Predicting Supplier FailureKen Bradley
The problem of identifying suppliers with a high risk of failure is becoming more serious as talks of interest rate hikes and free trade agreement dissolution become more common. While this blog considers suppliers in an electronics supply chain, the risks and mitigations described apply more broadly. Most companies have strategies and indicators for dealing with short term supply disruptions related to manufacturing issues but the prediction of catastrophic supplier failure is a less safeguarded space. How does one assure against catastrophic manufacturer failure such as bankruptcy? How do you know that everyone in your supply base is a going concern?
Financial analysis is often used in an attempt to gauge this risk. Like bankers, we look at balance sheet strength in the hope that this will provide a window to an answer. Bankruptcy is a condition where a company runs out of cash; the balance sheet shows sources of cash recorded as liabilities. The main sources of cash are from suppliers as payables, lenders as debt and shareholders as equity (retained earnings are in equity). The problem of predicting failure is in the company’s ability to manage these cash sources, not in the values of the numbers themselves. Their ability to manage these numbers involves non-financial factors.
For example, debt can be restructured with share conversion actions that may be appealing to bondholders if a company is about to announce a killer new product. Additionally, this new product may also cause a rise in stock price that enables obtaining cash through the sale of more treasury shares similar to a hot start up’s IPO. There are also cases where shareholders love the company and, in the case of a public company, take it private or, for private companies, provide them with bridge loans or new equity.
Another problem with financials is that they have to be available to you in order to perform any analysis. With private companies unwilling to share key information, this is often not an option. Private companies have to share financials with banks to get a loan, why don’t they have to share financials with a customer to get an order? Unlike banks that collectively won’t lend without evidence, many customers will buy without seeing going concern proof, so many private companies avoid sharing information which would dissuade them.
To identify going concern risk in public companies, look at their auditor’s report and their stock price. Auditors must comment if they have going concerns so absence of a comment is a good but insufficient sign. Stock price ratios in comparison to peers is another signal. Furthermore, look to see if they have issued too many shares such that if they had reasonable earnings their earnings per share would be anemic. This could be fixed with a share buyback or reverse split but why are there so many shares there in the first place? This may limit their ability to raise funds through treasury shares.
From the financial statements, look at cash through quick and current ratios compared to peers. Review their ability to borrow through debt equity ratios and obtain credit scores. Make sure to remove goodwill from any analysis that you do; too much goodwill is a sign of excess and unsubstantiated management enthusiasm. Note any increases in payables days and compare the absolute level to those of peers as it may reveal a desire or a critical need to keep cash. Also look at operational performance for on time delivery as poor performance may stem from an inability to pay suppliers.
With private companies, try to get the financial statements. If you can’t:
- Obtain a copy of the auditor’s report
- Get a subset of financials about cash, payables ageing and debt
- Closely track delivery performance
- Get contacts at suppliers to your supplier and request permission to contact them about payment practices and overdue status
If you can’t get this information, make sure you have supply alternatives and discontinue the relationship.
Security of supply risk mitigation comes down to assurance that your supply base has been structured with supply options using companies which are both financially secure and operationally competent. If you cannot ensure this, find alternatives; your company cannot afford catastrophic risk.