How to read a financial analysis as procurement professional

Posted on: December 11, 2017, by :

First of all: knowing the details of your suppliers are key to your success as a procurement professional. Understanding the financial details of your supply base allows you to determine which key numbers are healthy or industry standard. As well, it can help you to determine if they do not make too much profit (i.e. are too expensive or could be cheaper) or on the other extreme end: unhealthy.

The financials should be in a sweet spot, which is not easy to reach, maintain or even show. A supplier needs to have money in the bank (liquidity and solvability), low stocks (but not too low) and healthy investments.

Basic rules for buyers when assessing the suppliers financial results

You can make use of service providers like CreditSafe, Dun & Bradstreet or similar. I would always use these in favor of chamber of commerce results because of readability and additional services.

  • Make sure the report is an extended report. The compressed reports are useless.
  • The report should contain Balance Sheet and Profit & Loss accounts
  • Must be as recent as possible. In case of stock enlisted company, use quarterly results of the company itself.
  • Important limitations: any financial analysis based upon historical accounts are not fit for use in case of rapidly evolving markets (e.g. financial crisis 2009)
  • It only gives an indication of risk and profitability of the company
  • Always look at the direct trading company, then to the holding structures above

The “dont’s” in assessing supplier financial results

  • Do not look at the profit level of a company to make estimations of the profit. The net profit is only the number that the account wants you to see and has NO MEANING unless you do the rest of the analysis
  • Do not take is as the absolute truth, always combine it with the rest of the knowledge you might have of the company
  • Don’t use it “black and white” in negotiations. When you argue they make too much profit, in the other years they will put profit under other accounts
    • Such as company cars, restructuring of debt, increased stock levels, dividends to owners or increased wages on management. This means that equity will be leaking out of the company.
  • Don’t use the “risk indicators” from D&B. They tell you only how well this company is doing in their country in their industry in their relative size. It is not an absolute number. Most likely is that a company with a score of 80 in Germany is more healthy than a score of 100 in Liberia.

 

Step 1: First field of attention; ownership structure

  • First assessment to be made is the ownership structure:
  • Who are the shareholders and which moves have been made in the recent past? Do we know why these moves have occured?
  • What is the holding structure? This is crucial: if the holding is unhealthy, it can bring down the complete group. If the holding needs to pay for losses of company C in below picture, it might be that B and A also go bankrupt.
  • However, if the companies make a lot of money, they usually consolidate this to their owners (holding or in case of Sub B1, to Sub B), usually for tax reasons. This decreases transparency.
  • In worst case, you end up with a house of cards
  • There are many complex holding structures, which can also be designed as “sterfhuisconstructie”. Pay attention to this in case of mergers. In a “sterfhuisconstructie” a new holding is buying the vital parts of the partner, and let’s the rest go bankrupt. This is 1 of the ways to terminate contracts that are otherwise not able to be terminated.
A simplified holding structure of a company, with different subsidiaries

 

Step 2: Profit & Loss account: personnel cost

  • Classic from sales people: wages went up. Did they? Relatively easy to check: a full D&B report gives access to number of people and to personnel costs over the years. Always use country statistics to check.
  • Look at the total: personnel expenses which consists of wages and salaries, social security and health insurance, other social expenses.
  • More turnover generally means more production personnel and less management. This means that the average cost per employee goes down (change of overhead ratio)
  • Lots of overtime can make picture look worse but tells little about actual wages.
  • It can be used to show less profit: if there are 2 owners in the company, they can adjust their salaries.
  • Do such analysis in local currencies. Don’t be tempted to do it in the currency you pay, as this may backfire on you.

Step 3: Depreciation ratio

  • Fixed assets are depreciated in a standard way, which companies are usually by law not allowed to change. Exceptions are start up companies (they can depreciate at will in the first years) and other countries might have other legislation.
  • Standard depreciation is 7 years, in Dutch tax laws it is max. 20% of the original value per year, minues the rest value (for machines). There is a big difference between tax-depreciation, economical depreciation and technical depreciation. The P&L account shows the depreciation for tax.
  • Typically, profitable companies want to depreciate as much as possible, however it also makes the company less worth.
  • The ratio between depreciation and income defines how much capital is needed to renew it’s assets. In one case I managed, 4% of their total costs in 2011 was depreciation. In 2015, this was 2%. This means that they are making twice as much turnover with the same assets.
  • A company which doesn’t invest, will go to 0 depreciation pretty fast. This is not necessarily good news…
  • Depreciation is hard to interpret, as you have several depreciation periods (5 for computers and machines for example, 30 over buildings, no depreciation over land owned, but it is counted as asset).

