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Supplier Appraisal: Finances and Ration Analysis Report (Assessment)

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Updated: Jul 16th, 2020

Executive summary

A company needs to carry out an appraisal of suppliers before awarding them contracts. This ensures that credits worthy suppliers are selected. This paper focused on the appraisal of a supplier. Specifically, the paper focused on reviewing the income statement and balance sheet. The review reveals that there was growth in revenues, net income, and net assets. Besides, the company does not have debt. The second part of the appraisal focused on ratio analysis.

The analysis shows that the profitability of the company improved. However, the overall profitability was low. Further, the liquidity and investment ratios improved. However, the efficiency in the use of assets dropped. Finally, the Z-score shows that the financial standing of the company is fairly stable. Therefore, the supplier should be considered for a sourcing exercise for Facilities Management Services. However, the contract value that should be awarded to the company should not exceed the value of net assets.

Review of financial statements

In this section, the income statement and the balance sheet of the supplier will be reviewed. The subsequent discussion on the two financial statements is presented below.

Income statement

The profit and loss statement gives information on whether the company made a profit or a loss at the end of a trading period. Profit or loss is calculated by the difference between revenue earned by the company and the expenses for the entire financial year. The revenue earned by the company (turnover) grew from $138,276 in 2013 to $161,438 in 2014. The growth in revenue shows that sales improved. The cost of sales also grew from $112,654 in 2013 to $124,677 in 2014. For most companies, there is always a direct relationship between the cost of sales and turnover. As turnover increases, the cost of sales is also expected to increase. An increase in the cost of sales can also be partly attributed to an increase in the prices of commodities. The gross profit grew from $25,622 to $36,761.

The values are arrived at by taking the difference between turnover and cost of sales. The value of gross profit shows the amount of profit generated from the value of sales and direct costs. Other operating expenses also grew from $26,984 in 2013 to $32,561 in 2014. The company reported an operating loss in 2013. This shows that the number of operating expenses exceeded the value of gross profit. However, in 2014, the performance of the company improved and the company reported an operating profit amount to $4,200. Interest receivable dropped from $18 in 2013 to $17 in 2014. The taxes on profit /loss grew from $8 in 2013 to $1,545 in 2014. Finally, the profit for the year ($1,352) in 2013 to $2,672 in 2014. Thus, a review of the income statement shows that there was growth in the earnings of the company (Weygandt, Kieso and Kimmel 341).

Balance sheet

The balance sheet of the company gives information on what the company owns and what it owes to other parties as at 31st March 2013 and 31st March 2014. The total assets section contains the fixed asset and current assets. The fixed assets of the company comprise of the tangible and the intangible assets. The intangible assets dropped from $1,352 in 2013 to $1,202 in 2014. The drop of $150 can partly be explained by the amortization of the intangible assets. The tangible assets are plant and machinery, computer equipment, and other equipment. The book value of the tangible assets dropped from $1,786 in 2013 to $1,726 in 2014.

The value of total assets dropped from $3,138 in 2013 to $2,928 in 2014. This can be as a result of amortization and depreciation. It can only indicate that there were no additions that were made by the company during the year. Three items were recorded under the current assets. These were stocks, debtors, and cash. The company reported two categories of stock. These are raw materials and consumables and finished goods. The balance of raw materials and consumables was higher than that of finished goods. The raw materials and consumables dropped from $724 in 2013 to $576 in 2014. Similarly, the value of finished goods also declined from $722 in 2013 to $150 in 2014.

The total balance of the stock dropped from $1,446 in 2013 to $726 in 2014. The value dropped by more than half. This can be an indication of improved efficiency in handling stocks. However, it will hurt the working capital of the company. Another component of the current asset is accounts receivable (Weygandt, Kieso and Kimmel 291). The debtor balance grew from $30,457 in 2013 to $35,975 in 2014. The increase can be a result of a change in the credit policy of the company or inefficiency in the collection of debts. The cash balance also increased from $5,483 in 2013 to $12,253 in 2014. The resulting balance of current assets grew from $37,386 in 2013 to $48,954 in 2014.

