ratio by 365 it also provides you with the average number of days the Supplier is paying its suppliers. This can be useful in negotiating payment terms for example its not much of a concession to give you 60 day payment terms if they aren’t paying their Suppliers in 60 or greater days. The ratio can also be an indicator of health of the subcontractor relationships or potential problems with Subcontractors. For any extended periods ask why?

  1. The return on sales or profit margin ratio  (Net profit after taxes ÷ Sales) measure the efficiency of the supplier. It also tell you the average profit margin they have been making for use in negotiating the type of profit margin on your business. Its an anchor against which they would need to justify why they need to make more.

  1. The return on assets ratio (net profit after taxes ÷ total assets) indicates how profitable the supplier is based upon the invested assets.

  1. The return on net worth ratio (Net Profit after taxes ÷ Net worth) shows how profitable a company is based on the money invested into the Supplier

  1. The collection period ratio ( accounts receivable ÷ sales X 365) provides the average number of days before payment is made. A long collection period ratio can mean two things. One is the Supplier is offering extended payment terms or there are problems with customers paying on time which can be a symptom of either their customer base (taking riskier sales to make the sale) or it can be a problem with their product or service where the customer is withholding payment while it is being corrected. Ask why?
·      If they are taking riskier Customers to get business look for better pricing for dealing with you company.
·      If they are provided extended payment terms to other customers look for the same or ask for a discount to pay in shorter periods.
·      If its because of problems, understand what it is and what they are doing to make sure you won’t have the same problem

I can remember doing the ratios with a Construction Contractor that I had been asked to pre-qualify to do some major construction programs for the company I was working for. The one ratio that I found that was completely out of line was their accounts payable to sales ratio.  In looking at that in conjunction with their balance sheet what I found was the Supplier was making significant interest off short term investments with the cash for those investments effectively being funded by the fact that many of their payables to their Subcontractors were significantly aging.  This meant several things. First in any bids to us with this Supplier the subcontractors would most likely inflate their bids knowing the way the Supplier operated to cover the cost of money while they waited to get paid, so it would cost us more. It also meant that with Subcontractors not getting paid on a timely manner, it would create a bigger potential risk of having problems with the Subcontractors looking for ways to be more profitable by either cutting corners or looking for change order to increase their contract value. The practice also would require is to require a payment bond as protection against them not paying the Subcontractor and the Subcontractor filing liens against the facilities. That payment bond would add to the cost of the construction.  My recommendation was to not use the Contractor simply because their scheme to make short term profits off the money they owed the Subcontractors was going to cost us in several ways and create more issues during the construction.  Most Subcontractors in the area liked working for us because in lieu of payment bonds, we required the Suppliers to provide a waiver and release of liens from all Subcontractors for their portion of the prior month’s payment and that process helped ensure that they would get paid on time so they wanted our business. That was also one of the things the Contractor didn’t like about our terms. They had their way of doing business and in the end it wasn’t compatible with the way we wanted to do business.

One of the most common problems with performing financial analysis of Suppliers is when they are privately held and are simply unwilling to disclose their financials.  When faced with that my approach has been to offer them three choices – 1. They can disclose under confidentiality agreement. 2. We will provide them with certain ratios that we need them to have their Certified Public Accountant certify that they are better than all of the individual ratios provided. 3. We will either not source from them or will give them very limited business and we can’t verify the risk.

The credit check that would be done with a Company like Dunn & Bradstreet is the last step in the process. Fully audited financials statements are only done once a year and there can be significant changes that have occurred since the last statement. So what a D&B report does is capture the current payment performance history of companies as that can be a key indicator of a problem. For example a Supplier whose payment history has significantly gone past due or well past due can be a sign of problems. Just like with the ratios, if you see this occurring always ask why. There could be an acceptable reason for it, like having a force majeure or strike that impacted cash flow, or it could be a sign of the lack of orders and revenue to meet current liabilities.

Want to learn more? The companion book "Negotiating Procurement Contracts - The Knowledge to Negotiate" is now available on

"Flow-downs” and “back to back” contracts

A flow-down clause is a requirement placed on Seller by the Buyer that obligates Seller to include certain language in their agreements with their Suppliers for the goods or services they procure in support of sale to the Buyer. Flow downs are commonly used in Government contracting where the Government requires a supplier or contractor to place the same or similar obligations on their subcontractors that will be performing work as part of that activity or project. Flow downs are also be used in commercial contracting where the goal of the flow down is to ensure that all obligations that the Supplier assumes with their customer are passed down to their subcontractors and suppliers.

A slightly different form of flow downs is referred to as “back to back” contract. In a back-to-back contract situation the agreements are linked so that all liability, obligations, and rights incurred by the Seller in their agreement with the Customer are mirrored in Seller’s agreement with their suppliers and subcontractors.

A slightly different form of back to back term exists in most confidentiality agreements in which the recipient is given the right to disclose the information to a third party. Those type of flow-downs would require that the recipient enter into a separate confidentiality agreement with the third party where the third party agrees to assume the same duty of confidentiality equal to the recipient before the recipient can divulge information to the third party.

Suppliers may, as part of there agreements with Buyers require flow downs to the Buyer’s end customer for a product or service or, terms within the agreement could require the Buyer to include certain terms in their Customer agreement to flow down the requirement as protection. For example, if a Buyer agreed to indemnify a Supplier if their product was sold in high-risk applications, the Buyer may want a similar term in their agreement with their Customer.

The goal of both flow-down and back-to-back approaches is to ensure that there is no gap in contract coverage between the commitments that the Seller makes to the Customer and what the Seller gets from their Suppliers or Subcontractors thereby reducing the risk. If you fail to do that, you can have uncovered costs and risks that you are responsible to cover with your Customer. That either requires you to carry contingencies (which may make you non-competitive) or it will cut into your profits or cause you to lose money on the contract if a problem occurs.  Flow-down and back-to-back approaches do not eliminate the risk. There is always the risk if the Buyer is unable to recover damages or costs from their Supplier or Subcontractor. A good example of that is when the Supplier doesn’t have sufficient assets to cover the damages or costs.

If a Customer has specified a specific supplier that that they want you to use and you are unable to negotiate complete flow down or back-to-back provisions with that supplier always highlight that to the Project team. If they were prepared for that situation in the sales terms they may have included what is called a “nominated subcontractor” provision that excuses certain liability for customer specified suppliers. If they didn’t they will need to either carry a contingency or get the Customer to accept the risk.