A 360 Degree View of Risk

Jan. 8, 2010
Managing supplier risk, beyond the numbers

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

The economic scenario and the resulting company failures and bankruptcies of the last 12 months have created the need to go beyond analyzing numbers. There are several factors that can be incorporated in calculating supplier risk profiles which help to give a more all-round view of supplier stability.

Factors that cover the past performance of the supplier, industry trends in the supplier's industry, supplier's competitive position with respect to its peers and competitors and events that take place in the supplier's immediate business environment can be combined with financial factors to give a more wholesome view of supplier risk and stability. These factors -- let's refer to them as Predictive Indicators -- can be classified into two baskets: Supplier Performance Factors and Business Environment Factors.

Supplier Performance Factors

The simplest and most logical way of predicting supplier performance is by keeping track of the supplier performance in the past. Simple things like the track record of on time delivery, frequency and degree of discounts availed as well as adherence to quality levels can be good indicators of supplier performance. Although for these performance indicators to be of any value, they need to be tracked on a real time basis, for a longer period of time. The supplier may be evaluated as being very high on quality standards based on historical measurements; but recent events might force the same supplier to start using inferior materials in a bid to cut down costs. Just relying on historical data might not give you any indication of reduction in supplier performance, thus hindering your ability to make accurate predictions.

A solution could be to establish processes whereby supplier performance is tracked with every deal made or in shorter time frames enabling measurements on an almost real time basis. Any dips in performance can become alerts for you to investigate further.

Business Environment Factors -- Predicting Risk Not Reacting to It

  • Keep in touch with the business environment around you. Not just for the business areas where you play in but also the business environment of your key suppliers.
  • Analyze reports that indicate industry trends in the present and the future for the domains in which your suppliers operate.
  • Peruse through industry performance statistics not just for the industry as a whole but also for the supplier with respect to its peers.
  • The analysis need not be quantitative alone. Several qualitative issues especially pertaining to company vision and future strategy may be indicators of the likelihood of failure or success. An example of a faulty strategy is the failure of U.S. automotive companies to recognize the trend of fuel-efficient cars -- thereby allowing their Japanese counterparts to make significant gains in market share.

Arming Oneself With 360 Degree Intelligence -- With Risk Radar

Just staying up to date with the events in the business environment of your key suppliers can be the easiest way to proactively analyze risk. Events like instances of employee dissatisfaction, multiple layoffs at different business units, frequent changes in top level management and management policies may be key indicators to understand the probability of supplier instability. What needs to be a part of every company's risk management process is instant access to any events related to key factors of the supplier's environment. These events are point you towards the suppliers that you need to keep an eye on. Technology that can help you collate information about these events at a single place and alert you about them is a step in the right direction.

James Thomas is Product Marketing Manager at Zycus. Zycus is a provider of SaaS based, easy to use and integrated Spend Management solutions. http://www.zycus.com/

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