Assessing the financial position of a supplier or contractor is of utmost importance while selecting the supplier. The financial parameters make substantial part of the evaluation criteria during the selection process. If the financial position of company is not strong then it will not be able to perform his contractual obligations as per the contract and it will be a financial risk on part of procuring organization. Therefore, the suppliers are evaluated for his financial standing as per the financial statements submitted by him in their bid and on the basis of other information available about the suppliers so that the financial risk of the purchaser or procuring organization is minimized. A fair assessment of the financial stability of supplier is also very helpful during contract negotiation. Some ratios are very helpful to evaluate the financial position of a supplier.
Below are given the financial statements and information which has to be reviewed to evaluate financial position of a supplier.
Index
(A) Profitability Analysis
Profitability analysis is a test of how much efficient is a firm in generating profits through operations or by investing its assets and is analyzed by comparing following ratios and parameters:
Gross Profit Margin
Profit margins indicate a company’s ability to convert its revenue into profit. A gross profit margin provides idea about the money left from the sales of the product after subtracting the cost of goods sold. This indicator may be compared to the industry average to determine the company’s production efficiency. If a company keeps the prices of its products high, then it may have more gross profit margin but on the other hand the sales of the product may be reduced in such cases.
Operating Profit Margin
This ratio indicates that how much profitability a company generates form its revenue after paying all of its operating expenses, including cost of product sold and other general and administrative expenses but before paying taxes. High operation profit margins are better as they indicate that the company is efficient in operation of its functions.
Return on Investment (ROI)
Return on Investment is the ratio of net income of a firm and total capital invested. It is a measure of how efficiently the company is investing its money. Companies having higher than industry average ROI means they are using their assets well and are having a good financial position.
Return on Assets Employed (ROAE)
It is again a measure of how well an organization is investing its assets, including the impact of borrowed funds.
Return on Total Assets (ROTA)
This parameter is a measure of a company’s ability in generating income on its assets invested. A high ROTA means the company is efficiently using its profits to generate income. It’s appropriate to compare the ROTA of companies from the same industry as they share same asset base.
(B) Liquidity Assessment
Liquidity assessment shows how quickly the company can convert its assets into cash and it can be done by knowing and comparing working capital, current ratio and quick ratio which are described below:
Working Capital
Working capital of a firm is simply the difference between its current assets and current liabilities. A positive working capital indicates good financial health of a company since it has enough current assets to cover its current liabilities. It is not as useful as quick ratio because all current assets may not be perfectly liquid. A low working capital indicate a risk of default. A high working capital is not always a good thing as sometimes it may also be due to the reason that the company has high inventory or it is not investing its cash properly.
Current Ratio
By seeing the current ratio, it may be determined that how easily, the supplier can pay his short term debt or financial obligations (due within 12 months). It also indicates the willingness of a contractor or supplier to make concessions to obtain cash.
A current ratio of less than 1.0 indicates that the current liabilities of supplier is more than current assets and he may have short term liquidity issues. This ratio should not be viewed in isolation and should be reviewed along with other financial parameters.
Quick Ratio
This ratio includes only the assets which can be converted quickly into cash. It is also an indicator of a supplier’s short term liquidity position and determines supplier’s ability to meet short term expenses or current liabilities with its liquid assets. It is also called ‘acid test ratio’.
A quick ratio of less than 1 means that the supplier does not have enough liquid assets to cover its short term liabilities. A quick ratio of more than 1 is considered good.
A quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to liquidate.
(C) Financial Statements
Four financial statements namely balance sheet, income statement and cash flow statement tells about a company’s financial health, which are described below in detail:
Balance Sheet
A balance sheet is one of the most important financial statement the company has to submit during the evaluation process. Balance sheet shows company’s assets, liabilities and shareholder’s equity at the end of financial year. It does not shoe the flow of into and out of the accounts during the financial year.
