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Four Steps to Evaluating Suppliers Before Signing a Contract

Your company’s supply chain directly impacts your ability to function as a company and earn profits. If you are waiting on supplies or constantly searching for a new vendor, you lose valuable time and focus when it comes to running your company. And, if that vendor or supplier provides something that is critical to your operations—like flour for your bakery—then it is vital that you can guarantee uninterrupted service. To assess the risk associated with that supplier, you should evaluate the supplier’s financial health. Here are a few recommended steps that look at the supplier’s financial ratios and give them some context.
1.     Calculate the Supplier’s Profitability Ratios: If a company is not profitable, it likely will not stay in business for long. This becomes your problem when you suddenly have to find a new supplier with similar quality goods and immediate capacity. You can assess a supplier’s profitability and margins by focusing on a few ratios: Return on Assets (calculated as Net Income / Total Assets), Return on Equity (Net Income / Stockholders’ Equity), Gross Profit Margin ([Sales – COGS] / Sales), and Net Profit Margin (Net Income / Sales). These metrics, respectively, illustrate how the evaluated supplier is using assets to generate profit, the rate of return on investments in the business, the cushion they have to cover overhead, and earnings for that company—a key predictor of sustainability.
2.     Calculate the Supplier’s Liquidity Ratios: Liquidity ratios provide a measure of the supplier’s ability to meet short-term obligations and therefore the supplier’s sustainability. Ratios that should be used when evaluating a supplier are Current Ratio (Current Assets / Current Liabilities), Quick Ratio ([Current Assets – Inventory] / Current Liabilities), and Net Working Capital Ratio ([Total Current Assets – Total Current Liabilities] / Total Assets). These three ratios will also give you insight into the supplier’s ability to expand through sufficient working capital.
3.     Calculate the Supplier’s Activity Ratios: Activity ratios look at a supplier’s ability to convert balance sheet accounts into cash or revenue. Ratios that should be used when evaluating a supplier are Accounts Receivable Turnover (Sales / Average Accounts Receivable), Accounts Payable Turnover (COGS / Average Account Payables), and Inventory Turnover (COGS / Average Inventory). These ratios illustrate how well the potential supplier manages its collections from and payments to other partners and how well the potential supplier manages its inventory.
4.     Compare the Supplier to Averages for that Industry: If you are able to collect the financial ratios outlined above, the most effective way to use them is to compare or benchmark those ratios to averages from the supplier’s industry. This will give you some context as to whether the supplier is out- or underperforming compared to its peers. This comparison can be difficult if the supplier is a private company. Getting the supplier’s financial information might be a challenge in and of itself, but then finding information for other private companies in that industry could be problematic. If you can’t find decent industry data for private companies, use public company data from the supplier’s industry as a rough guide.
Engaging a new supplier is no small decision, especially if that supplier will deliver goods or services that are vital to your company’s operations. Financial due diligence, as abbreviated in the previous four steps, is one way to begin assessing the supplier’s sustainability as a business partner.