This week’s Wiki-Wednesday topic is financial statement analysis, and hopefully you’ll believe me when I say that if I can get comfortable with this, ANYONE else can too. Financial statements are not always easy to read, but with risk management and new supplier identification on the docket, the time has come for all of us to get used to doing it.
Below are some common ratios, how to find or calculate them and what they will tell you about your supplier’s financial stability. Once you have calculated them for each supplier, you will have a measurement that can be compared across all suppliers being considered for award in a project. Do keep in mind that ratios like these are based on a snapshot in time. It is important to keep an eye on the financial reports of suppliers that are particularly strategic, are small compared to the business you have awarded them, or have shown signs of instability in the past.
You may find it a little more difficult to get full financial information from privately-held companies, but if you are seriously considering them for award, keep at it. As this quote from Charles Purchasing Blog states, it is a myth that it can’t be done: “Many privately-held suppliers do resist sharing financials with prospects. However, making the disclosure of financial statements a condition of awarding business and being willing to make accommodations - such as signing a non-disclosure agreement and limiting access to the statements - can convince suppliers to share financials.”
As the Wikipedia article on financial statement analysis outlines it, there are two types of ratio analysis: risk (liquidity, solvency) and profitability. In this post, we will focus on risk analysis. I am going to pull together information from several Wikipedia articles here, and you can link back to them by clicking on the name of each ratio or measure of risk. Analysis of risk typically aims at detecting the underlying credit risk of the firm.
Ratios of risk such as the current ratio, the interest coverage and the equity percentage have no theoretical benchmarks. It is therefore common to compare them with the industry average over time. If a firm has a higher equity ratio than the industry, this is considered less risky than if it is above the average. Similarly, if the equity ratio increases over time, it is a good sign in relation to insolvency risk.
Liquidity analysis aims at analyzing whether the firm has enough liquidity to meet its obligations when they should be paid.
A usual technique to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful.
Current ratio: measures whether or not a firm has enough resources to pay its debts over the next 12 months by comparing a firm's current assets and current liabilities.
Current Ratio = Current Assets / Current Liabilities.
For example, if WXY Company's current assets are $50,000,000 and its current liabilities are $40,000,000, then its current ratio would be $50,000,000 divided by $40,000,000, which equals 1.25. It means that for every dollar the company owes in the short term it has $1.25 available in assets that can be converted to cash in the short term. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (i.e., your current assets are twice your current liabilities).
Interest coverage: Times interest earned (TIE) or interest coverage ratio is a measure of a company's ability to honor its debt payments. It may be calculated as either Earnings Before Interest and Taxes (EBIT) or Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) divided by the total interest payable. Interest Charges = Traditionally "charges" refers to interest expense found on the income statement.
Times-Interest-Earned = EBIT or EBITDA / Interest Charges
Times Interest Earned or Interest Coverage is a great tool when measuring a company's ability to meet its debt obligations. When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations. The Company would then have to either use cash on hand to make up the difference or borrow funds. Typically, it is a warning sign when interest coverage falls below 2.5x.
Solvency analysis aims at analyzing whether the firm is financed so that it is able to recover from losses or a period of losses.
A usual technique to analyze insolvency risk is to focus on ratios such as the equity in percentage of total capital and other ratios of capital structure. Based on the risk analysis the analyzed firm could be rated, i.e. given a grade on the riskiness, a process called synthetic rating.
Solvency ratios measure the financial soundness of a business and how well the company can satisfy its short- and long-term obligations. D&B uses six key financial business ratios to measure a company’s solvency:
Current Ratio (See above)
Quick Ratio: This ratio, also called "acid test" or "liquid" ratio, considers only cash, marketable securities (cash equivalents) and accounts receivable because they are considered to be the most liquid forms of current assets. A Quick Ratio less than 1.0 implies dependency on inventory and other current assets to liquidate short-term debt. This ratio is calculated using the following formula: (Cash + Accounts Receivable) / Current Liabilities
Current Liabilities to Net Worth Ratio: This ratio indicates the amount due creditors within a year as a percentage of the owners or stockholders investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80%. This ratio is calculated using the following formula: Current Liabilities / Net Worth
Current Liabilities to Inventory Ratio: This ratio shows, as a percentage, the reliance on available inventory for payment of debt (how much a company relies on funds from disposal of unsold inventories to meet its current debt). This ratio is calculated using the following formula: Current Liabilities / Inventory
Total Liabilities to Net Worth Ratio: This ratio shows how all of a company's debt relates to the equity of the owners or stockholders. The higher this ratio, the less protection there is for the creditors of the business. This ratio is calculated using the following formula: Total Liabilities / Net Worth
Fixed Assets to Net Worth Ratio: This ratio shows the percentage of assets centered in fixed assets compared to total equity. Generally the higher this percentage is over 75%, the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery and the margin for operating funds becomes too narrow for day-to-day operations. This ratio is calculated using the following formula: Fixed Assets / Net Worth