Obtaining a financial statement from your vendor(s) should never be considered a check-the-box exercise. In my daily work, I see organizations request a financial statement and, once they receive it, they simply file it away.I often remind our clients that, like with other due diligence, it’s extremely important to read and thoroughly analyze the vendor financial statement. It can lead to discovering unexposed risk like a potential service level decline or slow pay problems. It’s more than just about the numbers.
Reading a financial statement can be tricky at times. Let’s break it down.
6 Steps to Take to Effectively Read a Vendor Financial Statement
- The first step is to always have a subject matter expert review the financial statement. A CPA (certified public accountant) or an experienced, qualified individual can assist.
- Usually the financial statement for a public company is a form 10-K. So, the next step is to thoroughly review the form and watch for the following:
- The risk factors – The risk factors are shared within the financial documentation with notes pertaining to any regulatory actions that may have happened.
- Active legal proceedings or lawsuits – Keep yourself in the know. Be aware of any that are pending, as well as what the settlement charges will likely be.
- The auditor’s opinion on financial statements – Specifically look at their opinion on the comprehensive income.
- The auditor’s opinion on internal controls – See if the auditor deemed the controls adequate or not.
- If the vendor is a private company, the financial statements are no different. You just have less information. With private companies, it’s important to insist upon an audited financial review to ensure accuracy and appropriate disclosure in the financial notes section. This is included with step 2.
- In addition, as you review the financial statement, look at the following to compare year-over-year numbers:
- Balance Sheet – To better understand if their net worth (and tangible net worth) is rising or declining
- Income Statement – To better understand their revenue and gross margin
- Cash Flow Statement – To better understand how they are funding their operations
- Ratios – To help you understand the Altman Z-score, which determines a company’s likelihood of bankruptcy
Review year-over-year numbers for the last 3 years.
- As you comb through the financial statement, thoroughly evaluate what you’re reading. Ask yourself questions like:
- Is the vendor making money?
- Do they have sufficient capital (or access to capital) to support their ongoing operations?
- What is the vendor’s debt-to-worth?
- In particular, what is their tangible net worth?
- Can the vendor continue operations at the current cash level?
- Finally, the sixth step is to write up your analysis which should include key information and a clear conclusion. A best practice is to keep it to one page. The analysis forecasts what you need to do next to mitigate any risks. And, from there, you'd discuss next steps with the vendor.
Financial performance in and of itself is not an “event of default” in your vendor contract. The financial analysis is an early warning tool to alert you and the rest of your management team that a potential problem exists and that the product manager needs to pay attention to the agreed upon SLAs. Read and understand your vendors’ financial health. Don’t just file it away.
Learn more about vendor financial health. Download our eBook.