When it comes to supplier finance, watch for the warning lights
Like flashing lights on a big control panel, there are many signals that can point to potential supplier financial problems. Here are some of the most important to monitor.
By Paul E. Teague -- Purchasing, 1/14/2010 2:00:00 AM
What It Means to Buyers:
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Balance sheets are important, but they're only a snapshot and could be out of date. Still, they're a good start.
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Cash-flow statements show what cash is coming in the door and where it's coming from. They also show where the cash is going.
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Staff turnover, R&D budgets, changes in product quality and delivery performance are among other vital signs to check.
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Don't fire a key supplier immediately after discovering financial problems. That could force them into bankruptcy. Instead, do a deep dive into their problems and see if there are ways to help.
Happy New Year!
Now that 2009—a year of incredible stress in the economy—is history and the economy seems to be reviving, it's time to take stock of what everyone learned. Certainly, near the top of everyone's list has to be the importance of risk management.
If anyone ever doubted the importance of assessing supplier financial health, those doubts went away last year. Bankruptcies abounded. One study revealed that 20% of respondents had suppliers that were unable to service them. According to another study, by AMR Research, Cambridge, Mass., 12% of respondents indicated that 50% of their suppliers had experienced disruptions. Interestingly, though, AMR Research's recent quarterly risk survey revealed that supply chain executives believe supply chain risk levels plunged quarter over quarter. That could be an indication that risk-management strategies are working.
But before you can manage risks, you have to identify them. Are there signs to watch for that would indicate weak financial conditions at a supplier? Yes, say several purchasing professionals. And they emphasize the plural: SIGNS.
"It's like the monitoring center of a nuclear power plant," says Phil Krotz, director of Lean supply at Rockwell Collins, Cedar Rapids, Iowa. "There are hundreds of lights flashing, and you have to know which ones to pay attention to."
"Basically, you have to keep track of all aspects of a supplier," says James Thomas, product marketing manager at Zycus, Princeton, N. J. The software developer has incorporated the Altman Z scoring system into its Risk Radar software to help buyers do just that. The so-called Z score has been around since the 1960s and familiar to virtually every finance officer. The system's predictive model combines five different financial ratios to determine the likelihood of bankruptcy.
IBM has its own system for weighing important factors about a supplier's finances. Says Bob Murphy, vice president of outsourcing at IBM, Armonk, N. Y. The company checks financial statements, including details on cash flow. But buyers also look at evidence of social responsibility and the potential for natural disasters near the supplier's location, among other things. "You can't look at any indicator in isolation," Murphy says.
Moreover, says Mitch Lyman, project manager for risk at Rockwell Collins, "A lot of the important information is not on a balance sheet. Those balance sheets can be obsolete after a couple of days."
Red flags aplenty
Not that a balance sheet isn't important. It is. And so are a supplier's cash-flow statements.
It's just that there are other things that are equally as important. For example:
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Payment trends
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Performance versus delivery schedules
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R&D expenditures
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Capital equipment expenditures
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Plant closings
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Personnel turnover, especially in the executive and client-service functions
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Makeup of a supplier's customer base
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Deterioration of product quality
Marc Marini, global head of technology sourcing at New York-based Thomson Reuters and former chief procurement officer at Merrill Lynch, says important sources are Standard & Poor's ratings and a supplier's stock performance compared to major indices. At Merrill Lynch, he often used a computer tool that used FactSet Research Systems to access and assess a company's financial status.
Getting financial information on public companies is easy. Getting it for privately held companies is more difficult. "You have to request it from the companies, and they might not be willing to share certain information," says Marini. When he was at Merrill Lynch, he would ask private companies for three years of audited financials so he could look at their debt balance and the burn rate of their cash. He would also talk to venture capitalists, when appropriate, to see when a new company that they were considering as a potential supplier would be up for their next review.
