Electronics services due diligence: Financial, key operating indicators (KOI)
By VentureOutsource.com staff
Are sales falling or is production rising too fast? OEMs must learn to look at any given situation from more than one angel. When OEMs evaluate electronics contract manufacturers, it’s not enough that a particular contract manufacturer has a history or experience in the field of expertise, or product end-markets, the OEM is marketing its products in.
OEM executives must also be comfortable understanding the contract manufacturer’s financial position relative to his business profit objectives and, that the contract manufacturer will be around for a while to serve the needs of the OEM.
Below are some of the financial operating and overall company indicators, and a few possibly related causes, OEM executives might want to look into more closely when evaluating contract manufacturers for the purpose of engagement.
Naturally, it is easier to gain access to some of this information from publicly traded contract manufacturing companies. (Click here for more detail on metrics and liability)
High inventories might possibly indicated the following: quality of the products manufactured by the contract manufacturer has slipped; the competition is building a better-quality product for the same customer, or end-markets some of the contract manufacturers’ customers are financially strapped production costs are out of line the contract manufacturer is no longer price competitive.
One question executives should ask is, “are sales falling or is production rising too fast?” Keep in mind, companies may hold back some inventories while waiting for new product introductions (NPI).
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Most explanations for rising receivables are usually bad if receivables are rising faster than sales (relative percentage for each). Possibilities for this might include: customers are paying the contract manufacturer to slowly (again, due to financial troubles of their own, or business disputes) ‘channel stuffing’ or, increased shipments at quarter end to help make the quarter numbers (essentially, stealing from the following quarter) could be talking place.
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Look for inconsistencies. In years one through three, for instance, the contract manufacturer reports steadily increasing operating earning profits (with its stock price rising). Then, in year four the company reports an extraordinary loss per share, but adds that operating earnings, before the loss, were healthy. It could be there has been some neglect in capital spending necessary to maintain infrastructure in a high capex industry such as contract manufacturing.
Companies may sell a profitable business segment or division to raise earnings, but this cannot be done each quarter. Executives should place a smaller value on earnings derived from asset sales vs. core operations.
With evolving and emerging technologies such as lead-free SMT PCBA applications and nano technologies, contract manufacturers need to keep up. There should always be a good reason if R&D budgets are cut. Usually, there is not…the company is usually trying to inflate earnings, if only temporarily.
Reduced capital spending
Again, look for reductions. Capital spending is usually necessary to remain competitive. This can be deceiving, however, when reviewed during periods of low utilization rates across the industry.
For contract manufacturing companies with operations in foreign countries, check to see the growth is ‘true’ and not due to a majority of earnings reported under the rate in one particular country – using that country’s currency exchange rate. Currency translation effects can end up in the income statement or the equity section of the balance sheet, decided by internal accounting rules. Effects that end up in the income statement are not part of continuing operations.
Out of balance growth
Generally, revenue and earnings should rise roughly in tandem. When revenue rises faster than earnings, this is a sign profit margins could be slipping. Perhaps the contract manufacturer is not managing his business properly. Meanwhile, if earnings rise faster than revenue, earnings growth is most likely not sustainable. Growth in revenue should be larger than growth in accounts receivable.
Key operating indicators
Like any other industry, the electronics contract manufacturing sector has its own set of peculiarities. While contract manufacturers can typically carry more than their share of debt compared to companies in other industries, there are industry standards for most of the financial metrics in the space. A few of the more common industry metrics include:
- Days of Inventory
Inventory (two period average) / Cost of Goods Sold / Number of DaysInventory days measures the number of days of inventory the contract manufacturer has on hand given current production levels. Typically, the lower the number of days, the more efficient the management team is at managing inventory. Given the diverse product mix and OEM customer diversification preferences the EMS providers go after.
- Days Sales Outstanding (DSO)
Receivables (two period average) / Revenues / Number of DaysAgain, the lower the number, the better the contract manufacturer is at managing finances and, his customers.
- Days of Payable
Payables (two period average) / COGS + SG&A / Number of DaysTypically, the higher the number the better position the contract manufacturer is in with his suppliers and vendors. However, a high number could also translate to the contract manufacturer not being able to pay his bills – for a number of reasons.
- Cash Conversion Cycle
Days of Inventory + DSO – Days of PayableThe amount of time it takes from the contract manufacturer placing orders with his vendors; pipelining the materials in-house, producing the materials into finished goods inventory (FGI), shipping to his customers, and collecting payment for services (accounts receivable). The shorter this period, the better for the contract manufacturer.