Fiscal Red Flags

Know what to look for in your outsourcer's financial statements.

Whether a potential outsourcer is headquartered right down the street or in Bangalore, you need to do plenty of due diligence to ensure that your company's needs will be met by a stable, fiscally healthy partner.

Lawyers, analysts, consultants, insurance firms and others offer this advice: IT managers can make better outsourcing decisions if they're conversant in fiscal terms. "Today, I'm seeing more CIOs who really understand this [due diligence] process," says Dan Smolnik, senior partner at The Smolnik Law Office, a West Simsbury, Conn.-based firm specializing in corporate law.

The appropriate role for IT managers has its limits, however. Just as you wouldn't want a plumber removing your spleen, you need to confer with your company's financial specialists before committing to any outsourcing deal. Robert Zahler, a partner at Shaw Pittman LLP, who heads the law firm's outsourcing practice in Washington, urges CIOs, "Don't do it yourself. Turn to your corporate finance people -- ask them to do the analysis."

Nonetheless, an educated consumer is a wiser one.

Nail Down the Numbers

Before you analyze financial data, you need to find it. In the case of publicly owned companies, especially those in the U.S., this is easy -- you can find the information on the investor relations page of the company's Web site or look it up at sites like CBS MarketWatch (http:cbsmarketwatch.com) or Yahoo Finance (http://finance.yahoo.com). Digging up financial information for publicly held companies based overseas isn't much harder. One source is Standard & Poor's (www.standardandpoors.com).

Private companies present a bigger challenge. Gordon Brooks is CEO of Symphony Services Corp., a Palo Alto, Calif.-based outsourcer with operations in Bangalore, India. "We just generally don't share full financials," he says, noting that private companies' agreements with their financial backers often forbid this. However, Brooks says, "we do share key metrics, and we do talk extensively with CFOs [of prospective clients]."

That's a reasonable position, but experts say that it raises a red flag if an outsourcer balks at sharing metrics. "If my [corporate counsel] counterpart is not aggressively getting me this information, I'm hesitant about the company," says Smolnik. "And I pass that discomfort on to my client, asking, 'Can this relationship really endure?'"

Here are four metrics to analyze when gauging the fiscal health of outsourcers from RampRate LLC, an IT outsourcing consultancy in Santa Monica, Calif., as well as other experts:

1 Liquidity. Liquidity is the ability of a business to meet its short-term obligations; this is where early warning signs of financial difficulty will reveal themselves.

Metric A. To measure an outsourcer's liquidity, find its current ratio. Here's the formula: Divide current assets by current liabilities.

What you're looking for. What's considered a healthy current ratio varies by industry. According to financial analysts, a figure of 1.5 is generally reasonable, and a figure above 2 is desirable. A current ratio less then 1.5 indicates that any company's ability to meet its short-term obligations is stressed.

Metric B. There's a more stringent measure of liquidity called the quick ratio. The formula: Add accounts receivable and cash and then divide by current liabilities.

What you're looking for. A quick ratio higher than 1.1 is considered healthy.

Why is the quick ratio considered a tougher test than the current ratio? It excludes nonliquid current assets such as inventory from the equation, thus presenting a more accurate picture.

While the raw quick or current ratio is important, experts caution that such figures should always be compared against those of industry peers. That means that if you're considering a tiny Indian start-up for a portion of your IT outsourcing, you should compare it against competitors of similar size -- not against the Electronic Data Systems and Wipros of the world.

Mark Smialowicz, the chief financial officer at RampRate, says trends are vital, too. That is, check to see whether the outsourcer's current ratio is holding steady, shrinking or growing. "If it's trending toward 1, that's a big red flag," he says.

2 Capital Structure and Solvency. The next step in determining a potential outsourcer's fiscal health is to learn its debt-to-equity ratio.

Metric A. To find a company's debt-to-equity ratio, simply divide its total liabilities by its equity.

Metric B. To extend the time horizon -- which is a good idea if you seek an outsourcing contract with a five- to seven-year life span, as is often the case -- tweak the equation and find the outsourcer's long-term-debt-to-equity ratio by dividing long-term liabilities by equity.

What you're looking for. A low number is a good thing, but keep in mind that debt isn't necessarily a bad thing; it may merely reflect a heavy investment in the infrastructure needed to meet your company's needs. As with virtually all financial metrics, the key is to compare similar companies against one another. "Does [a potential partner's] level of debt as a percentage of assets top that of its peers? If so, you need to find out why," Smialowicz says. "They may have been burning a lot of cash lately, or they may have had to borrow a lot of money."

Keep in mind that an outsourcer with an unusually high debt ratio may use more capital servicing its debt and less servicing your account.

3 Statement of cash flows. It's easy to grasp a company's income statement and balance sheet, but few IT pros realize there's a third side in this triangle -- called a statement of cash flows -- that ties the other two together, presenting a more detailed snapshot of an outsourcer's cash position.

The metric. A statement of cash flows is a sophisticated measure with three tiers: operations, investment and financing. To calculate it, start with a company's net income. Then add (or subtract) funds provided (or used) from operations, investments and financing. The sum tells you the net increase (or decrease) in a firm's cash position in a given period. This is critical because a company's performance isn't accurately reflected by the income statement alone, Smialowicz says.

Many CIOs and other nonexperts attempt to measure performance merely by studying an outsourcer's income statement for earnings before interest, taxes, depreciation and amortization, known as EBITDA. This can be misleading, because on the income statement, capital expenditures on facilities and equipment are reflected only in terms of depreciation. To see true operating performance and any cash drains, the statement of cash flows is key.

Some companies have great EBITDA even when they're at death's door. As examples, Smialowicz points to the 2001 collapses of several competitive local exchange carriers (CLEC). Practically until the minute they filed for bankruptcy, CLECs like NorthPoint Communications Group Inc. and Covad Communications Group Inc. could boast healthy EBITDAs. "But they had to buy $100 million or so in new equipment over the next three years," Smialowicz says. The investment portion of CLECs' statements of cash flows served as warning signs -- to those who studied them.

What you're looking for. If a prospective partner's cash position is remaining neutral or decreasing, find out why. You need to know an outsourcer's current and projected income, of course -- but it's even more important to understand its projected capital requirements and how those requirements will be funded. Smolnik says that when representing organizations in outsourcing deals, he recommends that they demand to see historical and projected income statements, balance sheets and statements of cash flows.

4 Overall size and profitability. Experts say an outsourcer's size, measured in both revenue and customers, as well as trends in its gross margins, are important signposts.

The metric. The gross margin for any business is its profit before operating expenses are deducted. A company's size is self-explanatory.

What you're looking for. Where these interrelated measures are concerned, trends and comparisons are key. A small outsourcer isn't bad, but if it directly competes with much larger companies, it is likely a riskier bet.

Study the trend in the potential partner's gross margins. If an outsourcer is growing its customer base, that's generally a good thing. However, if a company is adding customers but its profit margin is shrinking (that is, if it's making less money per customer), that's a red flag. The company may be in an industry niche that's becoming "commoditized," and this may in turn strain an outsourcer's cash flow.

Ulfelder is a Computerworld contributing writer in Southboro, Mass. Contact him at sulfelder@charter.net.

Copyright © 2004 IDG Communications, Inc.

  
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