The Importance of Understanding Risk Better
The Global economy seems to be emerging from the downturn which has lasted for the best part of the last 18 months. For companies, the way ahead involves not just evaluating what went wrong but also establishing processes and mechanisms that help anticipate potential sources of risk. The most common methods used to analyze supplier risk include analysis of financial statements.
But understanding supplier health needs a perspective beyond just analyzing financial numbers. To proactively analyze supplier health means looking beyond the data, and understanding and monitoring the business environment that your supplier plays in. Analyzing trends for the industry that the supplier operates in and taking a deeper look at the (seemingly) peripheral factors which effect the supplier's business environment could help procurement organizations evaluate risk more accurately.
It's All About the Numbers
Risk assessment for large public companies is often restricted to analyzing common financial statements such as balance sheets and income statements. On the other hand for smaller/private companies often financial reports from external consultancies like D&B are referred to. It's not the numbers themselves but the message that the numbers deliver which is important. Important ratios like the quick ratio, the debt/asset ratio and the profit margin ratio might be useful performance indicators to start risk assessment but these are just foundation data points.
A supplier may end up in financial distress in spite of having strong financial numbers the previous year. One reason why this is not uncommon is that financial statements are not real time data points that keep updating on a daily basis. The time lag between consecutive reports or financial statements can seem like an eternity in a fast-changing global economy where cordons of suppliers seemed to disappear overnight during the height of the recession. The need of the hour is to supplement these basic financial numbers with real-time intelligence that can help sourcing professionals anticipate supplier risk better.
A strong predictive model that has been around for a long time, especially in the financial industry, is the Altman Z Score. The Z score is an anticipatory predictor of the likelihood of a company going bankrupt within two years. The calculation of the Z score involves ratios like Working Capital/Total Assets, Retained Earnings/Total Assets and EBIT/Total Assets. These ratios provide performance measurement in terms of internal parameters like the level of liquid assets, profitability and operating efficiency. The Z score further adds a market dimension to these factors by including ratios like market value of equity/total assets and sales/total assets. Apart from the fact that for over 40 years the Z score has had a proven accuracy of anywhere between 75-85% of predicting financial outcomes, it simply broadens the risk management perspective by helping you anticipate risk rather than contemplate on past performance.
Going Beyond the Numbers
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