Supplier Financial Risk: Health Assessment Report

Financial distress & failure of critical suppliers is predictable

Virtually every conference or conversation in procurement and supply chain management eventually touches on risk management. There are myriad risks that can disrupt supply chains – from natural disasters to political turmoil to labor strife, even to shipments lost at sea. And, the exposures have grown exponentially with the globalization of supply.

But of all the risks that chief procurement officers (CPOs) face, the one that is at once both potentially devastating and often entirely predictable is the financial failure of key, strategic suppliers.

The reality is, however, that procurement doesn’t have to be caught off guard. As this report shows, supplier financial instability is difficult, but not impossible, to spot. Early warning is critical. Chief risk officers, chief finance officers, CPOs, CEOs, and board members expect it. Use the right tools, analyze the right financial factors, and you can get an early warning so you can take action fast and position your supply chain for stability.

 

Continuous monitoring of financial health helps procurement assess suppliers

According to the American Bankruptcy Institute, total US company bankruptcies in 2011 dropped 15% from 2010 to 47,806 companies. The vast majority of these were privately owned companies.

But when it comes to key suppliers, one failed company is one too many. As one CPO, capturing a fundamental principle of supply chain management, says, every company depends on another business to achieve its own business goals. If a supplier fails, you can replace it, but that can take a significant amount of time.

A supplier failure can also be costly. How costly? One aircraft-engine manufacturer a few years back reported that the cost it incurred when one minor supplier failed was $4.5m.

Of course, many companies take great pains to monitor the risks associated with their suppliers. IBM, for example, looks at the potential for a natural disaster near a supplier location, among other things. But for many companies, financial health assessments of suppliers and other key stakeholders usually occurs inconsistently and occasionally rather than systematically.

Various functions within a company use different tools and compile different financial data, and they don’t always share that data with other functions. The result is an incomplete and misleading picture of the financial risks the company faces. And even when problems surface, solutions can be tricky. For example, in 2008, Lear Corporation, one of the largest suppliers to the aerospace industry, filed for bankruptcy despite receiving support from lenders and bondholders.

For procurement, the goal of financial monitoring isn’t necessarily to sever ties with suppliers in financial trouble. CPOs may simply want to know whether a supplier can handle an increase in business. If they see trouble ahead, they may decide to help the supplier. One major corporation recently bought commodities from a tier-two supplier and had them shipped to a tier-one to relieve the tier-one of a cash-flow strain.

 

Return on investing in a supplier risk management program

Many companies find third-party risk management solutions difficult to choose between and equally difficult to justify. The service isn’t free. The question for many becomes, “What is the return on my investment?”

Before answering that, consider this: 50% of respondents to a recent study by Gartner Research who experienced a supply chain disruption within the past year experienced a loss of more than $1m. Respondents to a Procurement Intelligence Unit survey estimated that the related cost of suppliers going out of business could approach $79m over a 12-month period.

The costs go beyond the downtime and loss of business. Even when a company recovers from a disaster, such as a tsunami, they may have spent so much on rebuilding that they don’t have the funds to sustain business. And there are other factors to consider, such as:

  • Brand impact when shipments aren’t made due to a supplier failure
  • Lost sales/revenue due to cancelled orders
  • Productivity drops due to lack of material (plant is idle)
  • Staff relocation to handle disruption
  • Contract services for such tasks as on-site inspections and customer service
  • Legal fees for overseeing bankruptcy
  • Reduction of cash due to supporting suppliers during disruption
  • Consulting fees for help managing the crisis
  • Logistics expenses to expedite shipments
  • General penalties that may be in contracts
  • Effects of mergers/acquisitions

“When comparing the cost of just one disruption to the cost of one or even two third-party risk management resources, you can easily develop the business case to support pursuing or continuing with a service that can protect you from those potential losses,” asserts RapidRatings’ former senior vice president of supply chain risk management, Rose Kelly-Falls.

Of course, there is one other rather subjective factor: peace of mind. That’s how Richard Zrebriec, director for FP&A for Integralife, looks at his investment in risk management. “The visibility we get into who is at risk is like a warm, comfy blanket,” he says. CPOs will agree that a dependable risk management strategy certainly ensures a good night’s sleep.