Total assets (sum of current and fixed assets) grew from $40,524 in 2013 to $51,882 in 2014. Further, it can be noted that a significant proportion of total assets are made up of current assets. The fixed assets accounted for 8% of total assets in 2013 and 6% in 2014. This proportion is quite low and it shows that the company does not have adequate fixed assets that can support growth in revenue and the entire company.

Another important section of the balance sheet is liabilities. It shows the amount that the company owes other parties. The first component of liabilities is the value of creditors that are falling due within a year. The value grew from $33,842 in 2013 to $43,524 in 2014. This shows that the number of short term liabilities rose during the period. However, there was a slight decline in the value of creditors that are falling due after more than one year.

The value dropped from $111 in 2013 to $73 in 2014. The balance of provision for liabilities grew from $2,340 in 2013 to $4,206 in 2014. The increase can be attributed to growth in the balance of short term creditors. The balance of net assets (the difference between fixed assets and liabilities) dropped from $4,231 in 2013 to $4,206 in 2014. The decline can be explained by the fact that the growth rate of liabilities exceeded that of total assets. The company does not have a short term and long term loans. It does not use debt financing.

The final important section of the balance sheet is capital and reserves. It shows how the company is financed and the amount of profit that has been retained. There were no changes in the share capital account. The value remained constant at $1,135. This shows that there was no issue or repurchase of shares. There was a slight drop in the profit and loss account from $3,096 in 2013 to $3,071 in 2014. The decline shows that the profit earned by the company dropped by $25 between 2013 and 2014. The total shareholders’ funds dropped from $4,231 in 2013 to $4,206 in 2014 (Ochonma 181).

Ratio analysis

The reported balance sheet and profit and loss statement do not give an in-depth analysis of the strengths and weaknesses of the company. Therefore, it is necessary to carry out a comprehensive financial analysis of the statement provided to have a better understanding of the company. Further, ratio analysis helps various users to make informed decisions. Ratio analysis breaks down the financial data into various components for a better understanding of the financial strengths and weaknesses of an entity. Some of the common categories of ratios are liquidity ratios, profitability, leverage, and efficiency ratios among others. These ratios measure different attributes in the financial health of a company (Weygandt, Kieso and Kimmel 310). This section will show the calculations and interpretation of the different categories of different ratios.

Profitability

Profitability ratios indicate the earning ability of the supplier. The ratios measure the effectiveness of a company in meeting the profit objectives, both in the long and short run. The ratios show how well a company employs its resources to generate returns. Commonly used profitability ratios comprise gross profit margin, operating profit margin, net profit margin, and return on asset ratio among others. Calculations of the profitability ratios are presented below.

Ratios 2014 2013
Gross profit margin = gross profit/sales revenue 36,761 / 161,438 * 100
22.77%
25,622 / 138,276 * 100
18.53%
Mark up = Gross profit/cost of sales 36,761 / 124,677 * 100
29.48%
25,622 / 112,654 * 100
22.74%
Profit margin = Profit before interest and tax/sales revenue 4,200 / 161,438 * 100
2.06%
(1,362) / 138,276 * 100
(0.98%)
Profitability = profit before interest & tax / total assets * 100 4,200 / 51,882 * 100
8.1%
(1,362) / 40,524 * 100
(3.4%)

The gross profit margin of the supplier grew from 18.53% in 2013 to 22.77% in 2014. The ratio measures the amount of profit that business generates from trading. The growth shows an improvement in earnings from trading. However, it can be noted that the values of the ratio were quite low. This can be attributed to the high cost of sales. The mark up of the company also grew from 22.74% in 2013 to 29.48% in 2014. The ratio gives information on the amount of profit that is added to the cost of sales. The increase in the value of the markup partly explains why the gross profit grew during the period.

The profit margin grew from (0.98%) in 2013 to 2.06% in 2014. The ratio gives information on the amount of profit that the supplier generated after deducting the operating expenses. The supplier was able to move from a negative position of net profit in 2013 to a positive position. This shows a significant improvement in performance. However, the value of the ratio was still quite low. It can be an indication that the company is no efficient in managing operating expenses.

Finally, the ratio of profit before interest & total assets grew from (3.4%) in 2013 to (8.10%) in 2014. The ratio gives information on the amount of profit generated from a unit of total assets. Therefore, the growth in the ratio shows that the efficiency in the use of assets improved. In summary, the profitability ratios of the supplier were quite low despite the improvement that was observed during the two years (Weygandt, Kieso and Kimmel 322).

