Financial Accounting Basics for Purchasing and Supply Professionals

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1 Financial Accounting Basics for Purchasing and Supply Professionals Dr. J. Patrick Cancro Assistant Professor of Business, Penn State New Kensington Upper Burrell, Pennsylvania Dr. Michael A. McGinnis, C.P.M., A.P.P. Associate Professor of Business, Penn State New Kensington Upper Burrell, Pennsylvania Abstract: This paper introduces basic financial accounting statements and selected financial ratios. It demonstrates how these statements and ratios can be used to evaluate suppliers and contribute to the organization s financial strength. The following section provides an overview of the balance sheet, income statement and selected financial ratios. The second section discusses how these statements and ratios can help manage internal inventory and equipment as well as evaluate suppliers. The final section discusses how purchasing and supply decisions can affect the organization s financial strength, and how these decisions can increase purchasing and supply s credibility with accounting and financial staff. Overview: Selected Financial Statements and Ratios. The following presents two financial statements and five financial ratios that are important to a basic understanding of financial accounting by purchasing and supply professionals. The two financial statements are the balance sheet and the income statement. The former provides a snapshot of the firm s financial condition at a point in time. As shown in Exhibit 1, the balance sheet is organized with assets on the top and liabilities plus owner s equity on the bottom. Totals on the top half and bottom half must equal. In Exhibit 1 Inventory and Plant and Equipment are shown in italics because they will be useful in later discussions of purchasing and supply decisions. For purposes of illustration, differences between the 2001 and 2002 balance sheets for Hypothetical Manufacturing Company are assumed to have resulted solely from purchasing and supply decisions. A basic comparative income statement for a manufacturing firm is shown as Exhibit 2. It provides a comparison of the summary of sales and expenses over separate but specified periods of time, in this case two years. The income statement reports sales and then subtracts three categories of costs to arrive at net income. These categories are: (a) cost of goods sold, (b) selling expenses, and (c) general administrative expenses. Cost of goods sold represents direct and indirect costs associated with production in a manufacturing firm or acquisition costs of materials intended for resale in a retail environment. The major expenses that comprise cost of goods sold in manufacturing firms are materials, labor, and overhead. Cost of goods sold has become increasingly important to purchasing and supply professionals because purchased materials and services can average over 50% of sales in manufacturing firms (In service and retailing firms, purchased goods and services can also be significant). For example, if purchased materials and services represent 50% of sales in Exhibit 2, then they are approximately 64% of cost of goods sold. This means that purchasing and supply management have a major impact on the organization s controllable costs! Selling costs are

2 any costs related to the sale of the firm s goods or services. General administrative costs, with few minor exceptions, are overhead costs related to running the business. In Exhibit 2 Cost of Goods Sold, Gross Profit, and Net Income (before interest and taxes) are shown in italics because they are the focus of later discussion of purchasing and supply decisions. Again, differences in the 2001 and 2002 income statements are assumed to be due solely to purchasing and supply decisions. Financial ratios are commonly classified as solvency measures or profitability measures, and these are summarized in Exhibit 3. Differences between 2001 and 2002 financial ratios are assumed to be the result of purchasing and supply decisions. Exhibit 1 HYPOTHETICAL MANUFACTURING COMPANY Comparative Balance Sheet December 31, 2002 and 2001 ASSETS Increase (Decrease) Amount Percent Cash $ 6,000,000 2,000,000 4,000, Accounts Receivable 9,000,000 9,000,000 Inventory 5,500,000 8,000,000 (2,500,000) (31.25) Prepaid Expenses 1,000,000 1,000,000 Plant and Equipment 28,500,000 30,000,000 (1,500,000) (5.0) Total Assets $ 50,000,000 50,000, LIABILITIES Accounts Payable $ 8,000,000 8,000,000 Notes Payable 1,500,000 1,500,000 Accrued Expenses Payable 500, ,000 Bonds Payable 15,000,000 15,000,000 Total Liabilities $ 25,000,000 25,000, STOCKHOLDERS EQUITY Common Stock, $10 par $ 15,000,000 15,000,000 Retained Income 10,000,000 10,000,000 Total Owners Equity $ 25,000,000 25,000, Total Equities $ 50,000,000 50,000,

3 Applying Accounting Statements and Financial Ratios to Purchasing and Supply. Purchasing and supply decisions often affect inventory levels, levels of plant and equipment investment, and cost of goods sold. In the balance sheet, shown as Exhibit 1, inventory levels were reduced by $2,500,000 between 2001 and This may have been accomplished by (a) better scheduling of inbound materials, (b) improved management of internal inventories, or (c) better coordination of supplier-buyer orders and shipments. Investment in plant and equipment was reduced by $1,500,000 during this period. This may have been accomplished by (a) identifying efficient suppliers that reduced the need to produce some components inhouse and/or (b) purchasing efficient manufacturing equipment that enables Hypothetical Manufacturing to maintain production (and quality) levels with less capital investment. The affect of these reductions increased cash by $4,000,000 or 200%! This means that there is more cash available for investing in the business, less need for debt, and (as we will see later) improved financial ratios. As shown in Exhibit 2, cost of goods sold decreased by 8.6% between 2001 and 2002, resulting in an increase in gross profits by 30.0% and an increase in net income of 250%. Reductions in cost of goods sold may have resulted from (a) negotiations with current suppliers, (b) the identification of more efficient suppliers, and/or (c) revised specifications resulting from value analysis and product improvement programs. Note that a decrease in cost of goods sold directly increases profits. To have achieved a 250% increase in net profits in 2002 without a reduction in cost of goods sold, 2001 sales would have needed to increase by 30% (to $58,500,000) in 2002! Exhibit 2 HYPOTHETICAL MANUFACTURING COMPANY INCOME STATEMENT FOR THE YEARS ENDING December 31, 2002 and 2001 Increase (Decrease) Amount Percent Sales $45,000,000 45,000,000 Cost of goods sold 32,000,000 35,000,000 (3,000,000) (8.6) Gross Profit 13,000,000 10,000,000 3,000, Operating Expenses: Selling 4,000,000 4,000,000 General Administrative 4,000,000 4,000,000 Net Income (Before Interest & Taxes) 5,000,000 2,000,000 3,000, Examination of Exhibit 3 shows that all three solvency measures improved between 2001 and The current ratio increased from 2.0 to 2.15 indicating an improved ability to meet current obligations. Inventory turnover increased from 4.4 to 5.8 indicating increased efficiency in managing inventories. Finally, number of day s sales in inventory improved from 83.4 to 62.7, indicating that 20.7 fewer days of inventory were required, on average, to support operations. Profitability measures indicate that profitability of stockholders equity increased from 8% to 20% and the profitability of assets increased from 4% to 10%.

