How do you know that your vendor, supplier, or service provider will be around in a few years’ time? It is depressing to buy a 3-year support agreement and think that you’re covered in the event that something goes wrong, only to find out that the company just filed for Chapter 11 bankruptcy. Maybe they will be acquired by a stable company and still operate the business unit you care about, maybe not.
Not to be alarmist, but we do need to pay attention to where we’re purchasing IT equipment, especially in these financial times. You should learn how to quickly assess whether or not a company is stable, in trouble, or even worse before signing a multi-year agreement.
Public vs. Private
Publicly traded companies are more transparent than private companies. You can easily find financial data and get a good idea of at least the likelihood that the company will be around in a few years. We aren’t trying to make a stock purchase decision, so this research is less rigorous, but just as important.
If you’re dealing with a private company, perhaps a small VAR that offers extremely good deals on things you generally purchase direct, you are not as well equipped to conduct a health assessment of the company. None of their financial data is public, and they will not share it with you.
A few things to consider when you cannot substantiate claims, or even as a good starting point with public companies, are:
- How long have they been in business?
- What strategic partnerships do they have with various manufacturers?
- How many customers do they have, and are they eager to share stories about similar situations to help you make purchasing decisions?
- How are they viewed in the marketplace; do they have mostly repeat business?
- Are they willing to put you in contact with some of their existing customers?
Additionally, the single most important way to keep on top of issues is by reading the news. Don’t believe everything you read, but if reports paint a picture of doom and gloom, use them as a starting point or alerting system. Once you realize that you must dig deeper into a company, do so.
At this point, if you’re dealing with a private company, it is possibly time to jump ship. Negative media coverage, layoffs or even unsatisfied customers mean that the company is likely struggling. Talk to them, and see what they say.
If you’re dealing with a publicly traded company, the fun is just beginning.
Assessing Financial Health
Financially stable companies don’t fail in the event of an economic downturn. There are certain indicators that should turn on warning beacons, but you need to know what to look for, and how to interpret it.
Financial ratios are good indicators of broad concepts such as whether a business is carrying excess debt or inventory and whether their operating expenses are too high. They are not gospel, but they do indicate that you should look more closely, perhaps even at competitors in the same industry for comparison.
For the sake of understanding, we’ll talk about a four common ratios and how they are calculated, but you will not likely need to calculate them yourself. Financial sites list these, and many variations of each, for easy retrieval.
The current ratio is a liquidity test, i.e. how easily a company can pay debts as they come due. It is: current assets / current liabilities
The result is called working capital. If a company can cover its debt 2x with cash on hand, it’s generally considered in good shape. This may vary by industry, but in general, a 2:1 ratio here is fine.
Net Profit Margin
There are many measures of profitability, but a good quick and dirty one is the Net Profit Margin: net profit / total sales
This shows how much profit is derived from every dollar of sales, and consequently how well the business is managing expenses. Again, it really needs to be compared to peers in the same industry. More often, it’s used as a trending tool: a downward trend means that business is slow, and the company has not responded properly.
Accounts Payable Turnover
The Accounts Payable Turnover ratio shows how often a business pays its debts in full: Cost of Goods Sold / Accounts Payable
If this number increases it means that the company is hoarding cash longer, likely because it is having trouble meeting its obligations. Of course, a one-time upward movement could indicate a change in policy with some large accounts.
Debt to Equity
Debt to equity shows how much a company has borrowed versus how much investment money it has. It is: debt / equity
This number should be fairly low, and an upward trend indicates that a company has taken on debt recently. If it remains high, the company may be unable to acquire new debt in the future. You can also take a look at the company’s corporate bond rating to see how available debt is to them.
How often do we get new numbers? Are these ratios accurate? Both are fine questions, and the answer to both is, “remember, these are indicators not decision making rules.” We get new numbers each quarter, when a company files its 10-Q with the SEC.
The ratios are accurate as long as we keep in mind what the ratios are really telling us, but there are caveats. Some ratios lag behind the actual state of the company. They can be manipulated, and due to the craziness of accounting laws, it can get quite confusing. If you stick to using the ratios as a quick verification test, you’ll be fine. Definitely do some more reading in this area if you’re interested, though. A good starting point is, “Company failure or company health?—Techniques for measuring company health” which explains some of these ratios and their shortcomings.
There are tons of other financial ratios. You aren’t buying a company’s stock, we said, but you do need to quickly assess its health. A book on company valuations or stock purchasing can certainly be helpful.
The takeaway is really: if any of these numbers are alarming, do more research. Likewise, if a piece of news is alarming, peruse these ratios to quickly substantiate or debunk the story.