5 Best Practices to Mitigate Supplier Financial Risk

Now is not the time to consolidate resources and scale back risk management efforts

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June 21, 2010 — As we dig out from the worst recession since World War II, some companies may be tempted to consolidate resources and scale back their risk management efforts. But don't be fooled. A strategy like that is potentially disastrous.

After all, if we have learned anything over the past two years, it's that in today's volatile global economy, businesses need to pay more attention to risk, not less. Supplier financial risk, in particular, still looms large. Undercapitalized and overleveraged manufacturers (the so-called "zombie suppliers") remain a significant threat, as do others that may be risking compliance, quality and your reputation simply because they need to cut costs.

Clearly, in today's connected economy, it is more urgent than ever for companies to monitor their suppliers' fiscal health. But where should you begin? Are there certain steps you can follow to initiate a comprehensive supplier financial risk management strategy? To help you get started, here are five best practices to mitigate supplier financial risk and help you better understand both the challenges — and the opportunities — that exist in your supplier network.

1. Identify critical suppliers and define your relationship with each one. Most companies keep a watchful eye on a few strategic suppliers, but these days you need to cast an even wider net. Risk assessments today are multi-faceted, interrelated and often highly variable, depending on fluctuating market conditions, and that means even threats from a minor supplier can create — or signal — bigger problems throughout your supply chain. Sure, if you're looking for a way to kick off a supplier financial risk management strategy, you'll want to start with careful consideration of your most critical suppliers — just be certain you define "critical" in broad terms. Naturally, suppliers that have big spend will top your shortlist. But don't overlook important others. For example, be sure to include any suppliers that provide components crucial to your operations, as well as those that offer unique technologies. You should also add suppliers that have benefited from your investment (of time, money, R&D) and all others that may be particularly sensitive to volatile market conditions owing to their size, location, etc.

2. Determine risk attributes that you need to monitor. Once you have prioritized your suppliers, decide on the particular financial risk attributes you need to monitor for each one. Consider factors such as the supplier's credit rating, the percentage of each supplier's revenue your company represents, immediate revenue and earnings information, stock price, Z-score, etc. Ultimately, settle on about a half-dozen key financial risk features for each supplier, so that you can attain a multi-dimensional profile of each one's overall fiscal health.

3. Gather/update supplier information. After identifying the financial risk attributes you want to monitor, you need to gather the most up-to-date, relevant information about each of these characteristics. To achieve this goal, you'll have to access multiple data streams, including both third-party sources (e.g., Lexis-Nexis) and information acquired directly from the suppliers. For established suppliers, this task involves updating and/or supplementing data you probably already have on hand. For new suppliers, you'll have to start from scratch. Don't be shy about picking up the phone and asking your suppliers for the details you need. After all, any successful supplier risk management strategy is grounded in precisely that kind of close cooperation and information-sharing between buyers and sellers. In addition, it's important to note that this step in the risk management process also involves determining how frequently you should update information on each supplier. For some, an annual review could be sufficient. Others may require attention every quarter or every month. Some companies find it beneficial to communicate daily with their strategic suppliers. Why? Because today's just-in-time inventory model demands that level of collaboration to ensure that goods and services get to market reliably and consistently.

4. Establish risk alerts. Regularly tracking key financial attributes for your suppliers is important. But that alone will do little to mitigate threats. You also have to launch a risk alert system that will let you know when one of your suppliers is underperforming financially. Establish parameters that make sense for each supplier. For example, perhaps managers need to be notified if a strategic supplier misses two consecutive monthly updates. Or maybe it's more important that the alert is linked to a poor quarterly report or drop in the supplier's credit rating. At this step, it's essential that someone "owns" the supplier information and is responsible for sounding the alert. You may find it helpful to group suppliers in sets of 10 or so; then you can assign each set to a different monitor.

5. Create corrective action plans and follow through. The final step in establishing a supplier financial risk management strategy is to generate corrective action plans for suppliers that pose a threat. If your alert system notifies you that a supplier's fiscal health is declining, you need to proactively address your concerns with the supplier and issue fair warnings for your intended course of action if the situation is not resolved. During this process, methodical follow-through is imperative. After all, the purpose of a supplier risk management strategy is to mitigate threats in your supply chain. If a supplier is in financial straits, you need to face the problem head-on. Provide triage if you determine that it's warranted. Otherwise, if the situation cannot be adequately resolved, you'll need to shift your business — and your focus — to an alternative supplier.

Supply chains today are more global, more interconnected and, therefore, more complex than ever before. Combine this with a worldwide recession that left many suppliers in poor financial health, and it's easy to see why supplier risk management is quickly becoming a top priority on the corporate agenda. Monitoring a few strategic suppliers is no longer sufficient. And even the old "80-20" rule (you need a risk management strategy for only 20 percent of your suppliers; the others don't pose a "real" threat) is getting harder and harder to defend — now that risk assessments are typically multifaceted, interrelated and often highly variable because they're dependent on the volatile global economy.

The good news is that it's not difficult to start mitigating supplier financial risk. A methodical, reasoned approach (as outlined above) will help diminish both the probability of a harmful event and the severity of its impact, should one arise. In addition, instituting a robust supplier risk management strategy will enhance collaboration between you and your suppliers, and that, in turn, can unlock opportunities for even greater competitive advantage.