4 These statements and ratios are important for the evaluation of potential and current suppliers. Due diligence requires that potential and current suppliers must be assessed initially, at periodic intervals, and when there is any indication of supplier financial problems. A failure to monitor supplier financial performance can result in interruptions in supply if a financially troubled supplier is unable to deliver goods and services as agreed. This can happen when a supplier (a) is unable to obtain credit from banks or their suppliers, (b) ceases operations, or (c) files for bankruptcy. Purchasing and professional managers should seek assistance from their organization s accounting, finance, and credit departments when conducting these assessments. Exhibit 3 HYPOTHETICAL PRODUCTION COMPANY Selected Financial Ratios December 31, 2002 and 2001 SOLVENCY MEASURES Current Ratio: Ability to meet currently maturing obligations Current Ratio = Current Assets = Cash + Accts Rec + Prepaid Exp + Inventory Current Liabilities Accounts, Notes, and Accrued Expenses Payable 2002 Current Ratio = $ 21,500,000 = Current Ratio = $ 20,000,000 = 2.0 $ 10,000,000 $ 10,000,000 Inventory Turnover: Assesses the efficiency of inventory management Inventory Turnover = Cost of Goods Sold Average Inventory 2002 Inventory Turnover= $32,000,000= Inventory Turnover= $35,000,000 = 4.4 $5,500,000 $8,000,000 Number of Day s Sales in Inventory: Assesses the efficiency of inventory management Number of Day s Sales in Inventory = Inventory, End of Year Average Daily Cost of Goods Sold Number of Day s Sales in Inventory = $5,500,000 = 62.7 $8,000,000 = 83.4 $87,671 $95,890 PROFITABILITY MEASURES Rate Earned on Stockholders Equity: Assesses the profitability of investment by stockholders Rate Earned On Stockholders Equity = Net Sales Average Stockholders Equity Rate Earned on Stockholders Equity = $5,000,000 = 20% $2,000,000 = 8 %

5 $25,000,000 $25,000,000 Rate Earned on Total Assets: Assesses the profitability of assets Rate Earned on Total Assets = Net Income + Interest Expense Average Total Assets Rate Earned on Total Assets = $5,000,000 = 0.10 = 10% $2,000,000 = 0.04 = 4% $50,000,000 $50,000,000 Purchasing and Supply Management s Impact on the Firm s Financial Strength. Each dollar that purchasing and supply professionals cut from the assets portion of the balance sheet (through reductions in inventory, plant, and equipment investment) can be used in several profitable ways. First, it can be returned to stockholders, increasing their rate of return. This makes your firm more attractive to current and potential investors. Second, it can help the firm be more competitive in the market place because fewer assets are needed to generate a given level of sales. Third, it can be used to enter new markets, develop new products, or acquire existing businesses. Finally, it increases the financial health of the firm, making it easier to obtain financing and trade credit. Each dollar that purchasing and supply professionals cut from cost of goods sold enhances solvency (current ratio, inventory turnover and number of day s sales in inventory) and profitability (rate earned on stockholders equity and rate earned on total assets). As discussed earlier, modest reductions in cost of goods sold can have a substantial effect on income. Finally, reductions in cost of goods sold contribute to competitive advantage by enabling the firm to be more profitable at any level of revenue. The following are some things that purchasing and supply professionals can do to affect their firm s financial strength and increase their credibility with accounting and financial staff. Develop a working knowledge of financial accounting basics. The material presented in this paper provides a foundation for further professional development. Develop positive working relationships with accounting, finance, and credit professionals. These individuals can help you better understand financial issues that affect suppliers and your own firm. Do not hesitate to seek information, either from training or from other professionals, about intermediate and advanced accounting and finance issues that are important to purchasing and supply management. Develop and maintain a positive attitude toward accounting and financial issues. An unenthusiastic attitude concerning accounting and finance will affect the attitudes of accounting and financial professionals toward you and your profession.

6 Take the time to educate accounting and financial professionals on purchasing and supply management. They will be much more able to contribute to your success if they understand what you do. Conclusion. A working understanding of financial accounting is critical to successful purchasing and supply management. This paper has presented an introduction to selected financial accounting basics and demonstrated they can be useful decision tools. For many purchasing and supply professionals, this understanding will increase their own contributions to the firm s success, help them focus their priorities, and improve their ability to get results by working with accounting and finance professionals.