Supplier management is a multidimensional, dynamic, and ideally a continuous process that encompasses supplier information, relationship, and performance management, and supply risk management. A considerable part of supply risk management involves training a sharp eye on your supplier base and looking at a number of factors, like market conditions, “in country” political and security risks, social responsibility, and many other factors. One factor that may get lost in the proverbial flood (but hopefully doesn’t) is financial risk. What is the financial health of your supplier(s)? Are they over-leveraged? What would happen to them during a market contraction? Are they at risk of going bankrupt? Would they survive a recession?
These are questions that sourcing teams ought to answer while conducting supplier due diligence — that is, before they sign on the dotted line. Sourcing teams should enter agreements confident that the supplier is going to remain in business, at least for the time being. But understanding the supplier’s financial risk profile shouldn’t end there, and fortunately for supplier managers, it doesn’t have to.
I spoke recently with William (Bill) Danner, President of CreditRiskMonitor, a New York City-based financial risk analytics firm that focuses on providing enterprises with web-based tools to monitor and assess the financial health of their suppliers and other vendors. It generates two financial risk scores — FRISK and PAYCE — based on a complex analysis of a number of different market and company-specific variables. You can learn more about CreditRiskMonitor, the services and solutions it provides, and the methodologies that underpin its analysis, here.
Getting “FRISKY” with Debt Data
One of the threads of our conversation involved companies that are over-leveraged, or that have extended their credit to the point where they cannot secure additional credit or refinance their existing debt to pay it down. Obviously, such companies pose higher financial risks, including the potential for bankruptcy, than those that borrow within their means, make regular payments, and can refinance or borrow more. According to Bill and his team, companies have been able to secure more debt for the past few years, even companies that have bad credit ratings, due to market optimism and low interest rates. As a result, corporate debt is reportedly higher today than it was at the onset of the Great Recession, putting many enterprises at heightened financial risk. As Bill told me, being over-leveraged can put companies at risk during even strong economic conditions; and it can doom them during recessions.
One of the companies that Bill cited was Tesla, the Silicon Valley startup and manufacturer of electric vehicles. Tesla has garnered mostly negative news coverage lately, mostly due to operational issues, like layoffs, production backlogs, crashes, and rumors of mass order cancellations. But the bottom line is that Tesla has not been profitable for two years and continues to rack up debt in order to keep the lights on. As Bill and his team pointed out, Tesla reported long-term debt of $10.8 billion at the end of 2017, and burned through $1.1 billion in cash during the first quarter of 2018 while reporting losses of $710 million. And on its most recent earnings call, Co-Founder and CEO, Elon Musk, reported second-quarter 2018 losses of $718 million.
As a result, “Tesla has seen its financial situation decline,” said Bill. Indeed, since January 2018, CreditRiskMonitor has downgraded Tesla’s FRISK Score from Level 5 to Level 3, which is indicative of “pretty serious risk.” [The FRISK Score assesses corporate bankruptcy risk for publicly-traded companies, with 10 being no risk and 1 being the highest risk.] Although Musk advised analysts, creditors, and investors that he doesn’t expect to have to raise capital because he expects Tesla to be profitable, and soon (indeed, Tesla has finally met its weekly and monthly production goals for the Model 3 and is poised to deliver orders on time), its financial risk is undeniably higher now. If another recession were to hit in the near future, Tesla would be in serious financial trouble, and it’s hard to imagine that it would survive.
Other Ways to Measure and Track Financial Risk
Another way that Bill and the team at CreditRiskMonitor measure financial risk data and track worrisome trends for enterprises is to tap into user behavior data, what Bill refers to as “subscriber outsourcing” and “click-stream analysis.” What they essentially do is harvest user click data on the site, like where they go and how they use the site. In doing so, Bill and his team can discern click patterns that change when users have specific concerns about a company. Subscribers could use that as a credit risk indicator by itself, much in the same way that Google has been able to tell when and where a flu outbreak occurs based on aggregated, geo-located search-term analysis. It’s a nifty reminder that aggregate user data can be more insightful than individual user data (although that is still interesting and useful).
Another tool that CreditRiskMonitor deployed in the first quarter of this year, PAYCE, is geared towards analyzing financial risk for private companies. The PAYCE Score is based on payment data that CreditRiskMonitor collects (hence the spelling of PAYCE), which it uses to develop a “Data Feature,” a distillation of the data into risk trends and values. According to Bill, company analysts take Data Features and put them through a neural network analytic model (a form of artificial intelligence that seeks to replicate human neural networks to analyze complex data), with 70% accuracy in capturing bankruptcies. Although Bill concedes that the PAYCE Score is not as accurate as the FRISK Score (which is 96% accurate), he believes that it is still pretty good considering the kind of data they’re using. Nevertheless, Bill and his team will continue to improve their use of neural networks to increase PAYCE’s accuracy, and they plan to apply them to FRISK scores, as well.
Final Thoughts
Although conventional wisdom is that economies tend to contract roughly every ten years, and it has been nine years since the end of the Great Recession, Bill doesn’t believe we’re necessarily due for one. “[Economic] expansions don’t die of old age,” he said, “they end because something goes wrong.” Indeed, economists have been warning for a few years now that the housing and stock markets are again overheating and creating bubbles that are only going to burst. They haven’t: interest rates remain low, borrowing remains high, and companies today carry more debt than they did at the beginning of the Great Recession. But Bill warned that when (not if) the next recession hits, it’s going to be worse for companies that are over-leveraged. Many likely won’t survive, and so it is important to keep an eye out for over-leveraged suppliers, because their debt may be more toxic than is apparent.
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