In today’s fast-paced business environment, it’s essential to include financial reviews in vendor risk management programs. This due diligence helps provide additional visibility into the viability of vendors and allows your organization to better understand its options in doing business with certain vendors that do or don’t meet certain financial thresholds and qualifications.
Despite this importance, many organizations struggle to get started or get overwhelmed in implementing sufficient financial reviews in their vendor risk management efforts. In most of these cases, this struggle arises from the lack of understanding as to which financial metrics and details are important and should be reviewed and monitored accordingly.
In this blog, we’ll unpack and explain the importance of a variety of different financial figures to review on a vendor. By understanding and utilizing these metrics in your vendor risk management program, your organization can work to better understand the risk a vendor’s financial health poses and begin to work with the vendor and your internal team members to mitigate the risks to palatable and appropriate levels.
Where to Start? A Vendor’s Financial Statements
Although it may seem obvious, the key areas to extract the necessary data for reviewing a vendor’s financial health are within three integral financial statements that every organization has: the income statement, the balance sheet and the cash flow statement. Each of these financial statements provides unique insight and a lens into a vendor’s financial health, performance trends and the potential outlook on its viability.
Without specific expertise and a repeatable approach on assessing vendor financial health, the task of reviewing these three financial statements can be arduous, time-consuming and challenging. Therefore, it is always best to start with some of the key figures we have highlighted here within each statement and build upon your approach as your vendor risk management program and experience reviewing details progresses.
Reviewing an Income Statement
The income statement contains the financial position of a vendor over a period (typically ranging from 1 month to 12 months’ worth of time). Typically, to get the most representative snapshot of a vendor’s performance, your organization should ask for 12 months’ worth of income statement data at a minimum (typically, two to three years of income statement data is most preferable if the vendor is willing to provide this data).
Once the income statement detail is made available, the essential figures and inputs you’ll want to extract, calculate and/or review as part of your vendor financial health due diligence are the following:
- Total revenue
- Revenue by segment (as applicable, if the organization has multiple business units, product lines or other segmentation)
- Revenue growth (typically, year-over-year revenue growth)
- Gross profit
- Gross profit margin
- Calculation: gross profit ÷ total revenue = gross profit margin (%)
- Total operating expenses
- Operating profit
- Calculation: (cost of goods sold/services + total operating expenses) – total revenue = operating profit
- Operating profit margin
- Calculation: operating profit ÷ total revenue = operating profit margin (%)
- Net income
- Net income margin
- Calculation: net income ÷ total revenue = net income margin (%)
What the Income Statement Metrics Reveal
Each of these financial metrics provide details on a vendor’s financial health that your organization can weigh and emphasize in the best manner that fits your vendor risk management program, such as the following:
Revenue and revenue growth: These are important, as they show how the vendor makes money, what scale it has (i.e., is it a leader with large revenue in its industry or a fledgling startup looking to acquire market share) and provide you a view of its trended performance (i.e., has the vendor increased its revenue, maintained it or experienced a decline in its revenue?). If the vendor has small amounts of revenue and/or a pattern of declining revenue, it may indicate potential issues that the vendor doesn’t have enough market share or not enough product/market fit to generate sufficient money to sustain long-term operations. Therefore, starting with revenue and the trend of revenue over time give a solid starting foundation into the viability and financial health of a vendor.
Profitability metrics: Gross profit, operating profit and net income help provide your organization information into the vendor’s ability to generate profit on every dollar of revenue it generates. This should give you an understanding into the vendor’s efficiency and sustainability in operations, the investments it’s making to sustain its growth and scale, and whether the vendor can support its long-term viability by generating profitability or, on the flipside, if the vendor will be reliant on capital infusions to cover for its lack of profitability.
Profit margins and profit metrics: Using these alongside each other helps provide your organization with additional detail to use in your reviews. A vendor with declining and/or negative profitability generally should be scrutinized further, as it indicates that the organization may have issues managing its costs or is spending too much to sustain operations. On the flipside, certain increases in costs or strategic investments a vendor makes may have a near-term negative impact on its profitability metrics, but are necessary to assist its future scalability, market penetration and/or market leadership. Therefore, like all metrics that we’ll discuss here, it’s important to couple these figures together in a holistic review, rather than viewing them in isolation.
Reviewing a Balance Sheet
Building upon the information extracted from the income statement, the balance sheet helps provide a view into certain financial metrics that a vendor possesses as of a point in time. Combining the balance sheet with the income statement information provides additional support as to whether a vendor has sufficient assets to meet its liabilities and obligations.
