A head for numbers

To understand your suppliers, you need to understand their finances

May 12, 2015
by Brent Jackson

From the April 2015 print edition

Procurement professionals know a thing or two about numbers. Negotiations and analyzing supplier pricing requires a grasp of the bottom line. But many practitioners were never formally taught how to read financial statements, and those who can’t assess the financial viability of potential suppliers may struggle to select appropriate contractors. A supplier’s finances can shift over a long-term contract. To mitigate risk, it’s important keep track of your suppliers’ financial stability—and that means regularly reviewing their financial statements.

What are financial statements?

Financial statements act as a company report card. Each statement tells about the company’s current and historical financial results. Collectively, a company’s financial statements provide details about its overall financial health. While public companies must make detailed financial statements publicly available, private companies generally aren’t required to share them. Financial statements typically include four elements: balance sheet, income statement, statement of cash flows and financial statement notes.

The balance sheet gives a snapshot of the company’s financial position at a point in time. It details assets owned and liabilities owed. By subtracting the company’s liabilities from its assets, you arrive at the company’s total net worth (assets – liabilities = shareholders’ equity). A look at the company’s assets shows if the company is maintaining a positive cash balance.

Assets are items a company owns that typically have monetary value, either in the short term or long term. Items like cash, accounts receivable, inventory, equipment or even trademarks are examples of assets commonly found on a balance sheet. Assets are listed in the order of how quickly they can be turned into cash or consumed. Liabilities are monetary obligations a company owes, such as loans, trade payables, wages payable and taxes. Current liabilities need to be paid back within one year of the balance sheet date. Long-term liabilities have repayment dates beyond one year.

When reviewing a balance sheet, there are certain ratios that can help you better understand how well the company is performing:

  • The current ratio (current assets ÷ current liabilities) indicates the company’s ability to pay back its short-term liabilities with its short-term assets. It can highlight the efficiency of a company’s operating cycle or its ability to turn its product into cash. Depending on the industry, a current ratio over 1:1 is typically seen as healthy.
  • The debt to equity ratio (total interest bearing debt ÷ shareholders’ equity) shows the company’s financial leverage, which is the amount of debt compared to equity it uses to finance the business. If this ratio is too high, it could indicate the company relies too heavily on debt, which could result in a riskier business, while if it’s too small the company may not be taking advantage of low rates of debt in the market and is financed at a higher cost. The ‘right’ ratio depends on the industry and type of business.

The income statement measures the financial performance over a period of time (i.e., fiscal year). It details revenues or sales (the amount of income generated in the year), its cost of sales (costs required to generate the income, for example in labour, raw materials or warehouse costs) and its expenses (all other cash outflows of the business). Key ratios include:

  • gross margin percent ((revenues or sales – cost of sales)/revenues or sales), which shows the direct profitability of the product or service. Margins are different across all industries and in order to understand whether the company is generating a healthy margin, you must compare their margin with similar businesses within the industry; and
  • net income (revenues – cost of sales – expenses), which represents the earnings generated in the year (revenues less all expenses (including interest and taxes).

This shows the ending cash balance for the year by measuring cash movements between fiscal periods (as reported on the balance sheet) and net cash inflows and outflows (as reported on the income statement).

The statement of cash flows summarizes where the money was spent or generated over the year, separated between three different spending activities:

Operating activities include net cash flows generated during the current fiscal period, including the net income and movement of current assets and/or liabilities;

Investing activities include net cash flows generated by/spent on investment activities in the business, such as on capital assets or other capital investments; and

Financing activities include net cash flows generated by/spent on financing activities, such as the receipt or pay down of debt (principal payments) and/or equity (new capital raise or dividends paid).

Most financial statements include “notes” providing more detail than in the financial statements. They include information about the nature of the company’s business, accounting policies and the detail behind all material accounts summarized in the financial statements.

Brent Jackson, CPA, CA, CBV, is senior manager at Grant Thornton LLP.

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