Why you don’t want to rely on payment scores to make decisions on your suppliers

Posted by Pete Tantillo on April 25, 2020

It is increasingly clear that the economic impacts of the current pandemic will be long lasting.  Global supply chains will continue to be disrupted as much by the effects of macroeconomic frailty and declines in global financial health (tracked here) as they are by individual companies’ fortunes.

If you have responsibility and accountability for the preservation and optimization of your business’ supply chain or other third parties, how can you get the best understanding of which companies can be relied upon in these turbulent times?  While RapidRatings has a robust playbook (hint: Financial Health figures in prominently), we share here why an oft-cited method of gaining financial perspective from trade payments is inherently flawed.

Information obtained from a first-party (meaning, from the supplier itself in this case) will always be more reliable, relevant and timely than information obtained from other, third-party sources such as payment data aggregators.  Whereas relying on third-party data has been widely used in historical approaches to risk management, this approach has proven to be a failure. This became clear in the last global economic meltdown in 2008, in which many sophisticated players were caught by surprise. Credit ratings agencies were not independent (paid by the same companies they rated), and their qualitative approach was prone to error.

Another form of third-party data, trade payment data, has also been widely used by those managing sophisticated global supply chains.  The premise is that by knowing how “on time” a company is in meeting its trade financial obligations, that it is possible to infer the strength or weakness of a company’s finances.  The connection is tenuous at best:

  • Payment data is historically collected by credit reporting agencies and other sources so it is, for starters, third-party sourced. The leading vendor of payment driven scores has approximately 80% of its payment data on fewer than 300 companies.  The very long tail of purported coverage is on scant data or data synthesized and approximated from factors such as company location and numbers of employees.  The value of this scoring is nil as these scores have accuracy rates of approximately 50%; meaning they’re at best, a coin toss. 
  • In the typical “negative” trade payment scenario, a company with declining scores will be flagged as in trouble. What does this mean really in the COVID-19 crisis, and can you easily infer the company has issues with their balance sheet and cash flow?  They may very well have issues, but many healthy companies are paying slower today for factors unrelated to whether they are inherently healthy and a good partner for the short or long term (e.g., changing industry-wide payment norms, working capital improvement initiatives, COVID-19 disruptions to A/P workflows).  The warning of a “false positive” - a company flagged as declining when in fact it is surviving just fine- is a tremendous time sink and creates inefficiency in already overworked supply chain risk departments. 

Is a company with “positive” payment score really that financially stable? What could be behind a good trade payables score and does it indicate good financial health of a business?  Here are some questions to show why this is likely not the case:

  • Has the company paid the payment score reporter for enhanced services or business which results in an artificially high payment score? The leading vendor in the payment score space sells service “upgrades” to companies, which, candidly, take advantage of the small private company trying  to make itself look better.  As a user of these scores, you won’t know this happened – there's no disclosure of this score enhancement or the influence of their commercial relationship with the reporting agency. 
  • In the COVID crisis, is it possible the company has accelerated their cash payments in order to stockpile on inventory critically needed for production during this current crisis or in other times of raw material shortages? Is the liquidity reduction a trade-off that hurts the company?
  • Is the company’s supplier requesting accelerated or prepayment of invoices because they are concerned about the company’s financial stability? How will that be reflected in a trade payment score then?
  • Is the company delaying interest or principal reduction on debt to make these trade payments which will cause other liquidity issues in short order?

These examples amount to “false negatives” - an indication that a company does NOT have weakness- but in fact it does.  The cost of this error can be extraordinary for one relying on these scores.  The cost isn’t paid only in inefficient time spent by the team, but in dollar loss, revenue disruption, reputational risk, share price reduction and so many others.    

These examples and many others highlight why relying on payment scores as an insightful measure of a company’s financial viability is inherently risky and ultimately wrong to do, particularly in this crisis period. Vendor risk ratings based on “payment history” are largely conjecture and do not provide an accurate and timely view of a vendor’s risk profile. If you look closely at the underlying score, you will see that much of the aggregated payment history comes from a small sampling of a company’s vendor base. Even in a best-case scenario, payment history is a severely lagging indicator as many companies often pay their bills right up to when they are insolvent.

To get in front of supplier financial deterioration, you must apply a robust financial assessment on the company’s actual financial statements.  The only source of truth is financial statement data which must be self-disclosed by the privately held company for the purpose of providing a financial health assessment to you. This is where RapidRatings pioneered the direct, first-person approach of obtaining source-derived financial data and is the only world-class business able to deliver this solution to you at scale. Therefore, you can have a high degree of confidence in the financial health ratings and analysis provided to you as a RapidRatings client.



Topics: Supplier Risk Management, COVID-19, financial health, payment scores, trade payment data, source-derived data