How Financial Discussions Drive Better Supply Chain Decisions
If there’s one thing that the current COVID-19 crisis has reinforced, it’s that while change is constant, it can quickly veer off in unexpected and disruptive directions. The “Cash is King” business logic figures in even more prominently in times of business turmoil and tightening access to credit; i.e., how do you know which of your suppliers is going to come up short? Without accurate and predictive analytics on the financial health of suppliers, many companies are struggling to know how their supply chains will perform.
In any economic climate, companies managing global supply chains should be keeping close tabs on all aspects of their business, focusing on the strategic and operational factors that drive profitability. With the turbulence roiling supply chains, more focus should be put on how efficiently critical suppliers are managing working capital (a key indicator of a company’s short-term financial health and ability to withstand shocks). An effective lens to review working capital efficiency is the Cash Conversion Cycle (CCC). This post reviews why understanding supplier CCC is increasingly a priority from the board room to the production floor and is key to making strategic decisions with your suppliers as you navigate these turbulent times together.
This renewed focus on supplier CCC stems from the fact that 70%+ of any given supply chain is comprised of privately-held companies that have historically been reluctant to disclose financial statements. So, how can you effectively manage the majority of suppliers if you lack access to key CCC measures such as days inventory outstanding (DIO), days payables outstanding (DPO), and days sales outstanding (DSO)?
Let’s look at how access to financial statements underpins better risk assessment. Take payment terms, for example: Generally falling into the 30- to 90-day range, these terms are established at the start of a new customer-supplier relationship. In situations where those terms are difficult to adhere to, the supplier’s DSO will reveal the average number of days to collect on the company’s receivables.
What is the Cash Conversion Cycle?
The cash conversion cycle (CCC) is an important measure of management effectiveness and company liquidity. It shows the amount of time (measured in days) for a company to convert its investments in inventory into cash. Generally, the lower this number is, the better the company. The formula for calculating the cash conversion cycle can be expressed as: CCC=DIO+DSO-DPO.
If, for instance, 30-day payment terms have been negotiated—and if the supplier’s DSO is 68 days—then there is an opportunity to discuss how the supplier and their client can review terms that would lead to the client preserving more working capital on their balance sheet while maintaining payment terms that are in line with what the supplier has with other clients. Without that DSO data, this discussion would not be possible.
Strong-Arm Tactics Don't Work
Other firms try to impose harsh commercial terms on their suppliers- such as mandating 120-day payment terms - without understanding the financial challenges that are inflicting on their valued business partners. This isn’t strategic business planning; it’s a larger company trying to impose its will without knowing if a supplier can pay the bill.
Even more importantly, it doesn’t work, especially in tough times.
One large company I spoke with recently was forced to purchase a critical supplier outright that would have otherwise gone out of business. Had they been aware that the supplier was struggling they could have extended credit terms to the supplier and, in turn, earned interest on the loan instead of investing time and resources in the acquisition- and bearing the risks associated with that company on its balance sheet for years to come. This is just one of many actions -rooted in a desire for collaboration and transparency- that a company can take to assist a struggling supplier.
Risk Management Through Financial Transparency
Risk management is not crisis management. Any business whose operations have been shut down or minimized due to COVID-19 is not only dealing with internal, quantifiable impacts but also many related to their suppliers’ financial resiliency and ability to continue to deliver.
RapidRatings’ clients prepare for major disruptions by building strong supplier relationships based on financial transparency. They have access to source-derived financial statements and RapidRatings' predictive analytics, so know where the weak links are coming into a crisis. Consequently, mitigation plans can be put in place and focus given on how suppliers manage inventory, payables, cash and other CCC metrics.
Put simply, you need to be having conversations with your suppliers about their cash conversion cycle on a regular basis. By taking the steps outlined in this article, companies can not only strengthen their overall supply chains and their supplier relationships, but also their own balance sheets.
Whereas a pandemic of these proportions may precipitate more oversight of financially-troubled suppliers, there are myriad other reasons that companies should strive for better financial transparency across their supplier bases, including; improved profitability, risk mitigation, and the opportunity to be more operationally efficient in a world that demands it.