When working with a vendor, evaluating their financial stability is essential. This ensures they can fulfil their obligations and provide the services or products they promise.
The due diligence process is necessary to assess a vendor’s financial stability before making contractual commitments.
In this article, we’ll take a look at when you should assess a vendor’s financial stability, why you should do it and how using vendor and contract management software can help you.
When should you assess a vendor’s financial stability?
Financial stability is usually assessed during the Vendor Onboarding phase, although you may choose to run some credit checks at the start of your sourcing exercise.
This assessment is a critical step in the due diligence process, as it allows the company to determine if the vendor is a viable partner for the long term.
This process, as part of vendor onboarding, includes activities such as collecting information from the vendor, setting up accounts, and providing training.
If your business is using manual onboarding processes, chasing information from your vendors can be time-consuming.
It can also be frustrating if they don’t provide you with complete and accurate information.
With Market IQ Finance from Gatekeeper, you can get instant access to your vendors’ credit scores and reports with only their names and website address.
One of my favourite perks of Market IQ is that if you send out an NDA to a vendor, Market IQ can screen the vendor and run a credit check against them.
This could be way before you intend to onboard them and could help prime some questions about their financial stability.
The assessment should include reviewing the vendor’s financial statements, credit rating, and debt-to-equity ratio.
What Checks to Carry out During Vendor Onboarding
When bringing a new vendor on board, it’s essential to ensure they meet specific standards for your business.
To do this, you should carry out certain checks, such as verifying their identity, ensuring they have the necessary qualifications, and checking their references.
We’ve included a few examples. However, you could expand this and cover other ratios, such as the current and gross profit margin ratios.
Request the vendor’s financial statements
Ask the vendor for their balance sheet and income statement, as these documents are essential for a comprehensive understanding of their financial health.
Reviewing the vendor’s assets and liabilities is vital to understanding their financial position better.
The balance sheet will provide an overview of what the vendor owns (assets) and owes (liabilities). In contrast, the income statement will provide insight into the vendor’s income and expenses over a certain period.
This information can help you evaluate the vendor’s ability to deliver on their commitments, pay their bills, and weather financial difficulties, which can impact your business relationship with them.
Analyse the vendor’s debt-to-equity ratio
One way to check a vendor’s financial stability is by analysing their debt-to-equity ratio.
This ratio compares the amount of debt a vendor has to the amount of shareholder equity they have.
Equity is the value of the vendor’s assets minus their liabilities, which represents the amount of money they have invested in their business.
Suppose a vendor has a high debt-to-equity ratio. In that case, they have borrowed a lot of money compared to the amount they have invested in their business. This could be a red flag because it suggests that the vendor may be relying heavily on debt to finance their operations.
This could make them vulnerable to financial difficulties if they experience a downturn in business or other financial challenges, such as a lack of additional investment from VCs.
However, a low score may suggest stagnation and an unwillingness to take on any debt to grow.
I’d personally see this as advantageous.
Knowing the vendor’s debt-to-equity ratio is also important, as high debt levels can lead to higher levels of risk, such as not being around for the entire length of the proposed contract should they lose the ability to fund their business.
Examine the vendor’s cash flow
Look carefully at the money that the vendor is receiving and spending.
When you examine a vendor’s cash flow, you look at how much money they are bringing in and spending over a certain period.
Cash Flow will be a big focus of procurement teams in 2023 with the cost of living crisis, energy crisis and many other crises impacting global supply chains like nothing we’ve ever seen.
You’ll want to ensure that your vendors bring in enough money to cover the bills each month because if they aren’t, you probably won’t have a relationship with them for long.
Cash Flow analysis can highlight any areas where the vendor is falling short in income or incurring too much expenditure. It would be best if you doubled down on asking questions about this with your vendor.
Let’s break down some of these terms so far because, in my experience, procurement teams can struggle with the financial analysis of their vendors. Often they rely on Finance teams but guess what?
Finance is maxed out with no capacity for helping out procurement.
So we need to get comfortable with the language here.
Positive cash flow is when a vendor has more money coming in than going out.
