108 • Supply Chain Risk Management: An Emerging Discipline
investment groups have long thought about risk from a nancial perspec-
tive. e following approaches for managing supply chain risk borrow
heavily from the nance side of the business.
Supplier Financial Health Assessment through Ratio Analysis
A common approach for evaluating a company’s nancial situation
involves ratio analysis. Ratios, also called nancial performance metrics,
simply represent one number divided by another to provide a value that
is then compared to an industry benchmark, internal historical perfor-
mance, or to other companies, usually in the same industry.
e reasons for calculating and then interpreting nancial ratios
are straightforward. We use supplier nancial ratios to manage risk by
providing insights that nancial data simply cannot provide. e ratios
take nancial data and turn that data into value- added information that
allows for relatively easy interpretation. Furthermore, ratio analysis, when
performed on a regular basis, can highlight trends that can be positive
or negative. Ratios can also be used to determine the relative nancial
strength of a supplier compared with other suppliers in an industry.
Perhaps most importantly, various tools use nancial ratios to predict the
potential of supplier bankruptcy. e most common bankruptcy predic-
tor, the Z- Score, is discussed later. Bankruptcy predictors are actually part
of something called predictive analytics, which Chapter 11 addresses.
Ratios are used at dierent times. Within the context of supply chain
risk management, nancial ratios are used when—
• Evaluating potential suppliers
• A purchase requirement involves a signicant amount of dollars
• Buying items that are critical to the functioning of your business
or product
• Entering into a longer- term contractual agreement
• Conducting regular risk scans of your supply chain
• Planning to do business with a supplier where switching options are
limited when a company starts using that supplier
Financial Ratio Categories. Literally hundreds of nancial ratios exist.
Toss some nancial data into a numerator and some into a dominator, add
a bit of pixie dust, and be prepared to be amazed as a nancial ratio magi-
cally appears. e rst test of a ratio should be that it tells us something
Financial Risk • 109
of importance rather than simply being the result of numbers thrown into
a formula.
Even though hundreds of ratios exist, they generally fall into one of six
major categories. It is important to note that not everyone agrees on these
categories. Some sources present a dierent mix of categories, sometimes
omitting the market and growth categories presented here and adding
ratio categories with names such as solvency, nancial eciency, cash
ow, and investment valuation ratios. Interestingly, a search of nancial
resources reveals that while overlap exists across some ratio categories,
total overlap or agreement is rare, if nonexistent. Regardless of the catego-
ries used, each ratio category should answer a specic question or satisfy a
specic objective unique to that category.
Figure6.1 presents four ratio categories along with examples of spe-
cic ratios within each category. One major category includes liquidity
ratios, which help identify if a supplier is capable of meeting its short- term
nancial obligations. A second major category, activity ratios, includes
ratios that probe how eectively a supplier is managing its assets. A third
Liquidity
Activity
Protability
Leverage
• Current ratio: current assets – current liabilities Higher
• Quick ratio: (current assets – inventories)/current liabilitiesHigher
• Cash ratio: cash/current liabilitie
sH
igher
• Asset turnover: sales/total asset
sH
igher
• Current asset turnover: sales/current asset
sH
igher
• Inventory turnover: sales/inventor
yH
igher
• Inventory days outstanding: 365/inventory turnover Lower
• Net margin: net income/sales Higher
• Gross margin: (sales – cost of goods sold)/sales Higher
• Operating margin: operating income/sales Higher
• Return on assets: net income/total asset
sH
igher
•
Return on equity: net income/equity Higher
• Debt to equity: total liabilities/equity Lower
• Current debt to equity: current liabilities/equity Lower
• Interest coverage: earnings before interest and tax/interest Higher
Preferred Direction
:
FIGURE 6.1
Examples of nancial ratios.
110 • Supply Chain Risk Management: An Emerging Discipline
category is leverage ratios. Ratios in this family evaluate whether the sup-
plier is capable of meeting its debt obligations.
A popular and widely used group of ratios that almost everyone agrees
on is protability ratios. Ratios in this group provide insight into the rate
of return a supplier is earning. Another category that doesn’t appear in
Figure 6.1 is market ratios, a set of ratios that indicate how well a sup-
plier is doing compared with market indicators such as price/ earnings and
shareholder return. A nal category, growth ratios (not shown in gure), is
somewhat dierent. Growth ratios provide insight into the rate of growth
over time that is occurring at a supplier. ese ratios are oen compared
from one period to another period and require data from multiple periods
for their calculation, which is not true of the other ratio categories. Taken
at a specic point in time, growth ratios will not provide much insight.
