Among the victims of the Great Recession were thousands of suppliers to major manufacturers, large and small. In a lot of cases, buyers of raw materials and key components had little warning that their sources were about to dry up. Expert monitoring services would downgrade the rating of suppliers after they went bankrupt. Big help.

If only there existed a magic formula for determining whether a supplier is about to fail. Unfortunately, the world is too full of unpredictabilities for that ever to be the case. One thing's certain, though: a vendor's basic financial statement won't always tell you the whole truth. Not unless you're looking for a really good rear-view mirror.

Some kind of early-warning system for supplier stability is essential - now more than ever. When it comes to the solidity of the typical supplier base, retailers and original equipment manufacturers these days are skating along on thin ice. To cut costs, they've consolidated vendors down to the barest minimum - sometimes just one for a given component or region. That's a fine way to boost buying leverage, but it also raises the risk of a major supply-chain disruption in the event of natural or economic disaster. The kind of thing that seems to happen every other week.

Making matters worse are the stretched-out lead times caused by outsourcing to Asia and other locations far from end markets. Companies that crossed the ocean in search of cheap labor are discovering how much tougher it is to solder a snapped link in the chain.

So how can manufacturers do a better job of detecting future failures among their suppliers? Start by realizing the limitations of traditional financial data. "It's one of the easiest things to [examine] - and the one that lets everybody down the most," says Jon Bovit, chief marketing officer with CVM Solutions. And when you do request a supplier's financial statement, don't stop with one. The best practice, he says, is to demand three years' worth of financials and credit reports on a rolling basis.

That's essential information, but it can be misleading. By the time bad news creeps into a financial report, it's often too late. Risk scores based on periodic statements provide a snapshot of the company's health several months or quarters ago. "They don't give you a very forward-looking perspective," Bovit says.

Take a closer look at your suppliers. Bovit recommends supplementing financials with a "usage trust metric." Simply put, that's a measure of whether a supplier is losing or gaining customers. CVM works with a lot of Fortune 500 companies, so it's privy to their spending habits. It turns that information into a scorecard, which it then shares with clients.

Be aware of the "chatter" surrounding particular suppliers. Social networks are an excellent place to get a sense of what companies are saying about their vendors. "If there seems to be a lot of pure news counts on a certain supplier you have in Japan, chances are it's being affected," says Bovit. Internal communications within a large buying organization can also reveal weaknesses within the supply base. It helps to know what the person in the next cubicle is talking about.

Bovit recommends viewing a supplier much like a financial analyst looks at a stock. External risk scores from rating services are valuable, he says, but they need to be accompanied by information secured directly from the supplier. Consider the Altman-Z score, which was designed to assess a company's chances of going bankrupt up to two years in the future. The Altman-Z of Nortel Networks Corp. fell six months before the company sought protection from creditors, Bovit notes. But the company's third-party risk score didn't drop until after the bankruptcy filing.

Of course, you could do nothing to assess the health of your suppliers, then count on your ability to adjust quickly when one or more of them goes belly up. "That's actually not a crazy strategy," says Josh Green, chief executive officer of Panjiva. "It's reasonable if you have a nimble organization." But do you really want to take that chance? There are too many stories about "best-in-class" manufacturers who suffered serious supply-chain crises after an economic slump or even a factory fire caused by lightning.

The problem with traditional risk-management tools, says Green, is that they weren't designed for the supply chain. They were created by credit-rating agencies to evaluate customers, not suppliers. And they're most effective when the user has access to a wealth of financial data about the company it's investigating, which isn't always the case with suppliers based outside the U.S.

Green says companies should use the onboarding process to ask suppliers for extensive information about themselves - then require them to provide that data on a recurring basis. Find out the identity of the supplier's suppliers, so you can track whether it's paying its bills on time. Of course, the supplier might refuse to part with this sensitive intelligence, and if you're not a Fortune 100 company with substantial purchasing clout, you'll have little recourse. You might even find the supplier vetting you. "That's actually quite jarring, particularly for entrepreneurs," Green says, pointing out that suppliers have been burned too many times by buyers "with big dreams and small bank accounts."

Other kinds of supply failures have nothing to do with financial distress. A key vendor might drop you as a customer, in favor of a more lucrative competitor. Such a scenario "has not even remotely been touched by traditional financial measures," says Green. There's also the possibility of severe damage to one's brand by irresponsible behavior on the part of the supplier, in the form of tainted products. One metric isn't going to tell the whole story - not by a long shot.

"When the Great Recession got going, all of a sudden it was all about risk," says Green. "Amazingly enough, two years on, there still is nothing even approaching a silver bullet when it comes to supplier risk management." But smart companies aren't without ammunition.

- Robert J. Bowman, SupplyChainBrain

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