 

Transparency & collaboration necessary for supply chain risk mitigation

More than half (55%) of respondents to a recent Procurement Intelligence Unit survey (see chart, above) said supplier insolvency would be the leading risk they face over the next 12 months. As Michael Chagares wrote recently in BusinessFinanceMag.com, the point is not to avoid such risks, it’s to more intelligently manage them. The key is to see potential problems, such as trends indicating a company may be close to being insolvent, before they actually arise and when an organization still has time to address the issues with the supplier. Once the problems do arise, it may be too late. And having that early warning can actually enhance the relationship with a supplier by presenting an opportunity for in-depth dialog.

Early warning can also promote greater collaboration according to a report provided by Gartner Research on one manufacturer’s experience with the supplier financial health reports developed by research firm RapidRatings. The report said most suppliers realized that providing transparency into their businesses was a new means for surviving as the manufacturer’s partner, or even growing from the partnership.

Financial risk assessment requires evaluating financial statements

Understanding a supplier’s financial health requires a deep dive into the supplier’s financials to see how several factors have changed over a period of time. For example, a supplier’s receivables may be growing, but that could mean its credit and collection standards are weak. So on top of financials, CPOs should be checking efficiency factors such as:

  • Revenue-performance
  • Debt-service-management
  • Leverage-management
  • Working capital
  • Cost structure
  • Operating-profit (upstream)
  • Net-profit (downstream)

“The longer the time series you can look at, and the deeper you can go into such data as a company’s cost structure and working capital efficiency, the better – especially if you measure the company against the record of other suppliers,” says James H. Gellert, chief executive of RapidRatings. The synergies among a variety of measurements are what’s really important for comprehensive analysis of risk, he says.

It’s important to take a portfolio approach – to look at all suppliers, perhaps subdivided by product, service, geography, or commodity manager. “Many often follow the 80-20 rule in supply chain risk management, focusing on the 20% of suppliers where criticality or spend is the biggest,” says Gellert. “But risks in the 80% group can also matter.” Criticality is potentially even more important than spend. It’s hard to replace dual-source and single-source suppliers. It may be impossible to replace a critical sole-source supplier.

New York-based RapidRatings uses scanning tools, one for each of the factors listed above. The tools incorporate a set of 62 financial ratios that produce a single, predictive overall Financial Health Rating (FHR) on an industry-specific basis. The ratios provide the equivalent of an MRI (magnetic resonance imaging) scan that provides deep insight into the inner workings of the company and its level of resilience and efficiency.

Case Study: Supply chain risk management requires an end-to-end view of suppliers

The CPO of a midwest capital equipment manufacturer got a call from the lawyer of a major supplier. The message: bring a large check to the supplier’s headquarters or the supplier would file for bankruptcy, making it unable to provide the required material for a major product the company was about to launch. The manufacturer brought the check as requested, thus avoiding a parts shortage.

Actually, the CPO had been monitoring the health of that supplier and the reports he checked were positive. What he didn’t know was that one of the tier-two suppliers was having trouble getting paid by another customer and was unable to pay for its own raw materials to provide the parts the CPO’s principal supplier needed.

It’s not uncommon. Part of the problem is tight credit. The Wharton School of Business at the University of Pennsylvania produced a white paper in 2009 that said tight credit could force many small suppliers out of business.

Several factors complicate the detection of financial problems in a supply chain. First, says the procurement team at Rockwell Collins, balance sheets can be obsolete after a couple of days. There is also the matter of globalization. Beyond the risks of natural disasters in some geographic areas, there are different accounting standards to consider. Additionally, distances increase the difficulty of on-site visits. Low interest rates increase merger and acquisition activity, increasing complexity of supply chain monitoring.

Companies may be inconsistent in their approach to identifying financial risk and use a silo approach where different departments use different analytical tools and methods and don’t share data. “There is often a triage mentality,” says James Gellert. “Companies may check for warning signs about a key supplier, or check the finances of a new supplier, but often they don’t have a regular program to analyze all critical factors together and systematically.”

