Executive Summary
The report is devoted to the analysis of the financial performance of a potential supplier (the Supplier). To understand if the company is eligible for a sourcing exercise, we will conduct the ratio analysis and evaluate various balance sheet indicators based on such pre-qualification criteria as financial stability, commercial capabilities, technological capabilities, and stakeholder accountability.
Financial analysis of any economic entity helps to identify the extent to which an organization is efficient and effective in carrying out its activities and reflects its overall economic well-being, the level of financial development, and ability to meet its obligations. A favorable financial condition is estimated, first of all, by the company’s financial stability and solvency. For this reason, the given criteria will be regarded as core attributes in the given paper and will be used as benchmarks during the provision of recommendations regarding the employment of the Supplier.
Ratio Analysis
Profitability
Gross Profit Margin (GPM) indicates the effectiveness and efficiency of enterprise operations.
There are no unified normative criteria for the evaluation of GPM values. However, positive values and upward trends can usually be considered as good signs. Higher GPMs are associated with higher shares of gross profit in the sales revenue structure. It is possible to say that the Supplier’s GPM values ranging in the diapason of 18,5 and 23 mirrors the stability and efficiency in the functioning of production assets. At the same time, the growth of gross profitability by over 4 grades during one year shows an increase in production efficiency, i.e., a decline in production costs.
Markup is the difference between the retail and wholesale price of goods/services necessary to cover the costs and obtain an average profit by the enterprise.
The ratio analysis makes it clear that the Supplier’s operations remain profitable and the margin covers all costs associated with sales and indirect taxes (VAT, excise taxes, etc.).
Net Profit Margin (NPM) indicates the profit volume that the Supplier received per a unit of cost of the capital about all types of the organization’s resources regardless of the sources of their financing.
Like in the case with GPM, higher NPM values, and the upward trends signify the financial health of the organization. The Supplier’s NPM numbers show that the company effectively uses the capital invested in the enterprise by its shareholders. NPM also impacts the stock price of the enterprise. Based on the results of the ratio analysis, it is possible to say that the level of the Supplier’s stock quotes is adequate.
Liquidity
Current Assets Ratio (CAR) provides an overall overview of the liquidity of assets showing how much cash the company’s current assets account for a unit of current liabilities.
The logic of calculating this indicator is that the company repays short-term liabilities mainly due to current assets. Therefore, the fact that the Supplier’s current assets exceed the current liabilities in value shows that the enterprise can be regarded as successfully functioning. At the same time, to achieve a greater level of sustainability, the Supplier should strive to increase the ratio.
Acid Test Ratio (ATR) has the same purpose as the previous indicator but is calculated on a narrower range of current assets when the least liquid part of them is excluded from the calculation.
Being one of the most stringent criteria for the assessment of liquidity, ATR shows how many of the short-term loan obligations can be repaid immediately if necessary. The results show that the Supplier managed to increase the amount of cash that can be used in the event of a forced sale of production stocks during 2014. However, the margin is on the borderline and, in the case of emergency or crisis, the company may be faced with significant financial losses.
Inventory Turnover shows how many times the organization used the average available stock balance during the analyzed period.
This indicator characterizes the quality of reserves and the effectiveness of their management; it allows identifying the remains of unused, obsolete, or substandard reserves. The low level of the Supplier’s inventory turnover ratio per 2013 may reflect the accumulation of surplus stocks and unusable materials, as well as the overall inefficient warehouse management (National Defence and the Canadian Armed Forces, 2014). However, the increase in the value by 2014 may indicate a slight improvement in the operating cycle.
Trade Debtor Collection Period Ratio (TDCPR) shows how many times during a year, the Supplier received payments in the amount of the average balance of unpaid debt from its customers.
Like other turnover indicators, there are no uniform standards for the evaluation of TDCPR as the values strongly depend on the industry features and technology implemented by organizations. However, it is possible to say that the Supplier’s TDCPR reflects that the company is on good terms with buyers regarding the issues linked to collecting receivables and effectively manages them through democratic and adequate policies. Although higher coefficients would mean that the company’s clients/buyers repay their debts faster and it would be better for it, the lack of tight control over the repayment of receivables is beneficial for contracting organizations. It implies that the Supplier values its customers yet controls them via the enforcement of a balanced payment discipline.
Trade Creditor Payment Period Ratio (TCPPR) shows what time it takes for the Supplier to make a payment in the amount of the average balance of unpaid debt to its creditors.
Based on the ratio indicators, it is possible to say that the Supplier is less responsible regarding the control over creditor payments than in the case of debtor payment collection. Moreover, the increase in the values during the year may be a sign of the weakening of the company’s payment discipline, and the given factor may have a negative impact (e.g., working capital deficits) on contracting organizations. At the same time, researchers suggest that effective activity is not necessarily always accompanied can be mirrored in high turnover rates. For instance, if a sale is carried out on a credit basis, the balance of receivables will be high while its turnover ratio, on the contrary, will be low (Harrison Jr., Horngren, & Thomas, 2014).
