Corporate debt could be a challenge for supply chains

Roger OakdenLogistics Management, Logistics Planning, ProcurementLeave a Comment

Risk management chart

Corporate debt in developed countries

If there was a global recession only half as serious to that of 2008, forty percent of the corporate debt owed by businesses in some countries is at risk. ‘Corporate debt at risk’ is when businesses are unable to cover the interest expenses on borrowings from corporate earnings.

This figure is provided in the half-yearly update of world financial markets by the International Monetary Fund (IMF). For supply chain professionals, the bad news about corporate debt is that it is focused on eight major trading countries – Britain, China, France, Germany, Italy, Japan, Spain and the US.

The build-up of debt is making the global financial system more vulnerable to a recession – the IMF notes that risks are ‘elevated’ in 80 percent of economies. Because of nervousness by lenders, a recession can be triggered by a relatively small event which can ‘freeze’ the global financial system. Examples of small events could be:

  • A large downward valuation by stock (shares) trading markets of a major public company
  • An increase is demanded in returns for corporate bond holders. Investors are currently accepting yields that are considered (by the IMF) as too low for the current risk. In the US, the returns on corporate bonds have been:
    • A low risk situation: central bank rate plus 2.5 percent
    • 2008 – 2009 recession: central bank rate plus 20 percent
  • Increased risks when lenders only require minimal covenant protection when lending to corporate borrowers. The situation is aggravated if the lender is also borrowing money on a ‘covenant lite’ basis. Credit rating agencies have commented about this trend as a financial risk
  • An accumulation of business losses, financial delinquencies and defaults can signal that banks will become less willing to lend
  • Negative outcomes of events, such as the current US-China trade dispute

Subsequent bankruptcies from an increased cost of debt could provide a contagion effect, whereby even profitable businesses have their access to debt funding limited.

An article in Forbes magazine notes that in the US, corporate debt owed by businesses that are not making profits is at the highest level ever; more than at the commencement of the 2008 recession.

Total US corporate debt is much higher, at close to levels just before the 2008 crisis. This includes the debt of small & medium sized enterprises (SME), family businesses and other business not listed on stock exchanges.

In May 2019, the US Federal Reserve noted that a large share of corporate borrowing is not being invested to growing productive capacity. Instead, the funds are used to pay dividends to shareholders, corporate acquisitions (M&A) and stock buybacks (used to return wealth to shareholders). The Federal Reserve also noted that “The historically high levels of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and, potentially, their creditors”.

Action by supply chain professionals

Based on the previous observations by financial institutions, supply chain professionals, especially those employed in Procurement, should take action to reduce their organisation’s supplier risk profile.

From the perspective of risk mitigation, supply chain professionals should be aware of:

  • Corporate debt levels among suppliers:
    • The risk of bankruptcy by a critical supplier
    • Awareness of the lenders who own the suppliers’debt
  • Inflated corporate share (stock) valuations of suppliers:
    • The price-earnings or PE ratios of companies is higher than historical evidence. When a stock/share valuation of a supplier business falls, the covenants on loans may be broken, requiring the debt to be re-negotiated (at potentially higher interest rates) or repaid

Options to reduce supplier financial risks are:

  • Limiting the life of a contract
  • Sourcing an alternate supplier (do not ‘single source’)
  • Take the process in-house (make instead of buy) or
  • Buy the supplier

Actions within your organisation can also reduce supplier risk. For all companies, cash is king – negative cash flow is a problem for a supplier, no matter its profitability. By using their purchasing power, customers can affect the cash flow of suppliers through extending the payment period. As often stated by Learn About Logistics (and others), a buyer’s expectation of suppliers as ‘deliver in full, on time, with accuracy’ (DIFOTA) must be matched to the suppliers’ expectation of ‘payment in full, on time, with accuracy’ (PIFOTA) from their customers.

Unfortunately, too many financial people view suppliers’ money as a free loan, using their organisation’s buying power to extend ‘net 30 day’ payment term to 90 days or more. It is a long process for supply chain professionals to change this approach by Finance (treasury), but paying suppliers ‘on time’ (or even early, as a negotiated supplier incentive) needs to be part of your supply chain strategy.

Paying suppliers on time or early is not a ‘once-off’ exercise, but a commitment to a process. This may require your organisation to have access to a ‘line of credit’, whereby in periods of tight cash flow, borrowed funds can be used to maintain the commitment to suppliers.

An additional action to reduce supplier finance risk is to monitor suppliers’ financial situation:

  • Identify your critical suppliers (they may not be the largest)
  • Understand the business approach of critical supplier’s and their supply chain strategy; include (where possible) their financial situation and that of their suppliers
  • Implement a continual financial monitoring process to preempt a potentially serious buying situation

It is a role for supply chain professionals to prepare their organisations for reductions in business volumes when the next recession inevitably comes. Taking action now is a good supplier risk mitigation strategy.

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About the Author

Roger Oakden

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With my background as a practitioner, consultant and educator, I am uniquely qualified to provide practical learning in supply chains and logistics. I have co-authored a book on these subjects, published by McGraw-Hill. As the program Manager at RMIT University in Melbourne, Australia, I developed and presented the largest supply chain post-graduate program in the Asia Pacific region, with centres in Melbourne, Singapore and Hong Kong. Read More...

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