Mitigate supplier risk through a clear & accurate picture of financial viability

To provide a clear picture of all important financial factors for private and public companies alike, Gellert says, RapidRatings’ FHR analyze 62 financial ratios under the general headings of debt service management, leveraging, cost structure, working capital efficiency, profitability, and sales performance. The 62 include such items as interest expense/total liabilities, EBIT (earnings before interest and taxes)/interest expense, cost of goods sold/total expenditure, tax/total revenue, working capital/total assets, and sales/capital, among others. “We don’t let any one of these disproportionately affect the final rating, because each one has a bearing on the ultimate rating,” Gellert says.

Many traditional rules of thumb used by financial analysts aren’t very helpful. Rely on just one and the results can be misleading. For example, typical credit analysis may say a current assets to current liabilities (CACL) ratio below 1.0 indicates stress. But, many companies go bankrupt when their ratio is higher. The Italian food giant Parmalat went bankrupt with a CACL ratio over 2.0, Enron  with a ratio over 1.0.

RapidRatings scores each of the ratios it develops for public and private companies on a 0-100 basis, multiplied by an industry-specific weighting. The industry specific risk comes from variations in the weights of each of the ratios in terms of their statistical significance in predicting distress and success across time. The cost-structure scores show how efficiently a company manages costs necessary to run the business and achieve a relative level of success. The sales score shows the efficiency with which a company generates revenue relative to balance sheet items. The working capital efficiency includes measurement of the value of quick assets generated per dollar of operating revenue or per dollar of current or total assets.

Gellert says that over the past 20 years, 90% of defaults have occurred at 40 or below on the 0-100 FHR scale, and that the most individual defaults have occurred at 26.

 

Benchmark financial risk of your suppliers to their industry

The resulting FHR, says Gellert, indicates a company’s ability to compete with its peers around the world. The rating also reflects how close a supplier may be to long-term stability – or, more ominously, how close it may be to collapse.

It also provides both portfolio risk reports that present an overview of the distribution of risks of all suppliers in a portfolio, and a peer benchmark report that shows a supplier’s risks against that of its sector. A supplier could have a high rating, but not very high versus its sector. Conversely, it can rate highly within a weak sector, such as forest products, which is declining at an annualized rate of 4%. Such information can be helpful in negotiations and in developing commodity strategies.

The FHR weightings came originally from continual analysis of RapidRating’s database of financial reports collected on more than 300,000 companies of all sizes in more than a dozen countries over 30 years. “Unlike traditional default modeling, which only measures whether a company should or should not fail, our system also gives more insight into how a company is doing across its lifecycle and how well it is positioned to maintain its success,” Gellert asserts. The system’s automation makes report generation quick. And users don’t have to invest much time or staff. The company once rated 3,000 private companies overnight and provided 15,000 reports as a result.

 

Predictive analytics mitigate supply chain risk

As an executive with a deep background in both finance and supply chain, Richard Zrebiec is passionate about spotting and managing risks. The director of FP&A for the neurosurgery division of medical device holding company Integra LifeSciences Corp., he regularly preaches the importance of risk management. For him, one of the critical elements of risk management is predictive ability. That ability came in handy in one of his previous professional assignments.

While working in finance at Firmenich SA, a $4bn Geneva-based flavoring company, he hired RapidRatings to, among other things, tell him the risks he faced with direct suppliers. “They put together a report of our top 50 suppliers where our direct and indirect spend was a billion and a half dollars,” he recalls. He was most interested in the direct suppliers, and the Rapid Ratings report showed him the top five and the bottom five suppliers.

“I was surprised at two of the bottom five,” he says. The next step was to decide how important the suppliers really were to the company and then talk with them about their finances. That led to in-depth conversations with one of the key suppliers about their financial condition. The supplier explained its financial strategy to Zrebiec, who quizzed finance executives there on several aspects of their balance sheet before he was satisfied that they could continue to do business with the supplier and assume the risks of which they were now more aware.

“RapidRatings’ reports helped us get a feel for whom we needed to talk to sooner rather than later,” he says. And, the conversation resulted in one other major positive for Zrebiec. “The supplier now knew that we were a company that knew their business in depth, that we were professional,” he says. “It made us closer.”

 

Enterprise-wide risk metrics to manage suppliers, customers, and counterparties

The same system for rating suppliers works for managing customer risk, too. There are many stories similar to the one told to the website OregonLive.com recently by the president of a machine-tool company. He said his company assumed that one of its main customers, a pulp and paper mill, would survive a shakeout in the industry. It didn’t. The mill’s parent filed for bankruptcy. The fallout means the machine-tool company will have to wait months to get paid.

