Why should I care about financial ratios?!

One of the biggest headaches in Procurement is when a supplier unexpectedly goes out of business and you have to scramble at the last minute to try and get the goods or services from someone else.

Whilst looking at historic accounts can’t predict the future, it can highlight risk areas where you might want to bolster your supply chain.

This article will look at the key financial ratios and terms that you will help you conduct due diligence on your suppliers.

Documents in financial accounts

Companies file their accounts every year, and in the UK these are published on Companies House.

Each set of accounts is made up of three parts:

·       Profit and loss

·       Balance sheet

·       Cashflow statement

The Profit & Loss account, as the name suggests, tells you how much profit or loss the company made! It does this by listing the turnover and itemising the main cost categories.

You can look at a company’s balance sheet to understand the value of their assets and liabilities. It won’t be clear from the headlines what these assets are, but there may be notes associated with them that will give you more detail. I always like looking at what the company classes as “intangible assets”!

A cashflow statement will show you where the company got its cash from and what the difference in its cash was at the beginning of the year compared to the end.

Profit

The word we dread talking about with suppliers!

There’s two ways to calculate profit that we care about when looking at accounts; gross profit and net profit.

Gross profit is the difference between a company’s revenue and how much they spent on their direct cost of sales. Net profit is the difference between a company’s revenue and how much they spent overall.

What happens if an organisation doesn’t make enough profit?

·       They may be tempted to cut corners on your project and reduce quality

·       They may go bankrupt

·       They may be tempted into unethical practices, such as modern slavery

·       They may subcontract out the work to a supplier you haven’t vetted

Gross profit = (revenue / cost of sales) * 100

Net profit = (revenue / costs) * 100

Liquidity

Liquid flows and moves. The same applies to ‘liquid’ assets, which are easy to use to pay bills and suppliers.

Imagine receiving an unexpected bill. What would be easier to pay it with; cash at the bank or the sale of your house?

Selling a house is likely to take months, in the mean time the company sending you a bill will be sending you reminders and maybe even legal action. This situation can make companies close because they don’t have the money to pay everything they owe.

The ‘liquidity’ of a supplier is a measure of how easy it is for them to cover their upcoming bills. We want suppliers to be able to pay their suppliers so that they don’t go out of business and leave us without the goods and services we need!

Acid test ratio = Current assets / current liabilities

Gearing

Gearing ratios are about how much debt a company has compared to their “equity”, which is the amount of money they’ve brought in from shareholders.

Companies will borrow money to invest in long-term requirements, such as new equipment.

Having debt is not necessarily a bad thing, but when we’re vetting suppliers we want to know that a company isn’t going to go bankrupt because it can’t afford to pay its bills.

As with profit, the appropriate level of gearing is different in each industry. A utility company or factory is likely to need higher levels of debt to equity than, say, a financial services company.

Can’t I just ask the accountants to look at this?!

Nice idea! Accountants and Procurement teams should definitely work together when vetting a new supplier or checking an existing one!

However, accountants are less likely to have the market intelligence that we do in Procurement. You’ll want your suppliers to be making a reasonable profit margin that’s in line with industry expectations. For example, the expected profit margin for a facilities management company will be a lot smaller than for a pharmaceutical company. If your FM supplier is making 45% net profit margin then they are either doing something incredible or they’re likely to be overcharging their customers. Similarly, if a pharmaceutical supplier was only making 5% profit, they would be making substantially less than competitors and that may lead them to long term financial difficulty.

Profit is one aspect of the triple bottom line, and we need suppliers to make a reasonable profit to be able to survive and grow in the future.

What should I do if I’m concerned about a supplier?

As the old adage goes, there are “lies, damned lies and statistics,” so the numbers in accounts will only give you part of the story.

If your calculations raise some red flags, make sure you talk to your supplier about it. They may have a high gearing ratio because they literally bought a whole new production line that’s predicted to double their turnover, for example. Alternatively, maybe they were a victim of fraud and that crippled their cashflow this year, but they have a plan to recover from it.

There are legitimate reasons why a company would appear to be struggling from their accounts.

Speaking with your suppliers can help you understand the full picture before making your decision about whether to continue working with a supplier.

Additionally, you should consider their strategic importance to your supply chain alongside your expected forecast with them. It probably won’t be too concerning if your routine suppliers go into administration as you can replace them easily. However, if you have concerns about a strategic supply you could build some resilience into your supply chain strategy.

Conclusion

Numbers aren’t everyone’s favourite topic! Reviewing financial accounts is a key skill when managing suppliers, though.

Use these ratios alongside discussions with your suppliers to understand their financial position and put in place any measures to reduce your risk of supplier failure.

That’s why this topic is covered in the following CIPS modules:

·       L4M4 – Ethical and Responsible Sourcing

·       L4M8 – Procurement and Supply in Practice

·       L5M4 – Advanced Contract and Financial Management