10 Financial Tools for Supplier Risk Assessment
When you visit your doctor for regular checkups, he or she typically gives you a summary report before you leave, outlining your vitals, things to keep an eye on, and things to change. Suppliers aren’t all that different. There are financial areas outside of component manufacturing that are critical to check up on from time to time to ensure suppliers are healthy financially.
Economic shifts are critical times in which you need to be extra attentive to a supplier’s financials; a downturn, or even upturn, may cause stress to a company’s lines of credit, working capital, and cash flow, all of which are pivotal for success.
There are many tools — ratios, statements, and formulas — for assessing the financial health of a business. In this blog, we’ll be highlighting 10 critical financial tools that, once attained from a supplier, will allow you to quickly assess its financial health, putting together a snapshot of it for a single point in time. When these snapshots are gathered regularly going forward, they’ll allow for a better assessment of a supplier’s financial health trend.
Teams who aren’t used to reviewing supplier financials on a weekly basis may be intimidated by large, seemingly complex statements. Further, gathering, calculating, and assessing a supplier’s financial information can be daunting during daily supply chain management activities.
It’s important to note that most companies determine it appropriate to conduct financial assessments on select suppliers that make up the largest portion of their spends, usually the top 20%, and/or strategic high-risk suppliers, due to management costs and risk.
10 Financial Assessment Tools
There are many tried and true simple tools for consistently assessing a supplier’s financial health that, once progressed through a few times, will allow teams to quickly assess a supplier. For the purpose of this blog, we’re referring to “Financial Tools” as a broader term for ratios, statements, and formulas that should facilitate your efforts to swiftly assess a supplier.
Below is a brief overview of the 10 financial tools we recommend for assessing a supplier’s risk.
1. Current Ratio
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 your suppliers can’t pay their suppliers consistently over time, you could experience supply disruption delays/stoppages, one potential warning sign of this issue, as a result.
2. Quick Ratio
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.
3. 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.
4. 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.
5. Z Score
The Z Score, or more formally known as the Altman Z-Score, is a number formula output of a credit-strength test that helps gauge the likelihood of bankruptcy for a supplier based on a series of financial inputs. The tool provides a consistent scoring framework to monitor financial health. A score below 1.8 means that a supplier is probably headed for bankruptcy, whereas a score above 3.0 indicates stability.
6. Current Assets/Liabilities
Current Assets and Current Liabilities are Balance Sheet accounts that represent the value of all assets and all liabilities that can reasonably expect to be converted into cash and paid respectfully within one year. These numbers are usually gathered by default as part of calculating the above ratios. However, large deltas from quarter to quarter should warrant further investigation and conversations with strategic suppliers.
7. Long Term Assets
Long Term Assets are a Balance Sheet account outlining the value of a supplier’s property, equipment, and other capital assets, less depreciation. Typically for stable suppliers, little to no change is expected. However, suppliers undergoing rapid change, mergers, acquisitions, or divestitures will see greater fluctuation.
8. 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.
9. 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.
10. 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.
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.
Identify the Bank
It’s important to know the creditor. Typically, banks support several firms in an industry. In an economic downturn, banks move to mitigate risk, meaning they’ll pick winners and losers by closing higher-risk credit lines.
Identify friendly banks that aren’t over exposed during a downturn. Developing a relationship with those banks and recommending them to your suppliers is a valuable relationship builder.
Consider Credit Lines & Cost of Money
Keep tabs on a supplier’s credit line terms and cost of money. Covenants (the conditions of a loan) must be adhered to by the supplier or the bank will utilize missteps to charge fees, raise rates, or pull lines of credit altogether. If the cost of money increases, then so does the debt to equity, forcing a supplier to reduce profits to service its debt.
Consistent review of suppliers’ financial health, regardless of industry and economic climate, will lead to lower ongoing supply risk. In addition, your 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.