Step 4: other items on the P&L account

  • Always look at changes throughout the years; quickly growing turnover with diminishing market share for you could be a threat or a treat. Has to be investigated but is probably already known by the buyer. It can be used together with other knowledge to determine the size of other customers and their growth potential.
  • Gross profit ratio’s that rise or fall as a result might be an indicator for the price level of the rest of the customers.
  • Interest costs can be easily calculated in percentages (divide the costs over the loans on the balance sheet).
  • ROA: the net profit can be divided over the total investment (total assets). There is no good or bad and varies widely accross industries. However, in 1 company the comparison over the years can show whether investments were wise or not.
  • Generally investors look more at the ROA than to the net profit as net profit is the number the accountant wants you to see. The ROA is much harder to influence so more fact based.

Step 5: the balance sheet

  • The balance sheet tells the most about how healthy a company is, but must always be seen with the P&L account
  • It shows the ratio between own equity and external funding
  • Shows the book value of machines, land, inventory
  • But also noteable changes in these items, which can tell complete stories about investments, de-investments and debt structuring.
  • Big changes in assets means large investments.
  • Pay extra attention to the funding
  • Increase of long term loans, short term loans, decrease of cash position, decrease in stock position
  • Large investments and big growth require a lot of cash to fund the growth in working capital.  See further down “growing to bankruptcy”.
  • Large growth and small debt can also mean lease-constructions on assets. These are generally (much) more expensive, but require less cash.
  • Change in accounts payable at closing date might be due to showing better numbers to banks (a commonly used “trick” in stock-listed companies) as it doesn’t show in KPI’s in some bank-ratio’s.
  • For the best insight you actually need a cashflow statement. Which you won’t get. Don’t even try.
  • Pay special attention to deferred revenue and deferred expenses
    • Deferred revenue are prepaid items for which goods still need to be delivered (liability). For example if my customer paid me 1 million EUR on December 20 for goods to be delivered in January, then I have 1 million deferred revenue on the balance sheet. When I deliver the goods in January, it goes back to 0 and the rest is booked as income (with its subsequent influence on other postings such as stock, equity etc).
    • Deferred expenses can be any type of item, such as lease contracts for which the total worth is on the balance as asset and transferred per month to the income statement. Example: if I have a machine leased for 1.000.000 EUR over 100 months, the amount on the balance sheet will be after 1 month only 990.000 EUR. 10.000 EUR is transferred to the income statement as actual costs at that moment.
  • No companies go bankrupt because they make loss. You only go bankrupt when you have no cash to pay your creditors.
  • Cash is king, cash flow is queen, credit is power
  • Cash position itself says absolutely nothing.
  • Cash flow is what makes the company live or die
  • Credit is power: if you have good ratio’s, you can borrow money to survive a cash deficit (e.g. in fast growing companies with heavy investments)
  • Many ratio’s come from the balance sheet and are related to debts of the company.
  • How a company is funded is crucial for success. Investors (means people who put money in for a part of the shares of the company) strive for a debt ratio which is as HIGH as possible. This increases risk, but also the lever of own equity.
  • Lenders (people who put money in against an interest rate) strive for low debts, especially low debts on short term. Short term debts can make a company extremely vulnerable for economic down turns.
  • Lessee’s (lease companies who put assets in against an interest rate) strive for the same as bankers, but against lower interest rates generally.

Growing to bankruptcy

You should also consider that when your supplier is rapidly growing, that this is stretching their cash position. After all, imagine  the following:

A supplier has a revenue of 200mio EUR (or whatever the currency is). 40% of this is cost of goods sold. This means that there is a purchased spend of 80mio EUR per year. If the average payment term is 60 days, it means an accounts payable balance of roughly 13.3 mio EUR and with the same payment term of the customer an accounts receivable balance of 33.3mio EUR.

Imagine that this supplier has a net profit of 10%, being 20 mio EUR per year. This supplier is now growing with 25% the next year and other conditions remain the same.

The revenue is now 250mio EUR and the purchased goods are 100mio EUR. The accounts payable grow towards 16.6mio EUR. This means that an additional 3.3mio EUR in cash needs to be available on average to cope with this growth.

On the accounts receivable part of the balance sheet, the supplier has grown towards 41.7mio EUR. As This is a growth of 8.3 mio EUR. As a balance sheet always needs to be in balance (what’s in a name?), it means that the actual growth of capital should be 8.3 mio EUR on the asset side of the company as well as on the debt side of the balance sheet.

Usually sales persons are very proud and happy to present such numbers of growth. But you should always be very critical: is it actually good news? How do they finance it? Where does the money come from and is this origin a threat or a blessing?

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