Qualitative and Quantitative Considerations When Reviewing Vendor Financial Health

Since assessing your vendor’s financial health can determine whether a vendor has the financial viability to provide the product or service they’re contracted to provide to you, reviewing financial health is a critical part of an effective third-party risk management program. When performing financial health assessments on vendors, your organization gains insight into the vendor’s potential risks to your organization’s security, operations, and reputation.

If a vendor has poor financial health, they may be unable to provide their agreed-upon solution or services that your organization requires. Conversely, a vendor with good financial health may prove to be a reliable vendor that you can continue to use in the future. Let’s look at what an adequate financial health assessment can tell you about your vendor and how you should use this information to inform the future of your relationship.

What a Vendor Financial Health Review Can Tell You

As part of your overall third-party risk management program, your organization should consider implementing financial health reviews on most vendors, especially those that are deemed critical to your organization’s operations or have a high or moderate inherent risk profile. This is because financial health assessments are a common best practice to help confirm a company’s financial stability. This can happen by assessing both the vendor’s quantitative and qualitative financial information.

By focusing on key quantitative items, such as financial information found in a vendor’s income statement, balance sheet, and cash flow statement, as well as qualitative items, such as the vendor’s management discussion and analysis on its performance, disclosures on the vendor’s customer and supplier relationships, and disclosures on the vendor’s capital, credit, and liquidity profile, your organization can create a consistent, repeatable financial health review process that scales well across your business’ growth and maturity.

Quantitative vs Qualitative Details in Vendor Financial Health

From the quantitative details contained in these financial health reviews, your organization can extract details into a vendor’s financial performance today and over time (if multiple periods of financial information are provided). This information can show a vendor’s revenue, profitability, and cash flow profile as well as its cost base and ability to adequately pay its obligations due to creditors or suppliers. These quantitative items are very useful, but often don’t provide helpful context to perform a comprehensive financial review.

To obtain a complete picture of a vendor’s financial health, you should also assess qualitative information, which provides the context (i.e., the how and why) behind a lot of the quantitative information. These details found in footnotes, management discussion, and analysis sections within a vendor’s financial statements can explain key details on why a vendor has trended in the way it has, why it continues to invest in its business to generate revenue, and how or why the vendor generates capital to support its operations.

With these combined pieces of information, your organization can work to assign a risk level on a vendor’s overall financial health profile, creating useful comparisons across vendors.

Projecting the Future of Your Vendor Relationship

When your organization performs adequate due diligence through a vendor financial health review, you can begin to make organizational decisions on a specific vendor relationship depending on the risks found and the overall risk appetite that is defined within your third-party risk management program.

If a vendor has poor financial health, you may decide to insert contractual obligations or service level agreements that ensure that a vendor must provide adequate financial information to your organization or, even, sever ties with the vendor. On the other hand, financial health reviews that show low risk or positive signs on a vendor’s financial health can help provide comfort to your organization that you are doing enough to identify and manage existing risks. However, you shouldn’t assume that a low financial health risk profile will remain the same throughout the relationship with your vendor. It’s recommended that your organization conduct financial health reviews on a regular basis with identified vendors, at least on an annual cadence, to ensure that these financial health reviews reflect the latest information on a vendor’s financial profile.

4 Quick Tips to Identify Red Flags During a Financial Health Review

While reviewing a vendor’s financial information, your organization should be aware of some tips that can help provide quick insights into a vendor’s potential red flags in its financial profile:

1. Period-over-period decline in revenue: While there may be adequate reasons why a vendor’s revenue base declines, this can be a red flag that the vendor has issues with customer churn, a poorly performing sales force or product/service, or an issue that can lead to other downstream issues on a vendor’s future financial health.
2. Inadequate liquidity to cover existing cost base: Without adequate liquidity or cash on hand, a vendor may need to rely on its ability to generate profitability or cash flow from its existing operations. If the vendor lacks profitability, they may need to either begin to cut costs (which can lead to poor service levels) or raise capital through financing sources (which can burden the vendor with debt and obligations to service in the future). In a worst-case scenario, inadequate liquidity can lead to eventual bankruptcy, which could cause significant disruptions to your organization.
3. Lack of profitability with limited to no rationale or explanation: Lack of profitability alone can be a red flag, but many times, high-growth vendors may intentionally be investing in their overall business operations to provide innovation solutions/services or to grow their scale and customer base. When your organization notices vendors with negative profitability, you should always inquire as to the why, and get a comprehensive understanding into the vendor’s access to liquidity/cash and capital to offset this lack of profitability, as well as the vendor’s journey to get to profitability in the future
4. Large debt and liability balances: Debt is a necessary component for many vendors and businesses across industries. However, when debt begins to balloon in a vendor’s financial profile, it can signal potential future issues into a vendor’s ability to pay down its obligations and service its creditors. Additionally, with debt, there are other covenants and limitations that a vendor must meet, which can put incremental pressure on its ability to provide services it contractually commits to with your organization.

To get a full understanding of how a vendor’s financial health can impact your organization, your team should work to create a consistent process with thorough documentation when performing financial health assessments. This work can serve your organization well as you continue to scale your third-party risk management program and attempt to identify and mitigate risks that may disrupt your business operations.