BUYING FROM THE RIGHT SUPPLIER
5. SUPPLIER FINANCIAL STABILITY
Let’s suppose that a supplier not known to the buyer quotes a favorable price for a vital component. However, extensive tooling must be funded before production begins. If the supplier is under financial strain, delivery problems might arise and shipment of the end item to the customer could be delayed; as a result, promotion and marketing of the using company’s product are delayed and customers who have placed orders are dissatisfied.
Quality and engineering personnel may concur in judging the company a good source, but it is still the purchasing managers’ job to ensure that the supplier can perform as promised. And, until satisfied with the company’s financial stability as well as its technical ability, the buyer cannot be confident that the source will be reliable.
Unfortunately, in dealing with small or start-up companies, the amount of financial information available is usually inversely proportionate to the need.
Consider that data from Standard & Poors, Dun & Bradstreet, and from
stockholder reports are available for large, established companies, but often little is available about the smaller firm—where the need to be cautious may be greatest! This is a concern, as about 90% of all U.S. corporations have assets less than $1 million, according to the Department of Commerce. Yet these smaller companies are often excellent sources of supply, usually being highly flexible and eager to make items that larger corporations may have no interest in producing.
If a potential supplier refuses to provide a financial statement, it does not necessarily mean there is a situation being hidden from the purchasing manager. However, it would be questionable buying practice to place $1 million worth of business with a company having a sales volume of $50,000, or with one that doesn’t give assurances of its stability. A shaky supplier faced with business failure may have to increase its prices sharply or allow lower quality by using cheap substitutes when confronted with the only other alternative, which may be to close shop. The supplier’s financial problems may make the owner desperate to accept an order even at too low a price, hoping to fulfill it—only to find the company in deeper trouble leading to inevitable collapse. Hence, the PM must be alert to the financial stability of his or her suppliers.
The annual 10-K report, required of publicly held companies by the SEC, is another excellent source of financial and operating information. These reports are often available from the company’s Website and are required to disclose significantly more information than the Annual Report to stockholders. A careful review of the 10-K report can uncover issues with management, pending legal actions, significant shifts in customer base, factory closings and many other areas of possible interest. While this document may not contain the answers to all the buyer’s questions, it does provide a comprehensive view of financial and operational issues for further discussion with the supplier.
5.1 Credit Rating Reports
Many small companies, especially when privately held, do not issue financial statements, In such cases, a Dun & Bradstreet (“D&B”) credit report can help by advising:
General information on the supplier’s facilities. If the report is clearly unfavorable, this can save the time and expense of a personal visit.
The company’s credit rating.
Information on the company’s ownership and management team, offering possible insight into their direction and stability.
Description of the company’s major products. If the company is already making something similar to what you propose to buy, it’s less likely that you will have quality or delivery problems.
Data on financial strength and profitability. A company with a healthy profit in a competitive industry is generally an efficient one. Conversely, the company with a record of losses is to be suspect for future business transactions.
Internal finance executives, too, can help the PM just as they help the sales manager—and in many of the same ways. They can:
Classify suppliers according to their volume of sales, reputation, dependability, and performance.
Help handle the problem supplier who, for one reason or other, must remain on the active list, even after financial problems are known.
Analyze any suspect current supplier in relation to size and help buyers assist questionable suppliers who are worth doing business with, but who have special internal financial problems.
Give objective operational information that the PM can use to better understand the supplier’s finances and performance capabilities.
Reduce supplier turnover and help eliminate unsatisfactory one-time purchases.
Advise on new prospective global sources’ trade practices and offshore reputation from banking connections.
It should be recognized that D&B ratings often report data given them by the supplier itself. Similarly, vital information can be withheld; and, while the practice is fortunately not too common, information may be falsified.
The PM should recognize the potential weakness that either situation implies. If a D&B report is suspect, the PM can ask the supplier for bank references, or for the sources of money supplied to them, and follow through in contacting these sources for their advice. Customer references can also be of value in analyzing a supplier’s condition.
5.2 Financial Statements
A typical balance sheet and a simple income statement as seen in Figure 5-1 A & B, both common financial statements, are used to describe a company’s financial condition.
