When Ford Motor Co. noticed in 1997 that a handful of its suppliers was having trouble making good on their deliveries of materials, the company realized it had to act–and fast. As a company that spends $90 billion a year on supplies worldwide and uses a single supplier for each of the many components used to put together its cars and trucks, a problem at one supplier could trigger a chain reaction that could delay the overall completion of its products. "It does us no good to have a weak link in the chain," says Daniella Saltz, a lawyer in Ford's general counsel office and the person who provides legal support for the automaker's purchasing efforts. "It paid for us to work with suppliers to make them as strong as possible, not be punitive and keep buying our parts from that supplier."
That meant encouraging suppliers to furnish complete and accurate financial data to help Ford gauge their financial health. For the Dearborn, Mich.-based car giant, it involved working with suppliers whenever a problem arose to ensure that materials would continue to be delivered. In some cases, Ford would even bring in consultants to help a supplier in trouble. And though it is difficult for Ford to point to specific statistics that would illustrate the company's success, Saltz suspects she spends less time wrangling with suppliers than many other manufacturers–in large part because Ford views its relationship with its suppliers as a partnership.
When it comes to doing business these days with both suppliers and customers, Ford's lesson of almost six years ago is now viewed as standard operating procedure by most big companies: When you are relying on a company for supplies or payments, you have to know with whom you are dealing. "There is a new recognition that you have to pay attention to the fundamentals," says Mike Shearer, a managing director in PricewaterhouseCoopers' financial risk management practice and leader of PwC's credit risk management team. "We are seeing people perhaps realize that they do need to ask more questions about what [those businesses] are doing."
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Who sounded the wake-up call? The recession and the tech-sector meltdown were clearly culprits. But first and foremost it was the almost overnight collapse of corporate giants like Enron Corp. and the troubles that befell WorldCom Inc. and Global Crossing Ltd.–companies with which any finance department would have been overjoyed to do business until the underlying shakiness of their financials came to light. Enron's problems wreaked havoc not only on the energy sector, but also on its customers and suppliers. And Enron wasn't the only warning sign that finance departments needed much more clout when it came to deciding with whom to do business. Just ask Lucent Technologies Inc., which managed to throw its own financials into total disarray after getting stiffed by vendors and customers that used its "liberal" financing programs. Lucent lost more than $2 billion in one quarter alone as a result of such missteps.
Testing the Brakes
Before Enron, it wasn't as if companies were willing to work with anyone who walked through the front door. But companies most often made evaluations of customers and suppliers based on ratings from the major credit rating agencies. They then dealt with the risk using hedging strategies and other counterparty risk solutions. "The credit function has always been viewed as the brakes on a car that you want to travel a great distance and go fast," says Roy Taub, executive managing director at Standard & Poor's Corp. and head of the rating agency's risk solutions group.
Then, the Enron and WorldCom "surprises" managed to bloody up the rating agencies, which weren't looking that good anyway after the high-tech and telecom meltdowns in 2000 and 2001. Finance departments came to realize that what they needed was not just an insurance policy through hedges, but also a preemptive program to either avoid the bad guys entirely or at least anticipate potential problems.
So these days, finance executives are back in the market looking for help to speed up the process of sizing up the guy sitting across the table. And as would be expected, there are a number of vendors stepping up with products that might take different approaches but in the end accomplish the same thing: determine the financial health of companies in a manner beyond the powers of the rating agencies. These tools enable purchasing, sales and finance departments to obtain real-time snapshots of a potential supplier's or customer's risk profile. "In the last year and a half, if you asked what is risk management, people would say it's market credit risk and looking at portfolios," said Austin Trippensee, solution manager for risk management portfolios at SAS Institute Inc., a Cary, N.C.-based software company that offers products to manage both suppliers and customers. "Today, the whole term of risk management has changed drastically." Ironically perhaps, credit rating agencies, with their stockpiles of data, are the most obvious source for these kinds of products. Among the offerings:
o Moody's KMV, a San Francisco-based unit of Moody's Investors Service, which has developed EDF Credit Measure, a Web-based tool that uses stock prices, debt levels and industry volatility to calculate the likelihood of a company defaulting. KMV has more than 30 years of data and can track the performance of more than 30,000 companies. A product called RiskCalculator performs a similar task for privately held companies.
o Standard & Poor's Corp.'s Trade Credit Services, which uses industry data, modeling tools and exposure management software to calculate default and late payment risk. TCS also enables customers to plug in their own historical data to see how their counterparties stack up against their rivals, and allows a company to set its own exposure limits if industry standards aren't a good fit for the company.
o Fitch Risk Management Inc.'s loan-loss databases, which provide performance data on private and public commercial loans. The company, a unit of rating agency Fitch Inc., also offers FitchCRS, which uses equity and financial-statement data to create "ratings" of public and private companies.
In addition, there is a whole range of products coming out of solutions providers like RiskMetrics Group, with its CreditGrades product that similarly uses stock price and volatility along with debt-per-share data to calculate a credit spread and likewise can illustrate a company's likelihood of default, and statistically based models like products offered by D&B and others. Other credit risk management software companies, like American Management Systems Inc., TradeCapture Inc. and SAS, to name a few, have credit risk management solutions that they say can be applied to evaluate customers and suppliers.
And just because a deal is deemed risky does not mean it won't get done. Experts say that by having a more accurate risk profile of a customer or supplier, transactions can be tailored to better suit a risk profile. For example, a potential customer that's assessed as shaky could be required to make a down payment as part of a sale or be asked to accelerate its payback schedule. In addition, a company can generate monitoring reports in order to keep closer watch on customers deemed to be risky. "When we are talking about a large volume of business, it doesn't take a whole lot in terms of performance to begin to pay off if you can avoid or lower your exposure to some problem credits," S&P's Taub says.
But obtaining a credit risk management solution for customers or suppliers is only part of the process of effectively managing these relationships. For these solutions to work, a company must bring risk management to virtually every aspect of the company. "This is about connecting the dots and deciding how you are going to bring risk and strategy together," Shearer says. "If you have good alignment between risk management and strategic thinking, you can make informed decisions about the level of risk you are trading for sales."
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