How to Assess Financial Risk of a Supplier

Within an organization’s due diligence processes, the proper assessment and understanding of financial risk tends to be underestimated. Like many other facets of third-party risk management, there are a lot of moving parts that make up the total picture of a supplier’s financial health.

If you’re uncertain where to begin, we have put together a list of helpful information and documentation from suppliers to dig into and to get the process going.

Types of Supplier Financial Information to Review

While this is by no means an exhaustive list, the following representative list is a good place to get started when it’s time to review your supplier’s financials and its financial health and risk:

Financial Ratios

There are a variety of financial ratios you can use to better assess and understand a supplier’s financial risk. Some ratios will be more important, depending on your industry or the type and size of your organization, but the following are commonly used across businesses:

• Current ratio. This represents an organization’s liquidity ratio with an emphasis on the near term, which helps paint a picture around how easily a supplier will be able to pay their short-term obligations (those obligations that are due within 12 months). To calculate current ratio, one should take a supplier’s current assets and divide it by its current liabilities. Viewing the current ratio over a trended basis and comparing it to benchmarks and other peers may allow for a more representative understanding of how useful it can be to assess a supplier’s financial health.
  
  Example: Current assets: $10,000 ÷ Current liabilities: $8,000 = Current ratio: 1.25
  
  A general rule of thumb when using this ratio: A current ratio of less than 1.0 may indicate short-term liquidity and solvency issues. However, this may not always be the case given the nuances of the composition of balance sheet accounts. Therefore, this ratio - like many others - should not be viewed in a vacuum and must be used in tandem with other pieces of financial information.
• Profit margins. These help convey whether an organization is successful in converting revenue into profit. Common profit margin ratios/metrics to monitor and include in financial assessments include the following:
  
  
  • Gross profit margin - For example, how much profitability does the organization generate on its revenue after paying its cost of goods sold or costs of services provided?
  • Operating profit margin - For example, how much profitability does the organization generate on its revenue after paying all of its operating expenses, including its costs of products sold and services provided, selling, general and administrative expenses, research & development expenses, etc.?
    
    These ratios can be helpful in determining an organization’s ability to generate, or conversely, its struggle to generate, profit from every dollar of revenue. Profitability can be a useful indicator of an organization’s current and future ability to sustain operations and/or generate sufficient profit to remain viable. Without profit, suppliers will have to seek external capital/funding infusions to maintain business operations.
• Total liabilities/net worth. When assessing additional ratios from a supplier’s balance sheet, it’s important to get an indicator of the organization’s overall total assets and total liabilities base (both short term and long term). Together, this information helps understand how much book value a supplier has, indicating its current financial position at a given point in time. Net worth represents the difference between a supplier’s total assets and total liabilities. By dividing total liabilities over a supplier’s net worth, one can determine how many obligations a business possesses in comparison to how much net value it current has in its current financial standing. This provides insight into the supplier’s leverage levels, and how they may be able to support this into the future. In typical circumstances, lower total liabilities to net worth ratios indicate a better leverage position when assessing the supplier’s financial risk.
  
  Example: Total liabilities: $75,000 ÷ Supplier’s net worth: $100,000 = Total liabilities/net worth value: 0.75
• Accounts receivable turnover ratio. For many organizations, accounts receivable is an important asset to get an understanding of cash inflows that the supplier has access to and will be able to collect on in the future. It’s calculated by simply taking a supplier’s existing accounts receivable balance and multiplying it by total days in the period being assessed (365 or 366 days if assessing an organization on an annual basis) and dividing that product by the supplier’s total revenue in a given time period.
  Calculating a supplier’s accounts receivable turnover can convey the amount of days a business typically collects cash on its outstanding billed accounts. Having this insight can show how fast (lower AR days) or how slow (higher AR days) a supplier collects cash on its outstanding accounts receivable balances, which suggests the supplier’s ability to sustain cash and liquidity to remain financially viable.
  
  Example: (AR balance: $15,000 x 365) ÷ Supplier’s total revenue: $150,000 = AR turnover ratio: 36.5

Management Discussion and Analysis/Audit Footnotes

Often, suppliers will provide audited financial statements or commentary from their financial advisors or management team that provides additional details on the performance and financial standing of the business. This detail conveys useful insight, such as recent restructuring a supplier has done to improve its focus on core operations or details around a recent acquisition the business has made to expand its presence in a certain market. 

While these nuggets of information are typically buried in the documentation provided by your suppliers during due diligence, they can help paint a clearer, more fulsome picture of its financial health. It also allows for good qualitative support and commentary to put alongside financial ratios and information gleaned from a supplier’s financial statements. Together, this information can be used to successfully monitor and manage risks that may arise from a supplier’s financial performance in the future.

Financial Statements

When reviewed together, the following financial statements can convey a more complete picture of a supplier’s financial health and standing. Assessing each of the financial statements in detail can help organizations assess the risk from a financial point that exists from suppliers.

• Balance sheet. The balance sheet provides details on a supplier’s financial position as of a given point in time. From the balance sheet, organizations can assess a supplier’s current capitalization and liquidity position, total assets and outstanding debt, and liabilities. Too much debt or liabilities and not enough cash or assets may indicate that the supplier needs new capital to sustain its operations.
• Income statement. The income statement provides details on a supplier’s financial position over a period of time - typically a month, quarter, or annual timeframe. In a supplier’s income statement, key information, such as total revenue, gross profit, operating expenses, and operating profit are detailed or can be calculated. Together, these metrics and pieces of information help provide insight into how a supplier is performing to sustain and maintain healthy operations to support its product and/or service delivery levels. They can also reveal trends in the suppliers’ financial performance that may require more scrutiny.
• Cash flow statement. Being “liquid,” or having cash, is a critical component in financial health. The cash flow statement shows the components of cash inflows and outflows and how effective a supplier is in generating, or consuming, cash. Major industry changes, economic volatility, and global events (like a pandemic) often have huge implications when it comes to cash flow, which can provide needed insight into a supplier’s financial health in different market environments.

You should also consider the following:

• Customer and supplier concentration. Vendors and suppliers that have customer or supplier concentration, such as a single customer who makes up more than 25% of the supplier’s revenue base, might have greater risk to your organization. This is a common measure to assess, understand, and monitor more thoroughly to ascertain the risk that may be posed to the supplier if it loses this relationship from a highly concentrated partner in the future.
• Creditors. What banks back your supplier? How much debt have these banks committed to the supplier? How much of this debt/capital is outstanding? Is the bank a reputable source of funding? Make sure to take note, as these can suggest further levels and insight into a supplier’s position and standing in the marketplace.
• Type of debt/financing. What type of debt or equity has the supplier raised or has access to? Are these financing sources available in the future? How do these financing sources help the business in the normal course of business and operations? This information can suggest a supplier’s ability to secure or access future capital and funding in the future if needed to support liquidity or operations.

The financial strength of a key supplier plays a critical role in your organization’s overall operation and financial health. Keep in mind, a well-capitalized supplier can help provide valuable products and services your organization needs to sustain its operations and continue its growth trajectory and success. 

Without the proper controls and risk management of a supplier’s financial health and standing, poor financial health of suppliers can have a disastrous effect on your business. It’s imperative that your organization take the proper steps to ensure proper controls and risk management processes are implemented and maintained to minimize the risk that arises from the financial health of suppliers in today’s complex business environment.