Liquidity

Liquidity ratios show the ability of an organization to maintain positive cash flow while satisfying immediate obligations, that is, the availability of cash to pay current obligations. The commonly used ratios are current and quick. It is necessary to maintain optimal liquidity ratios since either low or very high ratios are not favorable for the business. The calculations of the liquidity ratios are presented below.

Ratios 2014 2013
Current ratio = current assets / current liabilities 48,954 / 43,524
1.12:1
37,386 / 33,842
1.10:1
Quick ratio = (current assets – stock) / current liabilities (48,954 – 726) / 43,524
1.11:1
(37,386 – 1,446) / 33,842
1.06:1

The value of the current ratio grew from 1.10:1 in 2013 to 1.12:1 in 2014. Also, the quick ratio increased from 1.06:1 in 2013 to 1.11:1 in 2014. The increase is an indication of improvement in the ability of the supplier to pay current obligations using quick and current assets. The ratios also show that the supplier has adequate cash and cash equivalent in the short term that can be used to settle current obligations. The overall liquidity position of the company was low. However, the value of the ratios improved during the period (Weygandt, Kieso and Kimmel 325).

Efficiency ratios

Efficiency ratios focus on the internal operations of the company. These ratios show the level of activity, that is, how well the supplier manages resources to generate sales. Examples of efficiency ratios are fixed asset turnover ratios, asset turnover ratios, stock turnover ratios, debtor collection period, and creditor payment period. The calculations of the efficiency ratios are presented below.

Ratios 2014 2013
Inventory turnover = cost of sales / average stock 124,677 / ((726 + 1446)/2)
124,677 / 1086
114.80
Stock for 2012 not available
Debtor days = closing trade debtors / sales revenue * 365 35,975 / 161,438 * 365
81.34
30,457 / 138,276 * 365
80.40
Creditor days = closing trade creditors / cost of sales * 365 (43,524 + 73) / 124,677 * 365
127.63
(33,842 + 111) / 112,654 * 365
110.01

The inventory turnover ratio gives information on the rate at which a company replenishes stock. The value of the ratio in 2014 was 114.80. The value of this ratio is quite high. This shows that the supplier sells fast-moving commodities. However, high stock turnover often results in high reorder costs. The value of debtor days grew from 80.40 in 2013 to 81.34 in 2014. This ratio gives information on the number of days it takes customers to pay what they owe the supplier. Efficiency is measured by how quickly the company can collect money from debtors. In this case, the value of the ratio increased. This shows a slight decline in efficiency.

The creditor days grew from 110.1 in 2013 to 127.63 in 2014. The ratio gives information on the number of days it takes the supplier to pay their creditors. If the company takes more days to pay the creditors, then it may put a strain on their relationship with the creditors. Since the value of ratio increased, it shows that the company is inefficient in the payment of creditors. The efficiency level of the company declined. It is worth mentioning that a decline in efficiency has a direct negative impact on the profitability level and working capital of the supplier (Weygandt, Kieso and Kimmel 351).

Gearing

A company’s gearing is explained by the amount of debt financing it holds. This category of ratios is vital because it shows the extent of exposure to equity financing. A commonly used ratio is the debt to equity ratio. A high leverage ratio is not favorable because it hinders the ability of the company to attract new capital. This is based on the fact that high ratios increase interest expense. The effect is a reduction of income that is attributed to shareholders.

On the other hand, very low ratios are not favorable because they show that the management of the company is not willing to exploit the potentials of the company. In this case, the supplier does not have debt in the capital structure. The operations of the supplier are funded by shareholders’ funds and creditors. This can be an indication that the management is not aggressive in exploiting the growth potentials of the company. It also shows that the company has a high room for growth. Therefore, the supplier has an opportunity to borrow for growth and future expansion (Sollish and Semanik 201).

Investment

These ratios show the performance of the shares of the company.