One comprehensive source for corporate financial information is Rapid Ratings, New York, N. Y. James Gellert, CEO, says his company's financial-health rating system looks for synergies in several aspects of a company's business. "We look at a broad array of ratios—62 in all—that indicate, for example, how well a company uses the dollars it brings in and the efficiencies of its cost structure."
Within Rapid Rating's six performance categories, the company uses 15 ratios on profitability and 12 on cost structure alone. These include common and non-traditional ratios like EBIT (earnings before interest and taxes) to total assets and EBIT to equity, cost of goods sold to total expenditure and tax to total expenditures. The synergy of these and other criteria, Gellert says, gives insight into whether a company is improving, deteriorating or maintaining its financial health.
A cursory look at data can be misleading. For example, says Robert Adelman, senior vice president for credit and risk products at Rapid Ratings, growing receivables may actually be a bad sign because it could indicate that credit and collection standards and practices are weak. Growing inventories may indicate that sales are not good.
Gellert and Adelman say an integrated approach would include examination of several aspects of a company's performance. For example, Adelman suggests checking sales and earnings trends to see if the top line is growing or at least stable and how that performance compares with competitors and the industry as a whole. And, he says, dig deep. Absolute profits, for example, may be growing, but falling margins (profits/revenues) are a bad sign.
Rapid Ratings provides Financial Health Reports (FHRs) based on its analyses of these and other factors. And its record of predictions is good. Long before the homebuilding industry tanked, for example, Rapid Ratings' FHRs for the industry showed it was going into the high-risk range. Fort Lauderdale-based Levitt Corp. (now Woodbridge Holdings) was the first major homebuilder to file for Chapter 11–20 months after Rapid Ratings first downgraded it.
Likewise, Dun & Bradstreet, Short Hills, N. J., has a comprehensive set of factors for analyzing a company's financial health. Says Jim Lawton, vice president and general manager of the firm's supply chain solutions division, purchasing professionals need to take into consideration how the supplier financial information relates to what else is happening within that supplier's world. "For example," he says, "if you were to look at any auto parts dealer in Michigan the situation probably looks pretty grim based on financials alone. But, if you look at those numbers relative to how other suppliers of similar size or in the same industry are doing, that can change your view of the supplier. Relativity is key to understanding a supplier's standing."
Lawton says D&B has as many as 4,000 data elements on each company in its database and uses that information to illustrate how well a company is performing in relation to others in the industry and the risk associated with it.
A judgment call
Gathering as much information on a supplier's financial status as possible is important, but in the end it often comes down to judgment. Marini recalls a time early in his career when he felt in his gut, after his analysis, that a particular supplier was weak financially. The supplier's CEO and CFO visited him and made a slick presentation to show how financially solid they were. Marini still had his doubts. Months later, the supplier was out of business.
Murphy, at IBM, recalls one supplier that had experienced a 21% drop in sales and a 13% decrease in gross profit. But the company's balance sheet seemed strong and it showed no significant debt. IBM kept the company as a supplier.
Knowing a supplier's debt is important, says Rockwell Collins' Lyman. But be sure you know when it matures, he adds. "If the maturity is far out, it may be less of a concern than if it is an immediate hurdle for the supplier."
And, it's important to understand how your own reactions can affect a supplier's finances. Lyman says that when one key supplier made an end-of-life announcement on several parts it supplied, that was a red flag for Rockwell Collins. The Rockwell Collins team held several meetings with the supplier's executive leadership to understand what problems the company was having. Essentially, the problem was the supplier's costs for fabrication. "We developed contingency plans to mitigate the risk, including identifying an alternate source of supply," Lyman says. When the original supplier eventually filed for Chapter 11, Rockwell Collins felt no impact, thanks to its well thought-out preparations. And, the original supplier continued to perform even after its filing.
One other factor was important: "We made sure not to pull business away from the supplier immediately after we learned of their problems," Lyman says. "We knew how important we were to them, and we didn't want to put them at even more risk."
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