In recent years, there have been some well-publicised failures of large organisations supplying to the public sector. But the risks aren’t limited to the supplier going bust during the contract; they also include issues around general performance.
It can be difficult, too, to deliver against key performance indicators when there is risk of insolvency. This issue has been further highlighted during the Covid-19 outbreak.
Stay transparent
When undertaking the due diligence process, it is important to ensure that ratios and metrics are transparent, objective and non-discriminatory, with pre-determined thresholds that bidders are aware of.
Many organisations categorise their contracts based on criticality, vulnerability of supply chain and the value of the contract. This usually results in assigning gold, silver and bronze ratings; gold contracts are usually large value, complex and critical, requiring detailed financial assessment; bronze tend to be low value and non-complex, requiring simple checks.
In most local authorities, procurement professionals work alongside finance professionals. It is usually best practice for due diligence to be completed by finance professionals, with a report provided to the procurement professional based on pre-determined criteria.
There are a number of areas of analysis, outlined below, that the assessing officer should consider.
The evolving nature of the business and the related environment mean that a supplier’s liquidity and profitability can change quickly
Basic administrative checks
The assessing officer should verify that the organisation exists and has met its filing requirements with Companies House, with no issues regarding its status.
The supplier should also make available all the financial information required during the registration and selection process.
Profitability and turnover analysis
Attention should be paid to the following ratios:
- Gross profit margin – calculates the profit proportion of sales, only allowing for direct costs associated with sales
- Net profit margin – calculates the proportionate profit that an organisation makes after considering all costs
- Return on capital employed (ROCE) – measures profitability and efficiency regarding how well an organisation uses its capital
- Turnover – used to understand how large the contract is compared to the annual revenue of the bidder.
The results should be compared to industry averages. However, if these are not available, target ratio results should be set as: gross profit margin 50%; net profit margin 10%; ROCE 0.25; turnover ratio >2.0.
Liquidity
Attention should be paid to the following ratios:
- Current – demonstrates an organisation’s ability to settle short-term debts
- Acid test – equivalent to the current ratio but removes stock from the current assets calculation; it is usually the preferred ratio, as stock may not be easily convertible to cash.
In both cases, the target ratio is 1:1 and above, as any lower suggests that the organisation is unable to pay its short-term debts quickly.
Other information to consider
The organisation’s performance against industry standards and performance over time (usually three years) should be considered. This will help public officers to assess whether performance is improving or deteriorating against the following criteria:
- falling cash levels
- falling profit levels
- increase in gearing
- greater increases in creditors than debtors
- changes in reserves/retained earnings
- any relevant media reports.
Know the score
As a starting point, contracting authorities may wish to use credit-scoring agencies. For less critical contracts, if a supplier scores highly on a credit-scoring agency report, the contracting authority may decide to stop there without conducting any further assessment.
Credit-scoring agencies should never on their own be used to exclude suppliers.
Build an accurate picture
It is important to bear in mind that workable assessment systems tend to rely on historic information.
The evolving nature of the business and the related environment mean that a supplier’s liquidity and profitability can change quickly. It is therefore important to consider what information can be used to provide as accurate a picture as possible.
The assessing officer must also be aware of the risks of standard approaches to assessment. Public managers need to keep in mind fairness and, for example, not to disadvantage SMEs that may be able to add value to public services.
There are also instances where contracts are so large that they exclude legitimate suppliers who could provide better value if the opportunities were more manageable.
It is worth considering, too, whether it makes any difference that a supplier who fails the tests is already working on lots of other major public sector contracts.
Finally, the assessing officer needs to act proportionately and ensure that the cost of officer time in assessing the financial health of a prospective supplier is worthwhile when considered against the value of the contract opportunity.