Gearing
Capital structure indicators reflect the ratio of own and borrowed funds in the sources of the company’s financing, i.e., they characterize the degree of the Supplier’s financial independence from creditors. This is an important characteristic of the enterprise’s sustainability.
High values identified in gearing ratio usually mean that a company has a “higher degree of leverage and is more susceptible to downturns in the economy and the business cycle” (“Gearing ratio,” 2013, par. 3). The results for 2013 show that during that year, the Supplier had greater volumes of debt compared to the following year when the enterprise generated more equity to rely on. It is considered that investors are usually more attracted to organizations with a high share of their capital because these companies are associated with lower financial risks as they may repay debts at their expense (Lomax, 2012). Moreover, the decreased gearing ratio value may also imply that the Supplier managed to reduce the rate of the interest on payments and, accordingly, increased the volume of funds needed to make dividend payments and create reserves.
Investment
Return on Shareholders’ Funds (ROI) is the coefficient showing the profitability of an investment project (at a value of more than 100%) or the ratio of the financial loss (if the value is less than 100%).
The numbers make it clear that the Supplier is capable of generating the added value as the positive rates and the upward trend favorably affect the value of the company’s shares. A relatively high level of ROI is also can be regarded as evidence of strong management practices (McClure, n.d.). But at the same time, to verify the validity of this assumption for the Supplier’s situation, it is important to consider other internal non-financial managerial factors because high ROI rates can also mean that management is focused exclusively on generating profits ignoring the opportunities for the long-term growth.
Balance Sheet Analysis
The analysis of the balance sheet categories and indicators reveals that In fact, earlier we found that during 2014, the Supplier’s cash flow from operating activities increased. The cash flow statement can reveal the reason for this effect − the increase in accounts receivable could be compensated by an adequate positive cash flow although the growth in the number of short-term liabilities was also observed.
Additionally, the increase in the cash inflow due to debtors’ payments (from 30,457$ in 2013 up to 35,975$ in 2014) may indicate the improvement in the relationship with contracting organizations. The increase in debtors’ accounts payable and cash flows supported the growth in the overall revenue stream. This factor may be regarded as decisive in the Suppliers’ ability to maintain a regular positive cash flow and ensure its steady growth.
The Supplier’s Financial Profit and Loss Statement reveals that the company’s revenue before the taxation increased by 24,1%, while gross income increased by 43,4%. Overall, the favorable increase in the gross profit may indicate positive changes in the composition and structure of turnover, e.g., increase the level of extra charges or differentiation of the trade markup (Malitz & Ottaviano, 2008). At the same time, higher revenue values imply that the Supplier managed to balance between the control over the income and maintaining the prices at a competitive level.
The operating profit of the Supplier increased by 24,4% and the company managed to move away from the negative index in this category. While the negative value in the operating profit during 2013 could be a result of an increase in administrative, marketing, and other relevant costs (Maher, Stickney, & Weil, 2012), the significant improvement indicates that the Supplier had revised its operation management practices and it consequently balanced the loss and profit ratio.
Due to the noted desirable growth rates of the company’s profits and revenues, the Supplier’s net profit during the analyzed years had increased as well (by 33%). The difference in the amounts of the profit before and after taxation suggests that the favorable growth could become possible due to the decrease in the number of interest payments (e.g., the enterprise repaid part of the bank loans, etc.), as well as due to the ability to generate profit from non-general and non-core activities such as the sale of assets or receipt of dividends from the ownership of the corporate rights of other enterprises (Nikolai, Bazley, & Jones, 2010).
Analysis Based on the Pre-Qualification Criteria
Financial Stability
Financial stability is such a state of financial resources, as well as their management and allocation, that ensures the development of the organization due to constant profit and capital growth with the maintenance of solvency (Sarlin, 2016). Based on the results of ratio and balance sheet analyses, it is possible to say that the Supplier meets some required criteria in the given area with some major issues. The main indicators of the Supplier’s financial stability include the excess of income over expenditures, free maneuvering, and effective use of funds, and the uninterrupted process of service and goods production (Rezaee, 2015).
Unfortunately, the analysis does not allow a precise determination of what type of factors − internal (e.g., managerial practices, etc.) or external (e.g., solvent demand and income level of consumers, etc.) − contributed to financial growth in the organization. However, it is possible to presume that the profit increase over a year was fostered by the changes in the structure of the output; size and structure of expenditures, their ratio to cash incomes; condition and structure of the property; structure and efficiency of capital use (own and borrowed); and competence and professionalism of managers of the organization, flexibility of economic and financial policy pursued by them (ability to respond to changes in the internal and external environment), etc.
The relative indicators that provoke some concerns about the Supplier’s CAR − throughout two years, its value equaled 1,1:1, while higher ratios are usually associated with lower financial risks. It means that the company’s period of asset turnover is rather slow and it may be linked to some malfunctions in the production process (the volume of stocks decreased twofold over a year). Nevertheless, the increase in the cash inflow due to debtors’ payments shows that the inefficiency in this area of performance is likely not caused by the decrease in demand. However, the Supplier still needs to work on its exploitation of the assets, e.g., change the longitude of technological or production cycles, etc.
