On March 11, 2011 the world watched in horror as twin natural disasters - an 8.9 magnitude earthquake and a deadly tsunami - struck the island of Japan. Beyond the tremendous loss of life and personal property, the effects of this disaster have reverberated around the world, causing an immediate disruption to the global supply chain.
In this day and age of just-in-time manufacturing where parts are produced in countless nations, then shipped to a central buyer who assembles the final product before it is sold the disaster in Japan highlights the vulnerability of a process that relies on far-flung partners. As a major exporter of parts to the global automotive industry and electronics worldwide, Japan is a vital supplier to many U.S.-based manufacturers. In the immediate aftermath of the quake and tsunami, numerous Japanese industries suspended operations as the nation dealt with the destruction and widespread power shortages.
This disruption caused exports in Japan to fall 9.7% in March after initially rising 14.8% in the two weeks prior to the quake, as reported by the Japanese Ministry of Finance in the Wall Street Journal on April 20, 2011. The Journal also reported that shipments to the U.S. alone fell 3.4%. In the face of this interruption to the physical supply chain, treasury professionals throughout the world have been scrambling to ascertain the impact to their financial supply chain, and to determine the best strategies for moving forward.
The Challenge U.S. Manufacturers Face
While just-in-time inventory practices clearly deliver efficiency by minimizing the cost of carrying inventory on manufacturers balance sheets, this system provides little hedge against supply chain disruptions, such as the one currently being experienced. With lower inventory-days-on-hand, manufacturers have a smaller cushion against any interruption to the flow of vital parts, which means the supplier base is under increased pressure to resume normal production.
For treasury professionals, both in the U.S. and abroad, this supply chain disruption has forced them to rethink how they manage vital capital as their manufacturing capabilities slow, and reduced sales impinge on cash flow. Also of concern to manufacturers is the financial stability of suppliers who have been adversely impacted by the crisis. In many ways, the current situation is similar to the conditions experienced during the height of the economic crisis, where large manufacturers feared that suppliers, who could no longer secure credit, would succumb to the downturn, thereby cutting off the flow of parts and materials.
Managing the Financial Supply Chain During Disruption
Although insurance is available against losses experienced due to supply chain disruption, it is a relatively new and unknown product. Regardless of whether they have such insurance, one of the first actions to be taken by a manufacturer affected by such disruption is to find a replacement supplier. Presumably, this would allow full production to resume quickly. However, replacing mission-critical suppliers is not always a simple proposition. In the meantime, the cash flow impact may oblige companies to continue taking delivery from other suppliers to maintain production, leading to a build-up of raw materials and partially finished goods. Since production cannot be completed until the missing components arrive, sales will be reduced and cash will be increasingly tied up in inventory.
In order to manage this impact, one of the primary strategies employed by treasury professionals is to increase days-payables-outstanding by lengthening payment terms requested from suppliers that werent impacted by the crisis. By stretching payables, manufacturers can more effectively conserve cash.
Treasury can minimize the impact on suppliers by working with their banking partner to offer a supply-chain finance program. Such a program allows suppliers to sell the bank receivables owed by the manufacturer as soon as invoices are accepted by the manufacturer, thereby actually improving the suppliers cash flow, rather than damaging it. Instituting a supply-chain finance program signals a firm commitment to ones suppliers, and presents suppliers with a source of liquidity outside of their local arrangements, which may also be under stress due to the crisis.
Manufacturers who are not directly impacted by a disaster should take a look to see whether they have suppliers who are. Even suppliers not located in the disaster area may be impacted by reduced liquidity and be able to use such financing to help weather the proverbial storm.
Middle-market manufacturers with limited bank lines may be able to work with a banking partner to tap into supply-chain finance programs supported by the International Finance Corp. (IFC). The mandate of the IFC supply-chain finance initiative is to improve liquidity in emerging markets, and by partnering with the IFC, a bank may be able to provide supply-chain financing beyond what they would normally consider for a smaller manufacturer.
On the other side of the working capital equation, a manufacturer whose cash is being diverted into a build-up of inventory should explore structures for freeing up cash tied up in accounts receivable. Even companies that already use their receivables as collateral for financing are likely to find they can free up additional cash, with the side benefit of receiving better accounting treatment on their balance sheets by obtaining credit insurance and then selling their accounts receivables to a bank offering such a structure. With insurance in place, even foreign receivables and large amounts owed by individual buyers (viewed as over-concentrations by asset-based lenders) can be sold, often for close to 100% of face value. Rather than going on the companys books as bank debt, the accounting treatment is to remove the asset sold, i.e., to reduce accounts receivable. While this does require that credit insurance be arranged (and paid for), it can provide a means for expanding a companys borrowing capacity during a crisis.
Lessons Learned: Being Prepared for Future Disruptions
Several key lessons can be learned from the crisis that will enable manufacturers to be better prepared for any future disruption to the global supply chain. The first is for treasury to gain a deeper understanding of the financial viability of its suppliers. It is vital to ask the right questions. For example, can your suppliers deal with an unexpected business disruption whether from an earthquake, tsunami, a change in the regulatory environment, or even a shortage or supply problem with one of their own sub-suppliers?
Having an alternate set of suppliers at the ready that can be brought online quickly in the event of a business disruption can help mitigate risk. In addition, manufacturers should ensure they are adequately protected against disruption from an insurance perspective. Disruption may be on the sales side as well as on the supply side, as ones customers may also be impacted by a natural disaster. Trade credit insurance provides protection against nonpayment of accounts receivable due to commercial and political risk as well as Acts of God. Again, it is important to understand the implications of a possible supply chain interruption to the company, and how various insurance coverages match up against any potential gaps in risk mitigation.
One of the most important steps a U.S.-based company can take in preparing for future financial supply chain challenges is to begin a dialogue with a banking partner who can help treasury navigate the landscape of options available to them. A banking partner with experience in the global trade space can assist with advice on how to address various international risks, such as how to collect on open accounts receivable on a cross-border basis. The right partner can aid a manufacturer in taking the necessary measures that will provide the liquidity needed to minimize any negative cash-flow implications of their international activities and ensure they are adequately covered against financial risks associated with the physical supply chain.