When it comes to risk management, the supply chain cash cycle begins with a sale, i.e., when the customer signs a purchase order, explains Christopher Smith, vice president for finance and administration with SAIC, a provider of scientific, engineering, and technology applications. Once that happens, it's important to understand what could happen if the terms of that PO are not met. The biggest risk with a customer is they'll fail to pay you, while the biggest risk with a supplier is they'll fail to deliver on what they promised.
If your customer doesn't pay you, what impact will that have on your operations? Some of the implications, according to Smith, include: missed revenue and net income forecasts, lower operating cash on hand (and fewer opportunities to reinvest in your core business), loss of costs already expended in fulfilling a customer order, and the impact to the balance sheet (fewer tangible assets). "It takes 5X new revenue to make up for one defaulted payment," Smith notes.
It all boils down to how big a credit risk a potential customer might be, and Smith cites the "four Cs" of credit: character, capacity, conditions and capital. The goal is not only to be able to adequately identify credit risk, but to have a strategy in place in case a customer does indeed default. So besides fully vetting a potential customer (its payment history with other suppliers, the strength of the market or industry it's in), Smith suggests digging even deeper to predict any events that might cause the customer to fail to pay you, such as:
- How much money will they owe you at any one time?
- Can you repossess or secure your goods?
- How quickly can you stop shipping product to them if they breach the contract?
Similar considerations come up when the risk is on the side of a supplier, Smith notes, with the additional element of how important that supplier is to your ability to complete a project. "The criticality of what a supplier is providing is an integral part of the risk evaluation and mitigation process," he says.
Ultimately, what you have to determine from a supplier is how suitable the company will be as a supply chain partner. "If they can perform but cannot financially survive, then they're not a good supply chain candidate," Smith says. "And if they are financially viable but cannot perform, they're also not a good supply chain candidate."
Not every risk element is going to be of equal importance while evaluating supply chain partners, Smith adds. For instance, while payment history is of high importance for a potential customer, it's of low importance when evaluating a supplier. Conversely, the ability to obtain bonding or surety is low for a customer, but high for a supplier.
In either case, risk management involves the process of discovery that includes a review of as much information (publicly availably and otherwise) as possible, including financial reports, analysis, scoring and credit ratings. A standard rule-of-thumb SAIC follows is to assign five to six analysts for every billion dollars of business at stake.
In addition to getting accurate, timely and extensive information on your trading partners, Smith emphasizes the importance of considering worst-case scenarios: What could happen to your partner over time and how can you minimize that impact to your business?
"Maintain the ability to cancel a contract in the event of non-payment for a customer, or non-performance for a supplier," he says, "so if necessary, you can achieve the easiest dismissal possible."