Commercial Capabilities
The operational costs and profits values, as well as TDCPR and TCCPR indicators, make it clear that, in general, the Supplier meets the requirements in the given area yet its performance is associated with some minor issues. The given category is deeply interrelated with the category of financial stability. The flexible structure of financial resources and abilities of the Supplier and its creditworthiness allows the organization to repay debts within 90 days and, at the same time, maintain its financial resources that are needed for investments in capital and other expenditures.
Technical Capabilities
The fixed tangible assets values show that there was a slight decline in their number over a year. From 1,786$ in 2013, it has decreased to 1,726$ in 2014. The decrease may signify the deterioration in the technical capabilities of the Supplier as the fixed tangible assets include machinery, facilities, and land needed to conduct operations. The insufficiently developed technological environment is considered one of the major managerial risks which may interfere with the advancement of companies and negatively impact their business partners as well (Mentis, 2015). The insufficient level of technological advancement in the organization may interfere with the effectiveness of communication between the Supplier and the hiring enterprise. According to researchers, the lack of efficient communication and information technology that may ensure effective time coordination between firms can result in the decreased quality service delivery, loss of positive business reputation, financial loss, cost inefficiency, etc. (Danese, Romano, & Bortolotti, 2012). The technological factor is especially important in case if the hiring company uses an advanced infrastructure and logistics methods, e.g., the JIT model. For this reason, it is possible to say that the Supplier’s performance in this area is associated with major concerns.
Stakeholder Accountability
The decline was also observed in the values of the intangible assets. From 1,352$ in 2013, the numbers decreased to 1,202$ in 2014. Since intangible assets include goodwill that comprises the company’s brand name, customer and employee relationship, and other non-physical corporate values, the decrease in the numbers may show the deterioration in the attitude of leadership towards its major stakeholders (employees and clients). The insufficient level of fixed intangible assets may also refer to inadequate staff training and knowledge management systems, etc. However, such intangible factors affecting financial performance as quality measurement systems, customer service culture, knowledge management, and customer focus are essential attributes of business excellence (Cai, 2009). Based on the poor performance of the Supplier in the given area, it is possible to conclude that it is associated with major issues as well.
Conclusion
The up-growth trends in the Supplier’s profitability, the achievement of positive indicators in the profit per 2014 (in comparison to the negative ones in 2013), and the regular excess of the available assets over the obligations and liabilities show that the Supplier selected an appropriate strategy regarding financial development. Overall, the enterprise is characterized by stable income growth, and it is its major strength. The company is also capable to attract creditors and debtors. It allows the Supplier to avoid the deficits in financial resources. Nevertheless, it was observed that the situation about the Supplier’s capability to cover short-term debts is rather unstable. And it can be considered a negative sign because many companies fail to survive mainly because of an insufficient level of solvency than due to low profitability. Additionally, the decrease in the volumes of fixed tangible and intangible assets poses multiple concerns. The given downward trend may be detrimental to the Supplier’s ability to attract new partners and provide added value to its services and products. As a consequence, the reduced attractiveness of the organization may create barriers to the obtaining of loans, operation expansion, etc. in the future causing the inability to pay off its short-term and long-term obligations in time.
Recommendations
Overall, the Supplier’s performance throughout 2013 and 2014 was characterized by the upward trend in profitability indicators. However, the identified weaknesses such as low CAR, and the issues associated with the company’s technological abilities and goodwill, the company should not be considered for a sourcing exercise as yet. Nevertheless, in case it will be decided to employ the Supplier (e.g., if its performance will be more competitive and value-added in comparison to its competitors in the market), it may be recommended to establish the maximum contract value below the average market mark. For instance, if the 2014 annual budget value of contracts in the Facility Management Service industry is circa $2,5 million, the suggested value of the given contract maybe $2 million or lower. The low-budget value contract may allow the Facility Management Service to reduce potential financial risks associated with the Supplier and evaluate its performance before concluding a more valuable contract with the company.
The practical recommendations for the Supplier are as follows:
- Increase the asset turnover by investing in fixed tangible assets (acceleration of scientific and technical progress through the introduction of advanced technology), development of standardization, use of cheaper structural and raw materials, etc.;
- Bring the output production plans in line with sales volumes − the size and structure of working capital should correspond to the needs of the enterprise reflected in the budget, while current assets should be minimal, but sufficient for the successful and uninterrupted operation of the enterprise;
- Along with the inventory and asset turnover increase, and acceleration of the output production cycle, the company should develop an appropriate employee motivation and reward system to increase staff motivation and commitment to quality improvement initiatives;
- Make efforts to timely demand payment from debtors to optimize the financial condition of the company − the Supplier could set up a procedure for controlling the issued invoices;
- Evaluate the impacts of the liabilities structure on return on equity and select the one that will contribute to improving the profitability of the organization’s capital;
- Practice accountability of legitimate stakeholders (first of all, employees) by increasing the fixed intangible assets, and investing in staff training programs, enhancement of the corporate knowledge management.
References
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