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Focus on These Six Key Financial Metrics to Help Determine Vendor Viability

Gary Spivak

Gartner Data Center, Infrastructure & Operations Management Conference

7–10 December 2015 | Las Vegas, NV

1 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved.

Would You Trust This Vendor?

Would You TrustThis Vendor?

But What If They Looked Like This?

Should I trust

this guy?


What is your current level of financial expertise?

Little to none.

Not bad — self-taught.

I took a couple of accounting/finance courses.

I have an accounting or finance degree.

I am an expert at financial statement analysis.

Polling Question


Through 2018, more than 75% of IT leaders will lack the financial statement analysis skills to avoid overexposure to financially troubled vendors.

Financial Analysis Skills Are Rare in IT

Supporting the SPA:

Briefings and inquiries show

a lack of financial analysis skills

within IT.

I&O leaders are still more focused

on operational metrics than on

business metrics.

Alternative position to SPA:

I&O will mature faster than

expected in providing and

communicating business value to

business leaders.

A high-profile vendor failure will

cause IT leaders to urgently focus

on these skills.


Key Issues

1. Why should you care about the financial status of strategic vendors?

2. What are the most critical ratios and metrics to use in advanced

vendor financial statement analysis?


Key Issues





You Need Credible, Viable Solutions!

30+ Years


Supplied by MANY Vendors


But Some Run Into Financial Difficulties

Or Not!Either Get Help


How often are your strategic vendors evaluated on their

ability to remain viable?

Never.

Once a year.

Every two or three years.

Before every contract renewal.

Don't know.

Polling Question


Key Issues





Income Statement:

– Revenue

– Spending/Investments

– Profitability

Balance Sheet:

– Assets

– Liabilities

Statement of Cash Flows:

– Sources of cash

– Uses of cash

Public Financial Statements


Measures:

– Growth

– Profitability

– Ability to meet current obligations/solvency

– Cash flow generation

Gartner Vendor Financial Rating

Calculate:

LTM Revenue

Growth (%)

Gartner

Score

-1000.0% 0

-75.0% 1

-34.0% 2

-14.0% 3

-4.0% 4

1.0% 5

6.0% 6

16.0% 7

36.0% 8

76.0% 9

156.0% 10

Calculate:

LTM Profit

Margin (%)

Gartner

Score

-1000.0% 0

-100.0% 1

-50.0% 2

-25.0% 3

-9.0% 4

0.0% 5

2.0% 6

6.0% 7

12.0% 8

20.0% 9

30.0% 10

Calculate:

Current Ratio

(Decimal)

Gartner

Score

0.00 0

0.60 1

0.80 2

0.95 3

1.10 4

1.25 5

1.40 6

1.55 7

1.70 8

1.85 9

2.00 10

2.20 9

2.60 8

3.20 7

4.00 6

Calculate: LTM

CFO/ Revenue

Gartner

Score

-150.0% 0

-90.0% 1

-42.0% 2

-18.0% 3

-6.0% 4

0.0% 5

3.0% 6

9.0% 7

18.0% 8

30.0% 9

45.0% 10

Score Rating

0 Strong Negative

9 Strong Negative

10 Caution

19 Promising

25 Positive

32 Strong Positive


Six Key Financial Metrics

Revenue/TurnoverGrowth

Bookings Growth

Profitability —Net Profit

Margin

CurrentRatio

Cash From Operations

Margin

R&DSpending

Ratio


Metric No. 1 — Trailing Twelve Month (TTM)

Revenue (Turnover) Growth:

– Information Taken From Income Statement.

– Optional: Look at Major Product Growth, License, as Opposed

to Secondary Drivers, Like Maintenance or Services.

Metric No. 1 — Revenue Growth

TTM Revenue/Last Year's TTM Revenue — 1.