Obtaining Financial Data. Without question the key to successful
nancial ratio analysis is obtaining reliable data on a timely basis, which
is easier said than done. One challenge is that many companies use sup-
pliers that are private companies. ese companies are under no obliga-
tion to make available the same types of nancial documents as required
by public companies. Second, the growth in global supply chains means
greater use of international suppliers. It is common knowledge that nan-
cial data in certain parts of the world might not be accurate or accessible.
e method of using two sets of books, which is unthinkable (and illegal)
in developed countries is not so unthinkable in other countries. Even data
about public companies can be problematic. Large companies in partic-
ular will have several if not many operating units and facilities that are
aggregated into the nancial statements. Breaking out specic results can
be challenging, if not impossible.
In practice, companies should establish a repository that contains infor-
mation from a variety of sources. Internal users should then have easy
access to this information when they monitor supplier risk. What are
some sources of supplier nancial information? A partial listing includes
the following:
• Company- published annual reports
• Company- supplied 10-K and 10-Q reports
• Dun & Bradstreet reports
• Credit reports and bank references
Financial Risk • 111
• ird- party ratings with an independent rm such as Moody’s
• Trade and business journals
• Supplier- provided data
is last item is particularly important. One advantage of working with
suppliers on a longer- term basis is the opportunity to share valuable infor-
mation. Furthermore, as relationships and trust evolve, a supplier should
be more willing to share information with a customer, including insights
into nancial issues that might otherwise not be shared for fear of what
the customer might do with that information.
Bankruptcy Predictors
With a crisis oen comes opportunity, and that is exactly what happened
aer the nancial meltdown of 2008. A clear need presented itself for ways
to assess the nancial health of companies that combined sophisticated
algorithms and nancial data. As a result we are witnessing a growing
number of more third- party providers oering sophisticated tools for
assessing company health.
One of the most popular and well- established tools for assessing nan-
cial health using ratios is the Altman Z- Score. Developed by Dr.Edward
Altman of New York University, the Z- Score combines a series of weighted
ratios for public and private rms to predict nancial bankruptcy. e
Z- Score is almost 90% accurate in predicting bankruptcy one year in
advance and 75% accurate in predicting bankruptcy two years in advance.
e Z- Score has two attributes that make it a valuable tool for supply
chain managers. e rst is its relative simplicity. Only four ratios are
needed to calculate the Z- Score for private rms and ve ratios for pub-
lic rms. Furthermore, the Z- Score can be interpreted with an easy- to- use
red, yellow, and green system. e Z- Score also provides a single score
that can be used during the preliminary evaluation of potential suppliers.
It provides guidance regarding which suppliers to keep or eliminate from
the selection pool. And, it provides a basis for tracking nancial changes
over time. Supply chain risk managers should calculate supplier Z- Scores
at least quarterly. e following are the Z- Score formulas for private and
public rms. Notice that a company’s total assets appear in three out of four
ratios for a private company and four out of ve ratios for a public company.
112 • Supply Chain Risk Management: An Emerging Discipline
Private Company
Z-Score
Working Capital
TotalAssets
=× +6563..
336
672
×+
×
Retained Earnings
TotalAssets
EB
.
IIT
TotalAssets
Net Worth
TotalLiabili
+×105.
tty
EBIT Earnings before interest and taxes
where:
Z- Score < 1.1 Red Zone—Supplier is nancially at risk
Z- Score between 1.1 and 2.6 Yellow Zone—Some area of nancial
concern
Z- Score > 2.6 Green Zone—Supplier is nancially
sound
Public Company
Z-Score
Working Capital
TotalAssets
=× +12 14..
×
×+
×
Retained Earnings
TotalAssets
EBIT
T
.33
ootal Assets
NetWorth
TotalLiability
+× +06 1.
.. 9×
NetSales
TotalAssets
EBIT Earnings before interest and taxes
where:
Z- Score < 1.8 Red Zone—Supplier is nancially at risk
Z- Score between 1.8 and 3.0 Yellow Zone—Some area of nancial
concern
Z- Score > 3.0 Green Zone—Supplier is nancially
sound
e Z- Score Illustrated. It is benecial to not only present the Z- Score
methodology but also to illustrate its use. Table6.1 provides data for three
suppliers that are competing for a contract to provide a base chemical to a
pharmaceutical company. For Z- Score calculation purposes the required
data for the ratios appears in either the balance sheet or income statement.
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