How to Read a Vendor Financial Statement

Reading and evaluating vendor financial statements is an important due diligence activity that can reveal many hidden risks. For instance, a vendor with poor financial health can potentially lead to declining service levels or the vendor’s inability to continue providing a product or service.

It’s important to remember that analyzing a vendor’s financials shouldn’t be treated as a check-the-box activity, where the only focus is on data like revenue or cash flow. Vendor financials contain a lot of nuances that must be carefully evaluated to fully understand the bigger picture. Let’s explore what it takes to fully evaluate a vendor’s financial statement.

4 Steps to Take to Effectively Read a Vendor Financial Statement  

1. Engage a subject matter expert – Any type of vendor financial statement should always be reviewed by a qualified subject matter expert (SME), such as a certified public accountant (CPA), financial risk analyst, or another experienced individual. For vendors that are public, you can generally collect their data on the public domain, such as 10-K annual reports – or 10-Q quarterly reports with the SEC, if they are a U.S. based public company. 
   
   For private vendors, you’ll have to work directly with the vendor to get access to their financial information, which can come in the form of audited financial statements, unaudited financial statements, or statements of financial conditions from the vendor’s finance leaders, owners, or management team. Having a qualified SME perform vendor financial health reviews can provide you with much-needed insight to identify and mitigate any financial health risk across your current and future vendor base efficiently and adequately.
   
   
2. Evaluate the quantitative data and the numbers – It’s important to analyze different types of vendor financial statements, as well as the trended financial information over time. You’ll generally want to collect at least three years’ worth of the three primary financial statements: income statement, balance sheet, and cash flow statement. This data can then be used to calculate and evaluate key ratios to understand the vendor’s financial health. 
   
   Here’s an overview of the types of vendor financial statements to review and numbers you’ll want to compare: 
   
   
   • Income Statement – The income statement helps reveal whether the vendor can generate enough revenue and make a profit through its operations. Focus on the numbers that state how the vendor makes money and converts it into a profit, such as total revenue, gross profit, gross profit margin, operating income, and net income. 
   • Balance Sheet – The balance sheet focuses on a specific point in time and can reveal whether the vendor has limited cash or assets or if it has too much debt or liabilities. A balance sheet review should focus on data such as cash, current and total assets, current debt and liabilities, and tangible and total net worth.
   • Cash Flow Statement – Review the cash flow statement to better understand where the vendor’s cash is coming from and where it’s being used. This gives key insight into the vendor’s sustainability around its operations and funding. Focus on areas such as beginning cash, ending cash, net cash flow, and cash flow from or used in operations, investing, and financing. 
   • Ratios – Once you’ve reviewed the data from the income statement, balance sheet, and cash flow statement, you can calculate key ratios for additional context. Key ratios will vary based on the vendor’s industry and your organization’s preferences, but you can start with profit margins and liquidity/debt ratios. The vendor’s balance sheet health should also be assessed by looking at items such as current ratio, annual revenue turnover, leverage ratios, and the goodwill or intangibles as a percentage of total assets. 
     
     
3. Interpret the data – As you comb through the vendor’s financial statements and data, keep in mind the following questions to make sure you understand and thoroughly evaluate the data:
   
   
   • Is the vendor making money?
   • Does the vendor have a strong track record of revenue growth, scale, and/or stability?
   • Is the vendor profitable? If not, why not and when can they get to profitability or support their 
     lack of profitability through other capital objectives?
   • Do they have sufficient liquidity (or access to capital) to support their ongoing operations and support their contractual obligations?
   • Does the vendor have significant debt or liabilities? How will the vendor support the repayment of these obligations? 
     
     
   Pro Tip: It’s easy to misinterpret data if you’re only focusing on a small data set, only quantitative data and numbers, or a single financial statement. Therefore, it’s a good idea to combine qualitative data with your quantitative financial data review. This will ensure your organization is obtaining a broader picture of the vendor’s overall financial health.
   
   Here are some key areas to review and extend your vendor financial health reviews beyond just the numbers:
    
   • The risk factors – These are the risks that the vendor currently faces, and this section may also include notes pertaining to regulatory actions. Risk factors can be unique to the vendor itself or the vendor’s industry or region. Other risk factors may apply to the entire economy. This section can be helpful in bringing your attention to certain areas that need more context. 
   • Active legal proceedings or lawsuits – Be aware of any pending lawsuits or legal proceedings that the vendor is facing, as well as the potential settlement charges. This could give insight into the extent of these legal issues on the vendor’s bottom line.
   • The auditor’s opinion on financial statements – This usually precedes the financial statement tables and is generally presented in terms of an unqualified (good) opinion or qualified (bad) opinion. Another point to consider is the auditor’s going-concern opinion, which refers to the vendor’s financial longevity.
   • The auditor’s opinion on internal controls – This opinion states whether the auditor has deemed the controls adequate or not. You can usually find this information alongside the opinion on financial statements.   
   • Management discussion and analysis – Certain trends and other qualitative data will often benefit from some additional context. This is where the vendor’s management can further explain their business, results, and nuances.    
     
     
4. Build your analysis and document it accordingly – Finally, you can formally document the findings of your vendor financials review, which should detail what needs to be done to mitigate any risks.
   
   Consider collaborating with key stakeholders to develop a risk rating scale that aligns with your organization’s risk management goals. This risk rating and summarized document can be shared with other team members and/or auditors, examiners, and governance stakeholders. This provides a level of consistency, effectiveness, and efficiency that empowers your organization to improve your vendor risk management function. 
   
   With these reports  and findings, your team can take steps directly with the vendor, such as developing service level agreements (SLAs), changing contractual commitments, or exploring other alternative vendors that meet your organization’s desired financial health risk profile and provide a similar product or service. A common request in contracts or within SLAs is to have the vendor provide annual financial statements during the contractual period to allow your organization to perform its regular financial health reviews and assess vendor financial health risk over time. 

A vendor’s financial performance can be a strong indicator of potential risks down the line, so it is essential to fully analyze this information to identify any red flags that need to be addressed. A comprehensive understanding of your vendor’s financial health can help ensure your organization is better protected against hidden or unidentified risks that may have an impact across the rest of your organization and in other areas such as cybersecurity, data privacy, information security.