Executive Briefings

Why the U.S. Credit Downgrade Is a Supply-Chain Problem

So we have a situation where Standard & Poor's downgrading of U.S. sovereign debt is likely to have a serious ripple effect on the private sector. The immediate impact takes the form of severe market volatility, which makes it tough for companies to assess their need for capital. But there are also long-term factors which promise to disrupt global supply chains, particularly supplier-buyer relationships.

Bigger companies that have been hoarding cash are in better shape, in that they are less vulnerable to the whims of institutional lenders. According to REL Consulting Inc., a division of The Hackett Group, the 1,000 largest public companies in the U.S. had $853bn of cash reserves on hand at the end of 2010. They're taking advantage of their size and the low cost of borrowing to build up their coffers. These mega-companies could be worried about the near-term state of the economy, or they might be preparing to spend the money on a new wave of mergers and acquisitions. (They're certainly not using it to hire anyone.)

Meanwhile, thanks to continuing uncertainty in financial markets, small and medium-sized businesses are starving for capital. Their need for loans in order to grow isn't being met - despite the fact that the 2008 bank bailout was in part intended to address that very problem.

The problem is that many struggling smaller companies are suppliers to those powerful manufacturers, distributors and retailers. As such, they represent critical links in global supply chains. Even those with stable balance sheets need to be worrying about the viability of the smallest companies, for whom fresh capital is either prohibitively expensive or impossible to obtain.

For a major manufacturer in this shaky economy, it becomes critical to assess which suppliers are healthy and which are in danger of crashing. And so we come to the hottest topic in supply chain today: risk management.

"We would encourage all companies large and small to be as on top of their suppliers as they can," says James Gellert, chief executive officer of Rapid Ratings International Inc.. "Suppliers' financial health is going to play a critical role in their services and deliverability."

Historically, manufacturers have relied on a standard set of markers - balance sheets, payment terms, judgments and bankruptcy filings, to name a few - to assess supplier stability. Today, says Gellert, "these aren't enough - and probably never will be again."

In the new age of economic uncertainty, buyers need to know how well their suppliers can withstand major, unanticipated shocks such as earthquakes and tsunamis. They also have to be clued in on a vendor's financial woes before they become evident. Waiting until a key supplier goes bankrupt is too late to react.

Companies need to track both privately and publicly held suppliers on a quarter-to-quarter basis, in order to understand how their risk profiles are changing. One tool for that purpose is Rapid Ratings' own Financial Health Ratings (FHR) model. It generates a weighted risk score for each company, based on 62 financial ratios. Key areas of focus include debt-service management, leverage, working capital efficiency, sales, cost structure and overall profitability.

The FHR has the potential for sounding the warning bell earlier than the big three ratings agencies. In the case of General Motors, the model downgraded the giant automaker to sub-investment grade in June 2000, nearly five years earlier than S&P or Moody's Investors Service.

The model can also offer early signs of hope. According to Gellert, it has recently identified year-on-year improvements in the areas of transportation technology, equipment and machinery, metals and fabrication, communications technology and builders and building materials. All have improved between 6 and 9 points on the FHR scale.

Rapid Ratings' total U.S. coverage of some 4,000 companies currently shows a weighted average of 64.2 on a 100-point scale. Over the last 20 years, Gellert says, 90 percent of defaults have occurred among companies whose ratings stood at 40 or below. And only 1 percent of companies have defaulted above 65. Maybe recovery is on the way after all.

On the negative side, the next five to six years will see the maturing of a huge amount of corporate debt. Gellert describes the coming event as "ominous." This year, he notes, approximately $100bn of high-yield debt and leveraged loans are due to be refinanced. In 2012, the number jumps to just under $300bn. Then, in each of the next three years, it tops $500bn. Which businesses will be able to meet that challenge, and which ones won't? Every company with a multi-partner supply chain needs to be able to answer that question.

"You can't control what Washington is going to do, and what capital markets are going to look like," says Gellert. "What you can control is how well your team understands the suppliers you're relying on. The more transparency you have into that chain, the better off you are positioning your company to withstand the shocks that may come."