That’s a scenario not likely to happen at Microsoft, which has a vigorous and wide-ranging risk management program. The company uses RapidRatings to monitor risks associated with its customers. “It’s part of our 360-degree exposure strategy, which helps us uncover exposures we may want to unwind,” says Shruti Kulkarni, a member of Microsoft’s financial risk management team.

“RapidRatings gives us weekly reports on about 85 companies, and the list can change every week depending on our needs,” she says. “The reports tell us if a company went from low risk to medium risk to high risk.” Microsoft also sees other reports for public companies compiled by RapidRatings.

Kulkarni says Microsoft’s treasury group has different teams from several silos tracking different kinds of credit risk. In 2008, however, as credit quality was plunging, the company realized it needed that 360-degree view of all its exposures. So, the company began to pull all its data together.

The goal was to aggregate all of the risk information and give the corporate treasurer a single view of all exposures. Then, the economy got worse and the team realized it needed more timely information. Microsoft started using Altman Z scores, but because that system doesn’t include financial services companies or private companies, the financial risk management team added RapidRatings reports, which cover both. “Now, we have better visibility so we can make informed decisions on our exposures,” Kulkarni says.

 

Evaluate private company financials with the same rigor as public companies

Between 70 and 80% of the suppliers in the US economy are private companies, not public ones. Most of them are small companies, with fewer than 500 employees. Minority-owned companies fall into that category. With the trend toward diversity in supply chains, it’s only natural that many of a company’s suppliers are private.

Private companies in the US aren’t required to file financial reports. But CPOs need to know the financial health of their private company suppliers, especially since small private companies have been hard hit by the credit crunch. The key to obtaining financial information for private companies is to be persistent in requesting it and to reassure those companies that you will maintain confidentiality.

It is very important to avoid confrontation. “Private companies‘ first answer to requests for their financials is often ‘no,’ because most who ask accept that and don’t ask again,” Gellert recently told attendees at the spring energy conference of the IECA (International Energy Credit Association). “But you can go a long way in overcoming objections by providing assurances about confidentiality, explaining how the financials will be used and that the request is a supply chain-wide process, and is not intended to single out the individual company.”

A potential source for some private company financials is in the required filings of the private companies’ public parents. Additionally, some non-US jurisdictions require filings from private companies. One option is to put the requirement for disclosure into contracts. That’s the strategy of many organisations with one procurement executive we spoke to saying she puts the requirement for an open-book relationship into all contracts with private companies.

 

Using technology to manage supply chain risks

Microsoft has regular meetings with the RapidRatings team where both parties exchange information and where Microsoft learns of new reports that might be of help. With the data it gets from RapidRatings and its other sources, the Microsoft team produces its own charts showing exposures, including type and magnitude. The aggregation of all exposures has helped the team spot problems early, before they become problematic. “The RapidRatings team is very proactive, and their reports help us be more proactive,” Kulkarni asserts. “We can address issues before they get to be a crisis.”

So, how reliable are the reports in forecasting the potential for a crisis early enough to take action? In 2007, the FHR on MF Global showed a decline in a variety of measures and in 2008, it declared that MF Global was ‘High Risk’. Meanwhile, all three of the largest financial rating agencies in the US produced comparatively positive reports on the company. Just days before MF Global’s 2011 bankruptcy filing the rating agencies called the company sub-investment grade.

In 2008, RapidRatings generated an FHR of 30 for the merged LyondellBasell based on its first six months of combined operations (any score of 40 or less is either ‘High Risk’ or ‘Very High Risk’). Two months later, the company said it was entering into discussions with lenders to extend due dates on $160m of repayments and The Wall Street Journal reported that it was seeking up to $2bn in bankruptcy financing. On January 6, 2009, LyondellBasell filed for bankruptcy protection.

Petroplus, Europe’s largest independent oil refiner, offers another example. RapidRatings downgraded Petroplus in 2009. The major rating agencies only downgraded the company weeks before its January 2012 insolvency filing.

Obviously, the ratings of companies’ financial health can provide an early warning of trouble ahead. The key is to have the right tools to rate the right factors.

— Paul Teague

 

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