Zoom in on Financial Risk

Financial risk relates to the possible financial problems faced by a buying organization’s suppliers, its suppliers’ suppliers (and so on) or other third parties. In an extreme case, the supplier or third party may go out of business, causing a short- or longer-term interruption to supply. But even if matters don’t go that far, what the buyer might begin to observe in the face of a supplier’s impending failure is a decline in quality and timeliness of service, requests for early invoice payments or attempts to re-negotiate contracts.

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What causes financial risk?

Financial risk is inherent to the business uncertainties every company faces. Specific risks pertain to certain markets and industries. In markets with low barriers to entry, for example, the turnover of market players is high. There are warning signs that a firm is facing financial risk, such as high levels of debt, changes in senior management or a rushed through company sale. However, in some cases matters can suddenly escalate before one can observe the warning signs. There is also risk of business failure if two parties dispute about how much payment is owed for work carried out by the supplying organization — so having firm financial terms agreement is important.

How third-party financial risk affects your business

Like all risk types, there are varying degrees of ill effect or damage that financial risk can inflict.

• Lack of immediate direct supply: The most obvious issue is that if a supplier ceases to trade, its supply is no longer available. This could be the result of a sudden single event or the result of a long series of issues or decline. The interruption of supply of goods is probably the most frequent problem, but it can apply to services too. Outsourced service providers in many sectors can be critical to some customers, and history has demonstrated that service providers can certainly pose major risk problems.
• Commercial risk through non-compliance to contracts: There have been instances where firms have used bankruptcy or potential bankruptcy to get out of difficult contracts, and some have even filed for Chapter 11 bankruptcy while having a new owner already lined up. The goal is to force customers to renegotiate new long-term supply agreements as a condition to continue receiving parts in the short term.
• Stress of uncertainty: Even when a supplier has not financially collapsed, financial stress on their part can disrupt the buying company’s business operations. A supplier might ask for early payment of invoices — that may just reflect some seasonal cash-flow issues, of course, but it could be a sign of bigger problems. Inability to hit delivery targets is a sign that the supplier is under financial stress, and this might be because it cannot afford the raw materials it needs to fulfill its orders, hence early payment.
• Protection of company assets: A particular issue arises when the supplier holds customer stock for some reason; perhaps in logistics situations or when the work is being carried out on the supplying firm’s premises. This can also apply to subcontractors. The danger is of course that the buyer’s assets then get entangled with those of the supplier in cases of bankruptcy.

How to mitigate financial risk

The issue of protecting inventory can be managed by making it clear in contracts that entitlement to stock retained on supplier’s premises remains that of the customer and by physically identifying the stock held. More general issues of supply interruption risk can be mitigated in part by having alternative suppliers in place for all key purchases (of course, some goods, especially parts, are supplied by very few niche providers, making that more difficult).

Another strategy for getting early indicators of a supplier’s potential financial trouble involves monitoring the supplier’s financial health. While it is important — and strongly recommended — to carry out financial due diligence when you onboard a supplier or place a contract, it is simply not enough to mitigate this sort of risk properly. It requires continuous tracking of suppliers’ situations. Even using third parties for financial ratings and reports on an ongoing basis will not pick up every problem; there are numerous examples of firms going out of business without any obvious warning signs. Some agencies use only historical (not real-time) information to assess financial viability, so when situations change, which they can rapidly, it takes some time for this to be reflected in ratings and reports.

The best way to manage and reduce financial risk is to use tools that can pick up early warning signs from multiple sources. And those sources need to apply to the country level, the economic issues of which will have a knock-on effect on businesses, and the company level. A financial activity early warning system can include monitoring senior staff movements, changes in structure or new ownership and taking on debt or other corporate finance. Not all signals necessarily result in bankruptcy or threat of supply interruption, of course — but they could. The point is that buyers need to be prepared, implement proactive risk management and take preventive actions.

Conclusion

The risks resulting from supplier financial troubles cannot always be avoided. The best possible mitigation approach includes implementing a system and process that continuously analyzes relevant supplier information and data to provide early warning signals. And, as always, having alternative suppliers in place for critical items is strongly recommended.

This post is part of our six flavors of risk series:

Zoom in on Cyber risk here

Zoom in on Financial risk

Zoom in on Geo-political risk

Read our Introduction to risk management here.

And see our definitions of risk here.