Evaluate Your Suppliers

Good financial analysis before you buy is key to successful vendor relationships.

Of all the financial information a company publishes, the two most important are the Balance Sheet and Income Statement, which I discussed last month. With these two documents in hand, what's next? Where do you start looking for the important information? How do you make sense of the data?

This month we'll look at some of the key data points to examine when evaluating a supplier. You'll need to do just a little math to get the answers, but it's definitely worth your time.

Get the Ratios Right
It's important to make sure a supplier is going to be in business tomorrow and during the months after that. While you might not foresee mergers or consolidations, there are two key ratios—the current and quick ratios (collectively called liquidity ratios)—that assist you in judging a company's ability to pay its bills rather than file for bankruptcy when things get tough.

While ratios are usually expressed as x:y, they can also be written as fractions or decimals, so you may see a 5:3 ratio expressed as 5/3 or 1.66.

The first of the liquidity ratios, called the current ratio, is calculated by dividing current assets by current liabilities. Last month we discussed what makes up assets and liabilities. The "current" categorization limits you to looking at only those assets that are in cash or can be converted to cash within the next year. You may find assets and liabilities segregated into current (short-term) and long-term categories on a company's balance sheet. If not, realize that a company lists assets and liabilities in descending order of liquidity, so current items are listed first.

Current assets, also known as liquid assets, include:

  • Cash itself (which needs no conversion)
  • Short-term investments (certificates of deposit maturing within a year and money market funds)
  • Accounts receivable (money owed to the company; most generally restrict this to money that will be collected within 90 days)
  • Inventory (usually considered to be items that will be sold within the next 90 days)
  • Pre-paid expenses such as payment for a year's worth of insurance coverage.

Current liabilities include those short-term debts—as well as the portion of long-term obligations (a 10-year lease, for example)—that will be paid in the next year. On the balance sheet you should look for accounts payable, taxes payable, notes payable and accrued expenses.

A current ratio of 1:1 means that a company can be considered able to pay this year's bills with this year's assets. A company with a current liquidity ratio of 2:1 has roughly twice as many assets as it has liabilities. It therefore should be able to pay off its debts comfortably. That comfortable "cushion" is what you're looking for when examining corporate finances.

Financial Health Checklist

Before dealing with new suppliers, it pays to ask these questions:

  1. What is the company's debt-to-asset ratio?
  2. How has the company's ratio changed in the last few years?
  3. How does this company's ratios (and changes) compare with those of its competitors?
  4. Have individual assets and liabilities changed dramatically? If so, why?

The quick ratio is simply a variation of the current ratio. Also known as the "acid test," the quick ratio simply eliminates inventory when counting current assets.

Financial analysts use the quick ratio based on the reasoning that inventory may not be quickly convertible to cash, and its value on the company's books may not equal what the company can actually sell it for (especially if inventory is old or prices are dropping).

Look for a quick ratio of at least 1:1. The quick ratio is used to estimate whether or not a company has enough cash (and equivalents) to meet its current obligations. The quick ratio is, well, quick to calculate. And it can be an early indicator showing if a company could soon be encountering problems. In the case of a consultant carrying no (or very little) inventory, however, the current and quick ratios will be nearly identical.

Understanding Debt
You will also want to evaluate how much debt a company carries. Companies with large debt payments may be less able to take advantage of new opportunities—building a new plant, investing in R&D, and so on. A debt-to-assets ratio (total debt divided by total assets) is one way to judge the impact of debt on a company's operations.

First, understand that debt isn't a bad thing. It makes possible the acquisition of new technologies, processes, plants and equipment. You simply want to make sure that there isn't too much debt—that what the company owes isn't overshadowing a company's balance sheet.

Ratios Aren't Enough
Looking at ratios is just the first step. If Acme Software's current ratio doesn't at least meet the 2:1 benchmark, it may be time to eliminate the company from consideration. On the other hand, it could be worth your time to consider additional factors.

Compare a company to its competition. How does Acme's 2:1 (i.e., 2.0) current ratio compare to its competitors and to the industry as a whole? Yes, I know, it means doing more math, but if a competitor has a ratio of 3:1 (3.0), or the industry average is 3:2 (1.5), then you've learned more about Acme's performance. You should ask:

  • Why is Acme different?
  • How large are Acme's assets compared to its competition?

My company's current ratio is the same as IBM's. Does that mean we're comparable? Clearly not.

Look for trends. How have Acme's ratios changed over the last few years? If a ratio was 1:1 three years ago and now it's 2:1, then Acme's situation is improving—a good sign. Look for patterns of change over time; examine the last three years if you can.

Look at the change in individual assets and liabilities over time. Shrinking inventory may mean a company will more likely be out of stock on items you need, while rising inventories (growing as a percent of assets year to year) could indicate problems, especially for technology companies due to rapid product obsolescence.

Growing receivables (as a percent of sales, which you'll find on the income statement) could mean the company is selling to credit-riskier customers; taking more risks may make it less stable or indicate trouble.

Are sales (on the income statement) growing or slowing?

Look at individual balance sheet items. A large cash reserve means a company can move quickly to secure new technology. But beware: A growing cash reserve may mean it isn't making needed investments.

Gotchas Ahead
Looking at ratios and trends is just the start of your examination. Next month we'll look at some additional factors to consider, and I'll explain where to find the "gotchas" that may help you root out potential problems.