Within the balance sheet, at a minimum, the key items to extract, calculate and review in your vendor financial due diligence include the following:
- Cash and cash equivalents
- Accounts receivable
- Total current assets
- Total assets
- Total goodwill and intangible assets
- Current and long-term debt
- Total current liabilities
- Total liabilities
- Retained earnings
- Current ratio
- Calculation: current assets ÷ current liabilities = current ratio
- Total net worth
- Calculation: total assets – total liabilities = total net worth
- Total tangible net worth
- Calculation: total assets – (total goodwill + intangible assets + total liabilities) = total tangible net worth
What the Balance Sheet Metrics Reveal
As the adage goes, cash is king. Therefore, when reviewing a vendor’s balance sheet, be sure to extract the cash and cash equivalents balance, as it’s indicative of how much cash the business has available to sustain its operations. If the organization is unprofitable and has insufficient cash to support its total cost base, this would be a notable warning sign that the organization may not be viable or will require an external cash infusion to support its operations.
Accounts receivable: Including this in your review of cash on hand can provide you more insight into how much future cash the vendor will collect and is owed from its customers.
Current and total assets and liabilities: These provide a lens into how many obligations the vendor has for every dollar of assets it has on hand. Typically, you’d like to see vendors with current and total assets balances that exceed its current and total liabilities balances. To add to your review of the balance sheet metrics, including a calculation like current ratio, helps provide you a view into whether a organization has more current assets to meet its current liabilities - a current ratio above 1.0 - or vice versa - a current ratio below 1.0.
Other balance sheet items and calculations: Metrics such as retained earnings, current and long-term debt and goodwill/intangible assets each add on to the robustness of your financial due diligence. Retained earnings represents the amount of retained profitability (or losses) a vendor has generated or accumulated in the past. Typically, you would like to see a positive retained earnings balance, as a negative or declining retained earnings balance indicates that the organization has had a history of unprofitability.
Current and long-term debt: These are outstanding obligations that the organization has on its balance sheet. A larger balance in these accounts can be indicative of current or future financial pressures, given the vendor must repay these debt obligations and associated interest payments, or can also be indicative in the organization’s ability to receive capital infusion to support its operations, which can be viewed as a positive in certain circumstances because it shows the ability of the vendor to raise capital when it needs it.
Reviewing a Cash Flow Statement
The third and final essential financial statement to utilize in your vendor financial reviews is the cash flow statement. This detail helps provide your organization a view into the vendor’s cash flow generation and usage from three primary sources:
- Operating activities (i.e., its day-to-day operations)
- Investing activities (i.e., any investments, capital or M&A that the organization makes or disposes of)
- Financing activities (i.e., if the vendor receives any capital from equity or debt financing sources)
From the cash flow statement, you will want to extract these essential pieces of information to include in your vendor financial reviews:
- Beginning cash (to indicate what the starting cash balance was at the beginning of the period being reviewed/assessed)
- Cash flow from/used by operations
- Cash flow from/used by investing
- Cash flow from/used by financing
- Ending cash (this will match the same time period’s balance sheet cash and cash equivalents balance)
What the Cash Flow Statement Metrics Reveal
These line items expose how efficient (or inefficient) a vendor is in its use of cash:
Cash flow from operations: From a cash flow from operations perspective, it’s typically preferred that a vendor has positive cash flow from operations, as this indicates that the vendor isn’t burning too much cash in its normal course business activities. When reviewing this line item, it should be noted that a negative or declining cash flow from operations may indicate larger issues in a vendor’s performance and trends, and therefore, should be investigated more thoroughly.
Cash flow from financing and investing: This helps indicate other activities that the vendor is partaking in that have an impact on its overall cash balance. If the has movement in its cash flow from investing, it may show that the vendor is on an M&A spending spree, acquiring businesses and consolidating its space or may be divesting business entities to generate cash to bolster its balance sheet. Additionally, if the vendor has cash inflows/outflows from financing, it may be indicative of the vendor issuing new equity or debt facilities to raise cash for operations or for other reasons. Therefore, including these two components from the cash flow statement help provide a complete picture on a vendor’s ability to generate and sustain cash flow to be viable and support the product and services it’s contracted with your organization to provide.
Start Your Vendor Financial Reviews with the Basics and Build from that Foundation
It’s easy to get inundated with financial information and dive deep into financial figures and metrics to best understand a vendor’s financial health in your overall vendor risk management program. Therefore, it’s important to always take a step back and attempt to start with key foundational information and knowledge housed in the three critical financial statements to build a thorough and proper vendor financial review process.
By utilizing the specific metrics and details highlighted throughout this piece, your organization can work to bolster its vendor due diligence procedures and gain better insight into how a vendor’s financial health may impact your operations. Delving into a vendor’s key metrics in isolation or independent of each other may not always be entirely useful or helpful to the success of your team’s review process, but when combining them together and within the broader context of your vendor risk management program, your organization can successfully implement controls and work to mitigate risks that arise in normal business activities.
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