This is good because they have enough money to pay their bills and invest in their business.
But, if a vendor has more money going out than coming in, this is called negative cash flow.
This can be a problem because they may not have enough money to pay their bills or invest in their business, which could jeopardise their operations.
When considering a vendor, you need to keep this in mind. Ideally, I want a positive cash-flowing company for one of my strategic or important vendors.
For those vendors I categorise as transactional vendors - I could do away with the worry.
However, I need to consider the cost and time effort to find a new vendor should they go bust, regardless of their apparent importance to the organisation.
I once had a potential vendor whose cash flow looked off, and I was looking at spending over £5 million with them to make some parts we had designed. If they failed us - we’d incur huge liquidated damages with our customer."
I was concerned - and didn’t want this failing on my watch.
I pressed them on this, and they confidentially shared how they were closing several significant contracts, which meant there was no concern.
This raised more questions about their capacity to take on the work - which is excellent.
Investigating and analysing can lead to good outcomes and expose additional risks.
Research the vendor’s credit score
Before considering entering a business partnership with a vendor, looking up their credit score is vital. This is a reliable indicator of their financial health and can give you a good idea of whether or not they are a good fit for your business.
When you research a vendor’s credit score, it’s like asking someone whether they are trustworthy.
Gatekeeper utilises an integration with Creditsafe on our platform.
A Creditsafe business credit score, sometimes referred to as a company credit rating, calculates the probability of a company becoming insolvent within the next 12 months.
Creditsafe uses over 150 parameters with sophisticated statistical algorithms to create their credit scores.
If the vendor has a bad credit score, they may have had trouble paying their bills on time, which could make it harder for them to borrow money in the future. It would help if you addressed this with them, were open to ideas around payment structures and created a safe space for your vendor to discuss this with you.
Manual Vendor Finance Check vs Automated Finance Check
A manual vendor finance check is when a procurement pro reviews a vendor’s financial information meticulously after reviewing various documents they’ve acquired from the vendor.
Doing so allows the reviewer to ensure all relevant data is considered before making any decisions or taking any actions.
But it’s slow, tedious, and won’t give you the peace of mind you need.
Because of this, you cannot expect to have someone in your team dedicated to such a laborious task.
That’s why we love automation when it comes to finance checks.
An automated finance check is a process in which a computer system reviews the financial information of a vendor, providing a more efficient and accurate way to complete the review.
Using technology such as Market IQ Finance from Gatekeeper doesn’t just create efficiency. It also assigns grades to a vendor and provides a score that indicates the financial health and stability of the vendor.
This saves you time and gives you peace of mind that the vendor you’re working with is financially stable and will fulfil their contractual obligations.
You can continuously monitor the financial health of your vendor. This means we will monitor your vendors 24/7/365 so that you are always aware of their financial stability. If anything changes, you’ll receive an automatic notification - allowing you to make proactive decisions about your vendor relationship.
With our checks made possible via our integration with Creditsafe, you’ll get full access to a comprehensive credit report where you can use some of the above checks to dig deeper with some of your more strategic vendors.
Suppose any vendor suffers a decrease in their grade. In that case, you can kickstart a vendor finance mitigation workflow that notifies the contract owner, Finance and the relevant Procurement Manager.
You can also send out pre-built questions so the vendor can respond to you without manually needing to engage them.
It is important to note that manual and automated vendor finance checks are not a substitute for due diligence.
They should be used within an entire due diligence process to gain the most accurate assessment of a vendor’s financial stability.
Wrap Up
When assessing a potential vendor, it is essential to ensure that their financial stability is sound and reliable to guarantee that they can meet the terms of the agreement.
The due diligence process should include a comprehensive assessment of your vendors' financial statements, credit ratings, and other financial information to ascertain that they are a dependable partner.
This analysis should involve a detailed review of their financial records, such as their balance sheets, income statements, cash flow statements, and other documents, to assess their overall financial health.
Examining their credit ratings utilising Market IQ Finance will give you peace of mind that your vendor choice is good. Get started with Gatekeeper here.
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