Demonstrating long-term viability is more important than ever for suppliers. It’s critical to understand what information your customers are considering and how they’ll evaluate your enduring potential.
In these challenging times, there’s little room for error. Companies must evaluate all aspects of their businesses for weakness and potential risks. The ongoing struggles of the U.S. automotive industry have highlighted the importance of the supply base and its ability to survive. OEMs and tier 1 suppliers have gained a greater appreciation and understanding of the importance of identifying and supporting viable, long-term suppliers.
Identifying which suppliers are viable, long-term supply chain candidates versus those that aren’t can be a difficult task. Many manufacturers have initiated supplier risk assessment programs to evaluate the health of their supply base. As a supplier, it’s critical to understand what information your customers are considering and how they’ll be evaluating your business’s potential as a long-term, viable supplier.
Keys to Survival
The key to surviving in a difficult economy comes down to two things: short-term liquidity and a strong balance sheet. It may come as a surprise, but the balance sheet is often a better indicator of financial strength than earnings. In a struggling economic environment, customers are most interested in your ability to weather the storm, not necessarily your current profitability. One of the keys to evaluating where a business is heading is its financial trends. The following metrics are frequently used by customers when evaluating their suppliers:
- Current Ratio
- Debt to Equity Ratio
- Debt Service Coverage Ratio
- Altman Z-Score
- Net Income (Loss)
- Operating Income (Loss)
- Value-Add as a Percentage of Sales
Altman’s Z-Score for predicting bankruptcy is a formula for the measurement of the financial health of a company that forecasts the probability of a company entering bankruptcy within a two-year period. This metric only provides a snapshot of where a company stands and can be misleading if viewed at a single point in time. Assessing the Z-Score as a trend, on the other hand, provides insight into where a business is heading and is a better indicator of future financial strength.
Another useful financial metric is value-add as a percentage of sales. Value-add is calculated as sales price less material cost. If a supplier’s value-add is trending down, the supplier is providing less and less value to its customer and moving more toward becoming a pass-through entity. Suppliers that provide little value to the manufacturing cycle are often not sustainable when volumes decrease.
The Importance of Your Bank Relationship
Because a supplier’s bank generally plays an integral role in its long-term viability, customers frequently monitor a supplier’s banking relationship for indicators of weakness. Issues such as violating debt covenants and forbearance agreements are often signs that a business is struggling. Your customer is aware that many banks have little tolerance for struggling businesses in high-risk industries. They will likely attempt to address the situation quickly before risking a production shutdown caused by a liquidity crisis associated with insufficient credit availability.
Continuing as a Viable Supplier
How can you ensure that your customers view you as a viable, enduring supplier? The first step is to begin monitoring the metrics and ratios listed above. Even if your customer hasn’t asked you to submit financial information as part of a supplier assessment program, tracking the strength of your business, basic liquidity, and risk trends are essential for a high-performing business. Strong companies perform trend analyses on a regular basis and monitor their results closely. If liquidity and profitability begin to deteriorate, ratio and trend analysis can act as an early warning system, alerting management that action is necessary.
If your business begins to experience hardship, early action can mean the difference between survival and failure. We’ve seen many businesses end up in liquidation because they ignored early warning signs and delayed immediate and decisive action. Those that are proactive and address concerns as they arise are the suppliers that will ultimately be viable in the supply chain for years to come.
Mitigating Supply Chain Risk
In these difficult economic times, many OEMs and tiered suppliers are worried that their key suppliers may not be there when they need them, leading to production delays and missed customer shipments. A supplier risk assessment process can help ensure the timely receipt of materials, parts, and services an organization requires in order to operate efficiently and profitably. By collecting indicators of operational and financial health as well as bankruptcy predictors and scoring each supplier relative to risk, organizations will identify the following:
- Suppliers who require immediate review for resourcing
- Those who need deeper assessment and closer monitoring for signs of further deterioration
- Those who should be considered for increased sourcing
The assessment and monitoring process is designed to identify problems before they negatively affect business and a customer is the “last one out.” Plante & Moran has provided assistance to OEM and tier 1 suppliers in understanding supply chain risk through supplier risk assessments. Contact us to find out more.