Understanding Supplier Health through their Financial Performance

Supply chains are mechanisms that deliver value for customers and stakeholders. It is essential to understand supply chain performance from the perspectives of information flows, material flows, product flows, and money flows. Selecting the right suppliers and protecting your organization from supply risk is vital to its success. It is the responsibility of every procurement professional to choose only financially viable suppliers.

In this article, we will focus on financial performance indicators you can examine to understand supplier health.

1Inventory Turnover Cost of Goods Sold / Value of Average Inventory

Some sources claim that Inventory Turnover represents the number of times that an inventory is depleted/sold during a period, usually a year. NLPA’s position is that Inventory Turnover measures the number of times that an inventory would be depleted/sold if the organization restocked itself only when inventory was depleted, and all items ran out at the exact same time. The Value of the Average Inventory is calculated by taking the inventory value on the first day of the period and adding the inventory value on the last day of the period then dividing that sum by two. The higher the Inventory Turnover, the quicker the organization depletes its inventory or, in other words, the less inventory the organization keeps on hand. Inventory is often considered as something that ties up cash, so organizations strive to have high inventory turnovers. Many organizations fear that having high inventory turnovers can create stock out situations, leading to the inability to fulfill customer requirements.

2Accounts Receivable Turnover  = Sales / Accounts Receivable

Accounts Receivable Turnover measures how quickly an organization gets paid for the products or services it sells. A high Accounts Receivable Turnover means that an organization is being paid quickly.  A low Accounts Receivable Turnover means that the organization is experiencing difficulty getting paid. A low Accounts Receivable Turnover can be a sign of trouble. It means that, although the organization is generating revenue, it is not getting its cash quickly.

3. Return on Assets  = Net Income / Total Assets

Return on assets is a ratio, expressed as a percentage, designed to illustrate how well an organization is generating profits from its assets.

There are several variations to the return on assets formula so, if your finance department uses return on assets, be sure that you are using the same variation that they are.

4. Return on Equity  = Net income / Owners’ equity

This ratio, expressed as a percentage, is similar to the return on assets percentage. The difference is that in this case, the return is computed on equity.

5. Current Ratio  = Current Assets / Current Liabilities

The current ratio measures an organization’s ability to meet its immediate financial obligations – in other words, pay its bills – using the liquid assets it has available. Note that the higher the ratio, the better. What should a current ratio be? Obviously, if it is less than 1, that means that the company is in serious trouble: the company does not have enough money to pay the bills that are due now. Some sources claim that 1.5:1 or 2:1 is a rule of thumb for a healthy minimum. But be aware that certain industries may have different benchmarks for a healthy current ratio.

6. Quick Ratio  (Cash + Accounts Receivable) / Current Liabilities

The Quick Ratio is very similar to the current ratio. The big difference is that inventory is excluded from the numerator. Inventory is excluded because of the recognition that some organizations can’t simply turn inventory into cash at will. An organization that is overstocked may have a current ratio that misstates its true ability to pay its bills. The Quick Ratio solves that dilemma.

7. Altman Z-Score

Ratio analysis can be overwhelming as many different ratios exist. The calculation of some of them may indicate that a supplier is financially stable while the calculation of others may indicate that the supplier is in trouble. One ratio may indicate that one supplier is stronger than another while another ratio may produce the opposite conclusion. It would be easy to get lost in this situation.

Fortunately, there is a calculation that takes multiple ratios into account and provides a broad evaluation of a supplier’s health. That calculation is the Altman Z-Score.

The Altman Z-Score is a means of assessing the likelihood that a company will go bankrupt within the next two years.

Altman Z-Score is calculated as follows (note that working capital = current assets – current liabilities):

Z = 1.2 (Working Capital / Total Assets) + 1.4 (Retained Earnings / Total Assets) + 3.3 (EBIT / Total Assets) + 0.6 (Market Value of Equity / Book Value of Total Liabilities) + 0.999 (Sales / Total Assets)

After doing the math, you can compare the Altman Z-Score with the following ranges to determine the financial health of the supplier. Z ≥ 3.00: The supplier is considered financially healthy, unlikely to enter bankruptcy in the next two years, and “safe.” 1.80 < Z < 3.00: The supplier is considered to be in a “grey zone” or “zone of ignorance” where there is somewhat of a likelihood that the supplier will go into bankruptcy. Z ≤ 1.80: The supplier is considered to be financially distressed and there is a high likelihood that the supplier will go into bankruptcy.

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