Onboarding new suppliers is an integral component of supply chain management. Doing so successfully can make processes much more dynamic and robust — but a poor decision can cripple the flow of transactions and disrupt the chain altogether.
Therefore, it is best to get a full picture of the suppliers’ business interactions and overall health before engaging with them. Due to the importance of this decision and the complexity of the industry, however, this can be an overwhelming task.
So, what’s the best way to confidently vet these suppliers and determine if they are worth the time and investment? Here are some steps to assessing supply candidates.
Get the Paperwork
One of the first things a procurer should look for is basic information about the suppliers’ financial situation to glean insights and make themselves aware of any potentially negative indicators.
First, a copy of the supplier’s balance sheet will provide information on the company’s assets and liabilities. It also shows the shareholders’ equity in the company, which is helpful in determining a few factors that will be addressed later.
Relatedly, income statements show the supplier’s performance over time, illustrating how revenue is earned and in which markets. These files also prove useful when comparing a supplier’s expenses and profit margins to their competitors’ financial data.
Finally, obtain a Cash Flow Statement to determine how effectively a company generates cash to pay for its operations and obligations. It is also important to acquire this information from similar suppliers in the industry to get an idea of the field and more effectively compare these numbers.
Reviewing these financial documents allows procurers to adequately vet a supplier for a variety of factors and make note of any potential warning signs.
The Basics
James Pearson, an instructor with the Procurement Training Institute, suggests using the following three statistics when analyzing a supplier and reviewing them annually. First, determine the profitability of the company and then compare that data to similar suppliers’ figures.
Next, analyze return on equity (ROE) for the last three years and compare the resulting data to other suppliers. According to Pearson, ROE is useful because it “shows how well assets are being used and meeting industry norms for performance.”
Finally, determine working capital by subtracting liabilities from assets. Pearson says that a company should have at least three months of positive working capital to cover its monthly bills.
While there are many other aspects to investigate in order to fully vet a supplier aside from these statistics, these three elements offer a strong starting point to conduct a helpful financial overview.
Ratios and Z-Scores
The Current Ratio measures a supplier’s ability to pay both short- and long-term obligations to their suppliers. By measuring the company’s current assets against its current liabilities, this ratio can be a helpful predictor of future disruptions to those suppliers. In this case, any ratio over 1.0 is preferable. Getting a result under 1.0 doesn’t necessarily mean the company is insolvent, but it is worth keeping an eye on since an issue with their supplier certainly inhibits the procurer’s business as well.
The Quick Ratio is a more refined version of the Current Ratio in that it focuses on the supplier’s short-term ability to meet its obligations. This ratio is calculated by analyzing the most liquid assets of the company since they allow those obligations to be fulfilled the quickest. If those can be satisfied, then less disruption will occur.
Two other ratios to consider are concerned with inventory. The Inventory Turnover Ratio is used to see how many times inventory needs to be replaced in a given timeframe. Low turnover could indicate an opportunity since it indicates that the company might have poor sales or excess inventory.
Finally, the Days Sales of Inventory Ratio takes the number of days in the year and divides it by the Inventory Turnover Ratio to show how long it takes for its inventory to turn into sales. Though a lower ratio is always preferable, one should compare this ratio to other suppliers to get a sense of the situation and risk.
Extra Credit
Getting to know the lines of credit and rating of the company is another significant indicator of a supplier’s financial health. It’s important to find out which bank is supplying the credit and understand its reliability. The debt-to-equity ratio, calculated by dividing total liability by owner’s equity, will show how reliant the supplier is on creditors. Furthermore, understanding the loans given to the supplier and their conditions is essential in determining the likelihood of them being met and not being hit with exorbitant rates and fees.
Finally, the Z Score is a useful tool used to calculate the likelihood of bankruptcy. Anything that scores above 3.0 indicates stability while anything below 1.8 is a glaring warning sign. It is also useful to consult a rating agency for a credit rating on the supplier.
Additional Factors
A healthy supplier should also have a relatively low customer concentration; it should not depend solely on the business of only one customer, as that would make it extremely dependent on the health of that singular business. Anything greater than 40% concentration is significant while less than 25% is considered healthy.
An audit by an independent entity should also be obtained or requested to fully vet the supplier. A procurer can also assess the reliability of a supplier based on this request, as an unwillingness to have this done could indicate that something is amiss. Interviews can also be conducted with the suppliers’ CFO. James Pearson recommends hiring a specialized financial analyst for this aspect of the supply assessment.
Continued Vigilance
Though difficult and multifaceted, successful procurement is worth the work. Through an exhaustive investigation looking at these factors, a procurer can confidently assess a supplier. Once the supplier selection process is complete it is also useful to remain vigilant, keeping an eye on the health of those suppliers even after a relationship has been established.