Risk Analysis: Procurement Perspective


By: Vamsi Krishna Thota --

27 March, 2014

Risk Analysis: Procurement Perspective

Introduction: Corporate insolvencies worldwide are forecasted to decrease by 1% to 351,300 in 2014 compared to 354,850 in 2013, supported by the growth in world GDP by 3.1%. In North America the corporate insolvencies are expected to decrease by 5% followed by Asia with 1%. On the other hand, Central & Eastern Europe, corporate insolvencies are expected to increase by 3% in 2014 followed by Africa & Middle East with 2.9% and Western Europe with 1%. What happens to a company if its supplier becomes insolvent and ceases operations? The entire supply chain of the company will be disrupted leading to the loss in business until an alternate supplier is engaged with. How to identify such a risky supplier and avoid the loss of business? This paper consists of the holistic framework (BRAHMA) to determine the risk associated with a supplier. Proposed Solution: The framework estimates the risk associated with a supplier by systematizing it into quantitative risk and qualitative risk. Quantitative risk is defined as the risk arising due to the supplierï¾Âƒ??s financial performance in trailing twelve months (TTM). It is further analyzed to provide outlook on the supplierï¾Âƒ??s financial health in near future. While, Qualitative risk of the supplier is estimated from various parameters such as regulations, expansions, restructuring, foreign exchange rates etc. It is analyzed to increases the insight into supplier health. Quantitative risk evaluation deals with numerical quantities, on the other hand, Qualitative risk deals with qualities or characteristics. The framework to rate a supplierï¾Âƒ??s quantitative risk is discussed below Quantitative Risk: Quantitative risk is estimated by analyzing and comparing each financial ratio of the supplier with the general standards and industry standards. A total of 15 financial ratios were categorized into four buckets namely ï¾Âƒ?ï¾Â› Profitability ï¾Âƒ?ï¾Â› Liquidity ï¾Âƒ?ï¾Â› Efficiency and ï¾Âƒ?ï¾Â› Solvency Profitability: Profitability is the primary goal of all businesses. Without profitability the supplierï¾Âƒ??s business will not survive in the long run. So measuring current and past profitability of a supplier is very important to predict any kind of supply disruptions. In the framework the profitability of a supplier is measured based on three ratios, namely ï¾Âƒ?ï¾Â› Gross Profit Margin ï¾Âƒ?ï¾Â› Operating Profit Margin ï¾Âƒ?ï¾Â› Net Profit Margin Liquidity: Liquidity is a company's lifeblood. It attempts to measure a supplierï¾Âƒ??s ability to pay off its short-term obligations. This ability of supplier is of utmost importance when creditors are seeking payment. Liquidity determines whether a supplier will be able to continue as a going concern. Liquidity signals whether the supplier will be able to fund their ongoing operations on their own. The five ratio used in the framework to measure liquidity of a supplier are ï¾Âƒ?ï¾Â› Interest Coverage Ratio ï¾Âƒ?ï¾Â› Self Sufficiency Ratio ï¾Âƒ?ï¾Â› FCF to Interest Expense ï¾Âƒ?ï¾Â› Current Ratio ï¾Âƒ?ï¾Â› Quick Ratio Efficiency: No matter what kind of business a supplier is in, they must invest in assets to perform their operations. Efficiency ratios measure how effectively the company utilizes these assets, as well as how well it manages its assets. In the framework, the efficiency of a supplier is measured based on five ratios, namely ï¾Âƒ?ï¾Â› Asset Turnover ratio ï¾Âƒ?ï¾Â› Inventory Turnover ratio ï¾Âƒ?ï¾Â› Receivables Turnover ratio ï¾Âƒ?ï¾Â› Return on Assets ï¾Âƒ?ï¾Â› Return on Equity Solvency: Solvency is the ability of the supplier to meet their long-term financial liabilities. Good solvency position is essential for a supplier in to stay in business, but also needs liquidity to thrive as it is the measure of supplier ability to meet short-term liabilities. A supplier that is insolvent must enter bankruptcy; a supplier that lacks liquidity can also be forced to enter bankruptcy even if it is solvent. The framework measures the efficiency of a supplier based on two ratios mentioned below along with the short & long term rating by other rating agencies. ï¾Âƒ?ï¾Â› Debt to Equity ratio ï¾Âƒ?ï¾Â› Altman Z- Score   [gview file="http://www.beroeinc.com/wp-content/uploads/2015/05/risk-analysis-procurement-perspective.pdf"