In almost every RFP I've ever seen, including my own RFPs, there's a requirement for the vendors to send in some number of years of audited financial statements.  Some vendors hem and haw, but most dutifully send their financial statements with their proposals.  There's good reason for asking vendors for this information.  Among other reasons, you want to make sure that the vendor isn't going to go belly up halfway through your customer's project.  In other words, you want some sort of assurance that the vendor is going to be around for a while.

So, let's be honest...  When you get those financial statements, what do you really do with them?  Sure you might spend five minutes looking over the vendor's numbers to determine whether or not there's a positive net income and what revenue and expenses have been doing year-over-year.  But you probably make a judgment call and say something along the lines of "Uh, the vendor's numbers looked good..." when it comes to proposal evaluation time.  And that's about it, right?

If you're really being honest, and you do some sort of sophisticated financial assessment of your vendors' financial statements, then I would guess you're in the minority.  Put it this way, I know people with CPAs who can't read financial statements well enough to make an accurate projection of a vendor's future financial viability.  That doesn't mean those CPAs are stupid; it means that, unless you really know how to read financial statements for the purpose of assessing future viability, and unless you do that work frequently, you might as well get out a dart board.

With that said, assessing a vendor's financial viability is a key consideration of an RFP project.  According to the U.S. Small Business Administration, over 50% of small businesses fail in the first year and 95% fail within the first
five years.  Unfortunately, as purchasing professionals, we don't always have the luxury of buying from large companies.  In fact, many of us have requirements to buy from MBE/WBE companies which are almost always small businesses.  Does that mean you should only do business with a small business that has been around for at least five years?  Yep!  Sorry small business owners, but us purchasing professionals have an obligation to mitigate risk for our customers.

But what about those small businesses that have been around for a while?  We still haven't gotten around to anything better than a dart board to assess financial viability.  That's where a great little tool called the "Z-score" comes into play.  The Z-score measures the financial health of a company and predicts the probability of bankruptcy within two years.   The formula is said to be around 75% accurate.  The formula was developed in 1968 by Dr. Edward I. Altman, a financial economist and professor at the Leonard N. Stern School of Business at New York University.

The formula may appear to be intimidating at first, but it's not.  It's actually brilliantly simple.  All you need to do is pull the numbers (inputs) from a vendor's financial statement, plug them in the formula, push some buttons, and then compare the Z-score to a range of scores (zones) to determine the possibility of bankruptcy.  I'm going to reproduce the formula for "private" companies below.  (If you want more information on the Z-score or need variations of the formula for public companies, manufacturers, etc., check out Wiki.)

Z-score Formula Inputs:


Z-score Formula:


Zones of Bankruptcy Potential:


If you really want to understand how the formula works, there's a wealth of in-depth articles that you can Google.  Or, you can just thank Dr. Altman, use the formula, and finally analyze those financial statements in a way that really gives you valuable information in assessing the ongoing financial viability of prospective vendors.

Happy Calculating!