Debt: A Rising Risk in Your Supply Chain
Of all the sources of risk supply chain managers face on a daily basis—cargo theft, natural disasters, long lead times, and unpredictable demand—none is currently at an inflection point quite like debt.
This topic was addressed in a recent webinar by two leading authorities on corporate financial health: Dr. Edward Altman, Professor of Finance, Emeritus, at New York University's Stern School of Business and creator of the Altman Score, and CreditRiskMonitor Founder and CEO Jerry Flum. They discussed the current and potential future implications of today’s mammoth corporate debt problem with hundreds of supply chain and credit professionals.
Procurement and supply chain professionals should be concerned with the degree to which public companies are leveraged because they are the primary point of contact between their company and suppliers—not to mention a first line of defense against third-party risk.
In the webinar, Dr. Altman and Jerry Flum identified three unprecedented debt-related conditions putting pressure on the global economy that supply chain managers should be aware of from a risk mitigation perspective:
1. The total U.S. debt is currently at a historically huge 3.5 times GDP. Corporate debt is a large and growing percentage of this total. Overall debt levels have reached a point where we must be concerned about the investors who own this debt, not just the borrowers.
A 10-percent decline in value would destroy wealth equivalent to 35 percent of GDP, with a major effect on spending. Junk debt (high-yield bonds and leveraged loans) has soared to $2.5 - 3.0 trillion world-wide.
2. Now in the 8th year of a ‘benign credit cycle’ that would usually last 4-7 years, many executive teams have let their guard down and forgotten the lessons of the past.
As Dr. Altman explained in the webinar, a benign credit cycle has four characteristics:
- Low default rates
- High recovery rates when bonds default
- Low interest rates, yields, and spreads
- High liquidity
Credit is currently cheap and easily available to publicly traded companies. This has led many companies to take on more debt, some of which is then used to pay dividends and buy back stock, but make corporations riskier.
3. Corporate valuations are inflated, with market values far higher than historical norms. Private equity firms are paying as much as 10-to-11 times cash flow for acquisitions. High valuations make corporations less risky, but stock prices can fall, rapidly increasing the risk of default.
Regardless of your company’s current attitude towards debt, procurement and supply chain professionals can take action to mitigate supplier risk and prepare their companies to handle the downturn when the next recession inevitably comes.
Suggested Steps for Supply Chain Professionals to Mitigate Debt-related Supplier Risk
1. Build in a monitoring process. Don’t stop with an initial vendor screening. Companies’ financial health can change and even a periodic review simply isn’t good enough. Avoid surprises and react quickly to change.
2. Get to know the vendors you do business with well. Ask questions such as:
- “Who is the corporation we are paying? Is it under a different name?”
- “Are they actually manufacturing the product or is someone else?”
- “Is their financial strategy conservative or aggressive?”
Be cautious, especially if you are not getting clear answers.
3. Don’t over-do it. Not all your vendors will present a problem if they enter financial risk. Ask yourself:
- “Is the commodity/product easy to replace? Is this a one-time contract?”
- “Or, could this vendor create a major issue with our ability to ship on time, the quality of our product, or with our customer satisfaction?”
Only if you find that it’s a “yes” to the second question do you need extensive review.
4. Incorporate financial analysis in your key vendor review process. Be sure to include multiple periods of financial statements in your review to see trends. If you are finding it difficult to get financial information, be wary.
5. Compare your vendors with the financial condition of their peers. You may find more secure sources of supply.
6. When appropriate, take a hard look at the financial stability of your vendor’s suppliers. They are part of your supply chain and could be a significant exposure.
7. Have an open and honest communications process. You’ll want to explore with your vendor the performance factors that directly impact you, such as shipping reliability, product quality, etc. but also financial stability. Knowledge is power and knowing all the facts gives you the time to identify and prepare alternative source(s) of supply.
8. Finally, there are also more radical options if a vendor looks too weak:
- Make vs. buy decision
- Engineer a stronger vendor into the supply chain
- Buy the troubled vendor, or
- Help arrange for a preferred vendor to purchase the troubled vendor.
Today’s debt situation is historically unprecedented. And while we can’t be certain of the timing of a change in the financial markets or what will serve as the trigger, we know a shift is coming – so now is the time to prepare by putting processes and procedures in place.
The full webinar can be viewed here.