The term “financial skills” covers a range of activities that a professional buyer or procurement executive needs to have if they are to deliver value for money and manage commercial risk for their organisation. However, these skills are not always covered by conventional training which means that a buyer could be creating needless exposure both for themselves and their career as well as their organisation.
There are six financial skills that everyone who works in procurement should acquire.
1. Financial analysis – this covers the use of financial ratios that enable you to identify suppliers who are under performing compared to their competitors or who might be financially vulnerable and so create a supply risk for you. Ratios compare one financial value with another in order to give you an insight into the way that supplier is run. For example, liquidity ratios look at the ability of a supplier to meet its short-term financial obligations by dividing the value of current assets (such as cash and inventory) with the value of current liabilities (such as creditors). Other ratios tell you how efficient the supplier is in turning sales into profit, generating sales from the use of assets and its ability to grow.
2. Activity based costing – this is a method that takes all of the costs of an organisation and assigns them to the products or services that the supplier sells. The big difference between this approach and more conventional costing methods is that it first allocates costs to the activities that create those costs and then to products or services in direct proportion to the amount of those activities that they use in their production or service fulfillment. What this means is that you get a clearer picture of the true costs of making a product or delivering a service than you get from conventional means. The importance of this for the buyer is that they get an understanding of what drives costs and so what actions suppliers can take to reduce them which in turn lets them reduce the price to the buyer and still make an acceptable profit.
3. Understanding profit and loss accounts and balance sheets – the profit and loss account shows a buyer a summary of all the transactions a supplier has made in a period of time (such as a year) with the resulting profit they make and the balance sheet is a snapshot of the financial position of the supplier at that point in time. Accounting policies that the supplier adopts can make a big difference to the declared profit; for example, a supplier can choose how much to charge each year to the profit and loss account for an asset it has bought and this can have a major impact on the profit in any one year. Knowing what accounting policies a supplier uses can help a buyer to understand their accounts and so make sure that the financial ratios that are used to get an insight paint an accurate picture.
4. Understanding cashflow – the lifeblood of any organisation is its cashflow as it can only pay its bills on time and remain solvent if there is cash in the bank. It is important to understand that this is not the same as its profit. For example, if you sell something for $100 now and give your customer 14 days credit then you will not physically receive the cash for another two weeks. If you have bought materials that have been used to make that product and your supplier has given you only 7 days credit then you will have to make a payment to them before you receive the cash from your sale. If you do not have the money in the bank then you may be in difficulties. Understanding the concept of cashflow and how to calculate and analyse it is an important tool in predicting the solvency of your suppliers and their vulnerability.
5. Understanding break-even analysis – this technique calculates the level of activity your supplier needs to have if it is to break even. Levels of activity above the break-even point result in a profit for your supplier and levels of activity below it means your supplier is operating at a loss. The importance of knowing this figure is in negotiations. If your supplier is already above its break-even point and has included your current level of purchases in its calculation, then any further business from you will provide a “super profit” (that is, profit over and above its expected amount as their fixed costs have already been covered). You should be able to negotiate a price reduction based on this information.
6. Price and cost modelling – one of the key questions that procurement people ask of themselves is “am I paying the correct price for this item?”. Price and cost modelling helps to answer this question. Price modelling involves comparing the price you pay against some yardstick of reasonableness such as the price paid last time or a benchmarked price. Cost modelling goes further and is a technique in which you build up an understanding of the cost of the materials, component and other costs that go into the items production or delivery (if it is a service) so that you can assess whether or not they are reasonable and whether the subsequent profit is fair.