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So we have a situation where Standard & Poor's downgrading of U.S. sovereign debt is likely to have a serious ripple effect on the private sector. The immediate impact takes the form of severe market volatility, which makes it tough for companies to assess their need for capital. But there are also long-term factors which promise to disrupt global supply chains, particularly supplier-buyer relationships.

Bigger companies that have been hoarding cash are in better shape, in that they are less vulnerable to the whims of institutional lenders. According to REL Consulting Inc., a division of The Hackett Group, the 1,000 largest public companies in the U.S. had $853bn of cash reserves on hand at the end of 2010. They're taking advantage of their size and the low cost of borrowing to build up their coffers. These mega-companies could be worried about the near-term state of the economy, or they might be preparing to spend the money on a new wave of mergers and acquisitions. (They're certainly not using it to hire anyone.)

Meanwhile, thanks to continuing uncertainty in financial markets, small and medium-sized businesses are starving for capital. Their need for loans in order to grow isn't being met - despite the fact that the 2008 bank bailout was in part intended to address that very problem.

The problem is that many struggling smaller companies are suppliers to those powerful manufacturers, distributors and retailers. As such, they represent critical links in global supply chains. Even those with stable balance sheets need to be worrying about the viability of the smallest companies, for whom fresh capital is either prohibitively expensive or impossible to obtain.

For a major manufacturer in this shaky economy, it becomes critical to assess which suppliers are healthy and which are in danger of crashing. And so we come to the hottest topic in supply chain today: risk management.

"We would encourage all companies large and small to be as on top of their suppliers as they can," says James Gellert, chief executive officer of Rapid Ratings International Inc.. "Suppliers' financial health is going to play a critical role in their services and deliverability."

Historically, manufacturers have relied on a standard set of markers - balance sheets, payment terms, judgments and bankruptcy filings, to name a few - to assess supplier stability. Today, says Gellert, "these aren't enough - and probably never will be again."

In the new age of economic uncertainty, buyers need to know how well their suppliers can withstand major, unanticipated shocks such as earthquakes and tsunamis. They also have to be clued in on a vendor's financial woes before they become evident. Waiting until a key supplier goes bankrupt is too late to react.

Companies need to track both privately and publicly held suppliers on a quarter-to-quarter basis, in order to understand how their risk profiles are changing. One tool for that purpose is Rapid Ratings' own Financial Health Ratings (FHR) model. It generates a weighted risk score for each company, based on 62 financial ratios. Key areas of focus include debt-service management, leverage, working capital efficiency, sales, cost structure and overall profitability.

The FHR has the potential for sounding the warning bell earlier than the big three ratings agencies. In the case of General Motors, the model downgraded the giant automaker to sub-investment grade in June 2000, nearly five years earlier than S&P or Moody's Investors Service.

The model can also offer early signs of hope. According to Gellert, it has recently identified year-on-year improvements in the areas of transportation technology, equipment and machinery, metals and fabrication, communications technology and builders and building materials. All have improved between 6 and 9 points on the FHR scale.

Rapid Ratings' total U.S. coverage of some 4,000 companies currently shows a weighted average of 64.2 on a 100-point scale. Over the last 20 years, Gellert says, 90 percent of defaults have occurred among companies whose ratings stood at 40 or below. And only 1 percent of companies have defaulted above 65. Maybe recovery is on the way after all.

On the negative side, the next five to six years will see the maturing of a huge amount of corporate debt. Gellert describes the coming event as "ominous." This year, he notes, approximately $100bn of high-yield debt and leveraged loans are due to be refinanced. In 2012, the number jumps to just under $300bn. Then, in each of the next three years, it tops $500bn. Which businesses will be able to meet that challenge, and which ones won't? Every company with a multi-partner supply chain needs to be able to answer that question.

"You can't control what Washington is going to do, and what capital markets are going to look like," says Gellert. "What you can control is how well your team understands the suppliers you're relying on. The more transparency you have into that chain, the better off you are positioning your company to withstand the shocks that may come."

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