The New Weak Link in Your Supply Chain: Supplier Credit

Why companies need to behave more like their own credit rating agencies.

You can see it in stubbornly high unemployment rates or from the hundreds of companies receiving credit downgrades. After several straight years of distress, global economic growth remains sluggish. This is exacerbating a weak link in companies’ supply chains: the deteriorating financial strength of suppliers.

Increasingly, suppliers’ weaker balance sheets are posing just as great a risk to companies as suppliers’ potential operational problems. By rationalizing their supply chains during the recession, many companies have inadvertently become more reliant on fewer suppliers at exactly the moment when their own finances have become shaky. Meanwhile, those same suppliers are seeking to use their customers’ balance sheets to fund their working capital requirements.

As a result, supply chain risks have moved from the province of engineers into the realm of chief financial officers and treasurers. To emerge from the global recession unscathed, companies should rethink their approach to supply chains by behaving much more like their own credit rating agencies—and fast.

While low interest rates have permitted many companies to refinance recently, rating agencies have begun to warn that current lower default rates may be unsustainable. If GDP growth in the United States remains stuck in a range of 1 percent to 2 percent in 2011, defaults will rise again, according to Fitch Ratings analyst Mariarosa Verde. She estimates that a low default rate is only sustainable at growth rates above 2 percent.

Moreover, corporate credit ratings are still declining at an alarming rate.

Our research shows that credit rating agencies have downgraded the ratings of more than 500 companies in North America since April of 2010. The number of businesses that annually file for bankruptcy protection in the United States has soared by 126 percent since the financial crisis triggered the recession several years ago, according to data from US Bankruptcy Courts.

Preparing for Supplier Credit Failures

Companies urgently need to prepare for supplier credit failures that could create a new nightmare for their supply chain. That means they must pay as much attention to evaluating the probability that their suppliers may default as they do to potential disruptions in their suppliers’ operations. It means they must evaluate the potential impact of a supplier default on their cash flow. And it means they must scrutinize suppliers on a much more holistic basis, reflecting the fact that a company’s operations, finances and the quality of its management are linked.

To achieve this, companies should develop their own predictive credit analysis frameworks. They can no longer rely solely on credit ratings prepared by credit rating agencies. Instead, businesses need tools that will help them anticipate future problems in a supplier related to the deterioration of both the supplier’s finances and operations.

Developing Predictive Analytics

Designing forward-looking supplier risk analytics that can forecast suppliers’ credit problems in advance isn’t easy. Many companies still struggle to identify the touch points that enable them to shrink or expand their supply chains without putting their own businesses in jeopardy from an operational perspective. One reason for this is that efforts to improve and quantify the risks in their supply chains are conducted in silos. As a result, they usually fall short of a thorough view of the entire supply chain.

Adding to the challenge is the increasing complexity of supply chains, as companies purchase more products and services from firms located in lower-cost countries. In these locations, the credit of many companies is often not rated. Financial data is also often less reliable.

And yet, it has never been more important for companies to understand their suppliers’ financial vulnerabilities. The aftermath of a supplier bankruptcy can be devastating. For example, our research shows that when an auto parts supplier goes bankrupt, its parts prices can jump up by 10 to 15 percent.

The ultimate price tag of a supplier bankruptcy goes far beyond the direct cost of a business disruption in large part because supply chain management is now viewed as a company’s core competency. A supply chain failure can easily prompt customers to take their business elsewhere. Investors also punish supply chain failures disproportionately. Indeed, the impact of a supply chain breakdown on a company’s market valuation can eclipse all possible cost savings achieved from leaner chains.

Far too often, the additional costs driven by dealing with a financially weak supplier are underestimated. That’s in part because the metrics companies use to evaluate the impact of a supplier failure are often too simplistic. Companies often fail to take into account that the more they push out to potentially less secure suppliers, the more they are often obliged to use their own balance sheets to support suppliers. Many also miss the fact that they are just one of a supplier’s many customers. If a major customer also defaults, the company could suffer losses across the entire spectrum of its supply chain.

Credit Rating Agencies in Flux

Further underscoring the need for companies to conduct their own evaluations of financial weaknesses in supply chains is the fact that credit rating agency business models are also changing. The recent passage of new financial legislation in the US has made rating agencies more liable for the quality of their rating decisions. As a result, some credit rating agencies are starting to limit how their ratings can be used. In July of 2010, some dominant credit rating agencies refused to let bond issuers use their ratings in documentation for new bond sales, according to a Wall Street Journal report.

Improving Supply Chain Management Metrics

The first critical step in managing the increasingly strained financials of suppliers is for companies to acknowledge that credit has become a dominant driver of performance. Typically, companies select suppliers primarily based on their operational capabilities. But in today’s deteriorating credit environment, a supplier’s operations and finances need to be given equal weight.

Next, companies should reexamine their supply chain management metrics. Companies should evaluate the impact of a supplier default on their cash flow. Instead, most only examine the potential impact of a supplier’s default based on how much they are spending on its products and services.

Start with the impact of replacing a supplier’s contract on a company’s results. Ask yourself: How difficult will it be to replace a supplier if the company defaults? How tough will it be to find a customer to take the place of one that can no longer afford my products or services? And what will happen to my company’s cash flow during this search?

Look Beyond Financial Ratios

In order to enhance their credit risk management capabilities, companies need to develop predictive tools. This involves assembling a list of variables that could force a supplier or customer to default. We believe that companies must look far beyond simple financial ratios to span both a company’s operations and finances. After all, a company’s financial strength is dependent in large part on its operations. No company will remain financially sound for long if operational measures, like the percentage of orders filled, begin to decline.

Companies should also consider qualitative factors. A management team with a history of sound judgment may be more likely to chart a successful course through today’s troubled economic environment. To decipher whether the management team of a customer or supplier is up to this challenge, companies should examine everything from their ownership structure to their recent press coverage.

External risks must be examined. Besides common risks like exchange rate volatility or political interference, companies should consider large liabilities related to pensions and the environment. They can quickly reverse a company’s fortunes. So can events like strikes, terrorist attacks, corporate fraud or so-called acts of God like an earthquake or a plane crash.

Once companies have surveyed the full range of potential default factors, they need to determine which of these variables will be the most useful in predicting supplier and customer defaults and then assign appropriate weightings to them. That’s where an analytical tool becomes critical.

Applying statistical methods to determine the combination of operational, financial and more subjective factors will do more than explain past disruptions. As new data becomes available, a model can be rerun to assess whether particular risks are increasing, and corrective management action can be taken before the problem materializes.

Complexity Equals Opportunity

Making the potential impact of suppliers’ deteriorating credit a higher priority in supply chain management adds a level of complexity to an already complicated process. However, the very complexity signifies the magnitude of the opportunity. There are nearly limitless places for problems to spring up in supply chains. Companies that identify the full range of default factors—essentially becoming their own credit rating agency—will outmaneuver rivals who lack this level of sophistication.

Today, many companies are embarking on very costly measures to reduce the chance of a supply chain disruption. They are building up inventory and even purchasing their own sources of materials.

We believe conducting more thorough supply chain diagnostics—ones that incorporate the financial vulnerabilities of suppliers—is more cost-effective. The opportunity to match, or even surpass, the impact of such initiatives on a company’s bottom line should be well worth this manageable investment. Developing such frameworks will enable companies to avoid supplier defaults not only today, but also in the future.

The New Weak Link in Your Supply Chain: Supplier Credit