Ratios 2014 2013
Return on shareholders fund = profit after interest and tax/shareholders’ funds * 100 2,672 / 4,206 * 100
63.53%
(1,352) / 4,231 * 100
(31.95%)

Return on shareholders’ funds gives information on the amount of revenue generated from a unit of shareholders’ funds. The value of this ratio grew from (31.95%) in 2013 to 63.53%. The growth is an indication that the efficiency in the use of shareholders’ funds improved. The increase can be attributed to an increase in profit after interest and tax and a corresponding decline in shareholders’ funds (Turner 151).

The Springate method

The Springate method seeks to calculate the Z-score of the company (Booth 97). The outcome will give information on the overall financial stability of an entity. The calculations are presented below.

Components 2014 2013
A. Working capital / total assets (48,954 – 43,524) / 51,882
0.10
(37,386 – 33,842) / 40,524
0.09
B. Net profit before interest and tax / total assets 4,200 / 51,882
0.081
(1,362) / 40,524
-0.034
C. Net profit before tax / current liabilities 4,217 / 43,524
0.097
(1,344) / 33,842
= -0.04
D. Sales / total assets 161,438 / 51,882
3.11
138,276 / 40,524
3.41
Z-score = 0.10 + 0.081 + 0.097 + 3.11
= 3.388
= 0.09 – 0.034 – 0.04 + 3.41
= 3.426

The first component of the ratio gives information on the relationship between the ability of the company to settle current obligations and the size of the company. The value of this ratio grew from 0.09 in 2013 to 0.10 in 2014. The second component of the score measures the operating efficiency of the entity. It excludes taxes and interest expense. The operating efficiency of the entity grew from (0.034) in 2013 to 0.081 in 2014. The value of the third component grew from (0.04) in 2013 to 0.097 in 2014.

The last component is the total asset turnover. It shows the number of sales that are generated from a unit of total assets. A high ratio shows the company is efficient in the use of total assets of the entity. The total asset turnover dropped from 3.41 in 2013 to 3.11 in 2014. The value of the Z-score declined from 3.426 in 2013 to 3.388 in 2014. This shows that the financial standing of the supplier dropped in 2014. A company is considered to have a stable financial standing when the Z-score is greater than 4.48. When compared to the supplier’s Z score, it can be noted that the overall financial standing of the company is fairly stable despite the decline (Asefeso 134).

Recommendation

The discussion above focused on using the financial statement and ratio analysis to evaluate the supplier. A review of the income statement shows that there was an overall improvement in the level of revenue generated and profit earned. This is favorable and it shows that the company has the potential of growing earnings. In the balance sheet, growth was reported on the values of total assets and liabilities.

However, the net assets and total shareholders’ funds dropped during the period. A drop in the capital level of the company affects the going concern of the company. Further, the value of current assets exceeded that of fixed assets by a large margin. This might not be favorable for conducting business. The ratio analysis reveals that the profitability level of the supplier was quite low. However, some improvements were reported in 2014. The efficiency ratios deteriorated.

This drop is not favorable to the business. The leverage level is zero. Return on shareholders’ equity improved significantly. It shows that the company is efficient in the use of shareholder’s funds to generate income. Finally, the financial standing of the supplier is fairly stable. The overall financial position of this entity is fairly stable. The supplier should be considered for a sourcing exercise for Facilities Management Services. However, the maximum contract value that can be awarded to the supplier should not exceed the current level of net assets or total shareholder’s fund.

Works Cited

Asefeso, Ade. Lean Procurement and Supply Chain Management: (Key to Reducing Costs and Improving Profitability), London: AA Global Sourcing Ltd., 2012. Print.

Booth, Caroline. Strategic Procurement: Organizing Suppliers and Supply Chains for Competitive Advantage, New York: Kogan Page Publishers, 2010. Print.

Ochonma, Ernest. Procurement and Supply Chain Management: Emerging Concepts, Strategies and Challenges, Indiana: AuthorHouse, 2015. Print.

Sollish, Fred, and John Semanik. The Procurement and Supply Manager’s Desk Reference, New Jersey: John Wiley & Sons, 2015. Print.

Turner, Robert. Supply Management and Procurement: From the Basics to Best-in-Class, Florida: J. Ross Publishing, 2011. Print.

Weygandt, Jerry, Donald Kieso, and Paul Kimmel. Financial Accounting, London: John Wiley & Sons Ltd, 2009. Print.

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