Financial Tools for Supplier Risk Assessment

To ensure that our suppliers are financially healthy we need to keep checking up some of the financial areas of the supplier.

It’s essential to conduct financial assessments on selected suppliers that make up the largest portion of our spends, usually the top 20%, and/or strategic high-risk suppliers, due to management costs and risk.

Liquidity Ratios, Profitability Ratios and Inventory Ratios helps us to understand the associated risk with the supplier.

Liquidity Ratios

It determine a debtor’s ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Current Ratio

Current Asset / Current Liabilities

The Current Ratio is a liquidity ratio that measures a supplier’s ability to pay short-term and long-term obligations to their suppliers (your Tier IIs). If our suppliers can’t pay their suppliers consistently over time, we could experience supply disruption delays/stoppages.

Quick Ratio / Acid Test Ratio

(Cash & cash equivalents + marketable securities + accounts receivable) / Current Liabilities OR (Current Asset – Inventory – Prepaid Expenses) / Current Liabilities

The Quick Ratio measures a supplier’s ability to meet its short-term obligations with its most liquid assets, usually cash. Suppliers need to maintain healthy cash levels in the short term to ensure timely payment of their suppliers.

Days Sales Outstanding (DSO)

Average accounts receivable / Revenue per day

Days sales outstanding, or DSO, refers to the average number of days it takes a company to collect payment after it makes a sale. A high DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated on a quarterly or annual basis:

Profitability ratios

Generally fall into two categories—margin ratios and return ratios.

Margin ratios give insight, from several different angles, on a company’s ability to turn sales into a profit. Return ratios offer several different ways to examine how well a company generates a return for its shareholders.

Some common examples of profitability ratios are the various measures of profit margin, return on assets (ROA), and return on equity (ROE). Others include return on invested capital (ROIC) and return on capital employed (ROCE).

Gross profit margin is one of the most widely used profitability or margin ratios. Gross profit is the difference between revenue and the costs of production—called cost of goods sold (COGS).

Inventory Turnover Ratio

The Inventory Turnover Ratio shows how many times a supplier’s inventory is sold and replaced over a period. Generally, low turnover implies weak sales or excess inventory, which could highlight a potential supplier development opportunity.

Days Sales of Inventory Ratio

The Days Sales of Inventory Ratio measures how long it takes a supplier to turn its inventory. As a guide, the lower the ratio, the better, but ratios should be compared to similar suppliers to establish a proper baseline comparison.

Balance Sheet

Aside from providing information on what the supplier owns (assets) and owes (liabilities), the Balance Sheet outlines the value of a business to its shareholders. It can also be a general guide to supplier’s size, based on value – small, medium, or large – which can be used as a barometer for future sourcing, development, and partnerships.

Income Statement

The Income Statement is a financial statement that measures a supplier’s financial performance over a specific period of time. Reviewing Income Statements can be inciteful as to how suppliers earn revenue from various offerings and markets, and seeing their expenses and profit margins compared to competitors. A well-run, profitable supplier should be the goal.

Cash Flow Statement

The Cash Flow Statement provides the aggregate cash inflows and outflows of a supplier. Cash is the lifeblood of every business and this statement should be closely monitored during major industry changes or economic volatility.

Other Considerations

As with one’s personal health, the quantitative numbers only tell part of the story. Suppliers aren’t all that different. The above assessment tools can be of assistance in determining a supplier’s risk, but there are several qualitative financial metrics, outlined below, that also need to be considered to paint the full picture.

Review the Customer Concentration

The percentage of a single customer, typically greater than 40% is of concern, between 25% to 40% is a risk, and less than 25% is a healthy mix. If a single customer accounts for more than 25% of a supplier’s total business, how healthy is the customer? An unstable customer may lead to future hardship for the supplier.

Conclusion

Consistent review of suppliers’ financial health, regardless of industry and economic climate, will lead to lower ongoing supply risk. In addition, our organization will be better positioned to respond than your competitors, for supplier monitoring, development, and resourcing, which could be the difference between surviving and thriving in times of change.