On the left side of the balance sheet, company’s assets are mentioned and on the right side, liabilities and shareholder’s equity are mentioned. The sum of liabilities and shareholder’s equity are equal to the assets of a company.
Assets are of two types, current assets and non-current assets. Current assets are the assets which the company expects to convert into cash within one year while non-current assets are the long term assets which would take longer than one year to liquidate.
Similarly, liabilities are also of two types, current and long-term liabilities. Current liabilities are to be paid by the company within one year while the long-term liabilities are the financial obligations which have to be paid in the long run, i.e. after one year or more.
Shareholder’s equity is the amount; shareholders of the company have invested in the company’s shares plus or minus the company’s earnings or losses since inception. Sometimes company distributes its earnings among shareholders, which is called dividends.
Balance sheet of a company provides and overview of the assets and liabilities of a company and therefore gives an idea of financial standing of a company.
Income Statement
Income statement of a company gives information about revenue earned and costs and expenses incurred in earning that revenue during the financial year. Total money obtained from the sales of the products or services is called ‘gross revenue’. Then there may be some discounts or merchandise returns. If we deduct the discounts and value of merchandise returned, then we will get ‘net revenue’ of the company.
There are certain operating expenses that company have incurred to obtain the revenue. After subtracting operating expenses form the net revenue of the company we obtain what we called ‘gross profit’ or ‘gross margin’ of the company.
There is some other type of expenses that the company have incurred to support the operations of the company, like salaries of the staff and other administrative expenses. These administrative expenses are deducted from the gross profits to get operating profit before interest and income tax expanses. These are termed as ‘income from operations’.
Companies may have interest income or interest expenses depending upon whether they have earned interest income by investing their assets or paid interest on loans taken by them.
Finally, when we add or subtract the interest income or expenses whatever the case may be and subtract income tax form the income from operations we arrive at ‘net profit or net losses’.
This tells us how much did the company finally earned or lost during the financial year.
Income statements also report ‘earnings per share (EPS)’. EPS tells us, how much money the shareholder will receive if the company decides to distribute among shareholders, its net earnings for the financial year.
Cash Flow Statements
Cash flow statements mention about company’s cash inflows and outflows. The organizations need cash for their day to day operation, therefore it is important to know the position of companies regarding cash available with them. There are three parts of cash flow statement.
The first part analyzes company’s cash flow from net income or losses.
The second part shows company’s cash flow form net income or losses. In the second part, cash flow from all investment activities of the company are shown. It includes purchases and sales from assets. If the company sells some of its assets like property, etc. then it will be shown as cash inflow from sale of that property and if company purchases some property or machines, etc., it will be shown as cash outflow.
Third part of cash flow statement shows the cash flow from all financing activities which include the cash received from selling stocks and bonds and borrowings form banks. Paying bank or other loans is shown as cash outflow.
Key Takeaway
- Assessing the financial position of a supplier or contractor is of utmost importance while selecting the supplier.
- Two types of analysis are done for assessing the financial position of a company. One is profitability analysis and the other is liquidity assessment.
- Profitability analysis includes determination of some ratios and other parameters like gross profit margin, operating profit margin, return on investments (ROI) and return on assets and shows how much efficient is a firm in generating profits through operations or by investing its assets.
- Liquidity assessment shows how quickly the company can convert its assets into cash and it can be done by knowing and comparing working capital, current ratio and quick ratio.
- A current ratio of less than 1.0 indicates that the current liabilities of supplier is more than current assets and he may have short term liquidity issues.
- A quick ratio of less than 1.0 means that the supplier does not have enough liquid assets to cover its short term liabilities. A quick ratio of more than 1 is considered good.
- Three types of financial statements are analyzed to determine the financial standing of a company namely, balance sheet, income statement and cash flow statement.
- Balance sheet gives an idea about assets and liabilities of a company, income statement gives information about revenue earned and costs and expenses incurred in earning that revenue during the financial year while the cash flow statement mention about company’s cash inflows and outflows.