Metric No. 1 — Data on Income Statement

Microsoft Corporation

Yearly Income Statements

(In millions, except earnings per share)

FY12 FY13 FY14

Revenue 73,723$ 77,849$ 86,833$

Cost of revenue 17,530 20,249 26,934

Gross margin 56,193 57,600 59,899

Research and development 9,811 10,411 11,381

Sales and marketing 13,857 15,276 15,811

General and administrative 4,569 5,149 4,821

Goodwill impairment 6,193 0 0

Integration and restructuring 0 0 127

Other expenses 0 0 0

Operating income 21,763 26,764 27,759

Other income (expense), net 504 288 61

Noncontinuing items 0 0 0

Income before income taxes 22,267 27,052 27,820

Provision for income taxes 5,289 5,189 5,746

Net income before accounting change 16,978 21,863 22,074

Cumulative effect of accounting change 0 0 0

Net income 16,978 21,863 22,074


Common in business models with

ongoing deliverables —

like maintenance, subscriptions

Deferred revenue is only recognized as

revenue ratably throughout the period

Remainder "stored" on

the balance sheet

Pure subscription

models will be slower

growth than revenue

recognized at sale

What Is Deferred/Unearned Revenue?Why Should You Care?

Liabilities and stockholders' equity

Current liabilities:

Accounts payable 7,432$ 4,828$

Short-term debt 2,000 0

Current portion of long-term debt 0 2,999

Accrued compensation 4,797 4,117

Income taxes 782 592

Short-term unearned revenue 23,150 20,639

Securities lending payable 558 645

Other 6,906 3,597

Total current liabilities 45,625 37,417

Long-term debt 20,645 12,601

Long-term unearned revenue 2,008 1,760

Deferred income taxes 2,728 1,709

Other long-term liabilities 11,594 10,000

Total liabilities 82,600 63,487

Total stockholders' equity 89,784 78,944

Total liabilities and stockholders'

equity 172,384$ 142,431$


Bookings is nonstandard — it is not defined the same way by

every company.

Bookings = Revenue + change in deferred revenue.

Metric No. 2 — "Bookings" Growth

Bookings growth = (TTM bookings)/(the year ago TTM bookings) — 1


Why Is Profitability Important?


Income Statement Example

The Bottom Line



(In millions, except earnings per share)

FY12 FY13 FY14

Revenue 73,723$ 77,849$ 86,833$

Cost of revenue 17,530 20,249 26,934

Gross margin 56,193 57,600 59,899














Net income 16,978 21,863 22,074


Revenue Growth Is Important —

but Ultimately, MUST HAVE Profitability.

Displays the Ability to Generate

Shareholder Value From the Business.

Measures:

– Gross Margin.

– Operating Margin.

– Net Profit Margin = THE BOTTOM LINE!

Measurements of Profitability


Metric No. 3 — Net Profit Margin

Net margin = TTM net income/TTM revenue:

Net profit margin IS the bottom line:

– Information from the income statement.

– Strength depends on sector:

Software — over 10% good.

Hardware — medium to high single digits.

Service — single digits.

– If negative — find out why:

Growing?

Restructuring?

Headed for oblivion?


LIQUIDATION

BANKRUPT INSOLVENT

Why Meeting Obligations Is Critical


Balance Sheet

Current obligations MUST be met.

If not, results could be default,bankruptcy, liquidation!

Microsoft Corporation Balance Sheets

(in Millions)

June 30

2014

June 30

2013

Assets

Current assets:

Cash and cash equivalents 8,669$ 3,804$

Short-term investments

(including securities loaned of $541 and $579) 77,040 73,218

Total cash, cash equivalents and

Short-term investments 85,709 77,022

Accounts receivable, net of allowance

for doubtful accounts of $301 and $336 19,544 17,486

Inventories 2,660 1,938


Other 4,392 3,388

Total current assets 114,246 101,466

Property and equipment, net

of accumulated

depreciation of $14,793and $12,513 13,011 9,991

Equity and other investments 14,597 10,844

Goodwill 20,127 14,655

Intangible assets, net 6,981 3,083

Other long-term assets 3,422 2,392

Total assets 172,384$ 142,431$

Liabilities and stockholders' equity

Current liabilities:

Accounts payable 7,432$ 4,828$

Short-term debt 2,000 0

Current portion of long-term debt 0 2,999

Accrued compensation 4,797 4,117

Income taxes 782 592

Short-term unearned revenue 23,150 20,639

Securities lending payable 558 645

Other 6,906 3,597

Total current liabilities 45,625 37,417

Long-term debt 20,645 12,601

Long-term unearned revenue 2,008 1,760


Other long-term liabilities 11,594 10,000

Total liabilities 82,600 63,487

Total stockholders' equity 89,784 78,944

Total liabilities and

stockholders' equity 172,384$ 142,431$


Metric No. 4 — Current Ratio

Current ratio = Current assets/current liabilities.

Measures ability to meet near-term obligations

with cash (or soon to be cash).

Normally want to see ratio greater than 1.

Ideally want to see at or greater than 2.

Deferred revenue can skew the value —

watch for this.


Why Is Cash Flow Important?


Measures the cash generated three different ways:

– Operations

– Investments

– Financing

Cash from operations — the most important;

measures how business activities generate cash

Cash used for investments:

– Includes capex

Cash flow from financing:

– Includes cash from issuing/buyback of stock, debt, dividends

Cash Flow Statement

Operating Activities

Investing Activities

Financing Activities

Statement of Cash Flows


TTM cash from operations/TTM revenue.

Measures ability of business to generate cash.

Be wary if consistently negative.

Gain comfort when consistently over 20%.

Similar sector dynamics as net profit margin.

Metric No. 5 — Cash From Operations Margin

Cash inflow

Cash outflow

Cash in hand


Source: Gartner (November 2015)

TTM R&D expense/

TTM revenue.

Monitor spending on research and

development to gauge vendor

commitment to product enhancements.

Metric No. 6 — R&D Spending



(In millions, except earnings per share)FY12 FY13 FY14

Revenue 73,723$ 77,849$ 86,833$

Cost of revenue 17,530 20,249 26,934

Gross margin 56,193 57,600 59,899














Net income 16,978 21,863 22,074

Sector

R&D as a

percentage

of Revenue

Communications Equipment Average 14.9%

Technology Hardware, Storage and Peripherals Average 12.7%

Diversified Telecommunication Services Average 1.9%

Internet Software and Services Average 16.8%

IT Services Average 3.5%

Semiconductors and Semiconductor Equipment Average 12.0%

Software Average 18.8%

Wireless Telecommunication Services Average 0.4%

Electronic Equipment, Instruments and Components Average 11.2%


Action Plan for I&O Leaders

Monday Morning:

Identify the key strategic vendors in your organization.

Discover which contract renewals arise in the next three months.

Collect financial information on those vendors.

Next 90 Days:

Calculate the six key metrics on those relationships due to renew in the next six months.

Determine where the best source of financial information is for each vendor.

Develop proficiency in this exercise.

Next 12 Months:

Utilize awareness of financial status in negotiations.

Illustrate the financial analysis when requesting authorization in product acquisition.


Recommended Gartner Research

Analysis of Income Statements Exposes Secrets to Reduce Risks of

Vendor Obsolescence

Gary Spivak (G00261495)

Analyze Vendor Balance Sheets to Reduce Risk of Vendor Obsolescence


Analysis of Vendor Cash Flows Helps Predict and Mitigate

Risk of Vendor Obsolescence


How to Re-evaluate Strategic Vendors Acquired by Private Equity

Gary Spivak, Colin Fletcher and Robert Naegle (G00267514)

Understanding Gartner's Financial Ratings of IT Vendors

Joseph Baylock, Frank Marsala and Others (G00166659)

For more information, stop by Gartner Research Zone.

http://www.gartner.com/document/2659016?ref=QuickSearch



http://www.gartner.com/document/2840319?ref=QuickSearch&sthkw=G00267514&refval=154253304&qid=82fb1aecb3564947de2a4d9d464e8fb0



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