The balance sheet shows the value of what the company owns (assets) versus what is owes (liabilities) and the owners equity (net worth) as of a particular date, normally the end of the accounting period. On the left side of the balance sheet is the assets column, listing all goods, owned property, and any expected receipts. On the right-hand side are the liabilities—those debts that are owed, some payable soon (current liabilities) and others over the longer term (such as bonds to be redeemed). Net worth includes stockholders’ equity, which is the money put in by the owners of the business, as well as the earned surplus retained by the business to permit
growth. The total assets must equal (or balance) total liabilities plus net worth.
By reviewing the balance sheets for several years, significant changes can be detected. For example, new loans may have been necessary, or old loans may have been paid off. Inventories may have been increased to take care of increased sales, or reduced to show better performance.
The profit and loss (income) statement shown in Figure 5-1 B summarizes the financial transactions of a company over a specific period of time, normally a fiscal year. It shows the receipts from selling goods and from other income, such as interest on bank deposits or stocks and bonds.
This statement matches these incoming funds against the costs of goods and other expenses in operating the company; the net profit after tax is what is left for the year. Of course, it is also possible to show a net loss, which would be a prime concern to any buyer.
5.3 Ratios as Guides
Ratios that show the relationships of various financial data help provide a clearer picture of a company’s financial position.
Some of the ratios used in determining a supplier’s financial strength are:
Working capital ratio: Current assets divided by current liabilities.
Indicating the amount invested in current assets compared with the amount of current liabilities at a particular time, this is a general measure of a company’s liquidity.
Acid test ratio: Cash and receivables divided by current liabilities.
Comparing the amount of cash and receivables with the total current liabilities, this measure is more exacting than the current ratio in determining the firm’s ability to meet its obligations with funds easily converted to cash.
Return on investment ratio: Net profit before taxes divided by fixed debt and equity; this measures the rate at which capital investment is producing profits.
Profit ratio: Net income after taxes divided by net annual sales, this shows the rate of earnings, after taxes, on net sales. Low profit may worry stockholders; what is more important to the buyer is the regularity with which a company has made a profit—evidence that it can stay in business.
Inventory turnover: Cost of goods sold divided by average inventory.
Showing the number of tunes a company turns over, or receives and sells, its average inventory, this is a measure of how well the investment in inventory is being utilized to support production.
Debt to equity ratio: This compares the capital obtained by borrowing with the capital invested by owners. When this ratio is greater than one, it
shows that the amount owed to creditors is greater than the amount owners have invested. Any downturn in profits, such as unexpected loss of sales volume, rapid cost increases, or catastrophe puts a strain on management and may force the company to take undue risks to maintain operations.
Applying some of these ratios can provide some interesting information.
How can the PM tell if the implications are positive or negative? Let’s apply some of the above ratios to a hypothetical company, Amanda Kay Products (AKP), whose P&L statement and balance sheet were already shown in Figure 5-1.
As previously stated, the supplier’s strength can be judged by a study of its balance sheet, together with its profit and loss statement. In this case, the working capital ratio—which shows the company’s ability to meet its obligations and still provide for future growth—is 3.48, which compares favorably with an old rule of thumb that says the minimum safety requires current assets to be at least twice the value of current liabilities.
The acid test ratio for AKP, cash and receivables divided by current liabilities, shows a ratio of 1.05. This means the company has the financial strength to meet all obligations presently due. The profit ratio is 761,000/13,000,000 = 5.85%, which is quite healthy when compared to 3.64 for others in the field.
Inventory turnover is 8,500,000/4,500,000 = approximately 1.9, which raises a question about the company’s inventory position. The size of the inventory appears high when we compare the other favorable ratios—but perhaps there is good reason for high inventory this year. Remember, inventory turnover will depend on the type of business and time of the year for cyclical businesses. Large inventories are dangerous because price drops can cause losses; they may also indicate a high percentage of finished goods that can’t be sold.
Other ratios should also be checked. A trend of several years is more significant than a single year’s report, since strikes or such other one-time problems as fire, flood, or debt repayment can make the one-year misleading. Year to year changes also show whether management is being made to “look good” for a short period of time. A company can show a profit yet be borrowing money, deferring payment of bills, or postponing purchases of needed equipment; or it may show a small loss in order to clear out a high-interest debt or provide improvements designed to place the company in a better long-range competitive position. Because of the complexities involved in interpreting financial data, it would be wise to check with your financial officer to ensure accurate conclusions are reached!