Business Partner Solvency Analysis
August 2, 2011
So, the proverbial excrement is starting to hit the fan. The situation can be summed up by Bank of America – Meryll Lynch economist Ethan Harris, quoted in The Wall Street Journal (9 July 2011): “Every major component of the report [US government report about jobs and hiring] was weak. That doesn’t happen very often — usually there’s some ray of hope.” If one includes those workers who are discouraged, and therefore no longer looking for work, the unemployment rate is now 16.6%. We’re getting progressively closer to the 24.9% unemployment rate experienced during The Great Depression (1933). Looking at another economic indicator, the S&P/Case-Shiller 20-city composite index of US home prices is down about 45% from its 2007 high. Similarly, according to the US Courts, business bankruptcies have increased for the third straight year in a row. Pick your favorite indicators — they nearly all look bad, and they’re getting worse.
The world is running low on non-renewable natural resources — very importantly including petroleum — and these inputs to production have been a big part of why we have been able to grow the economy for over a century. We now need to shrink the economy, and that process is in fact already underway, so that we will come back into balance with nature, and use only a sustainable amount of natural resources. Unfortunately many businesses, government agencies, and non-profits are still geared to the growth model that prevailed in decades gone past. Organizations urgently need to retool their thinking so that they consider the downside of the business cycle that we are now entering. Organizations also need to examine exactly what that shift of direction is likely to mean in the years ahead.
Among other painful adaptations, the downside will involve a massive liquidation of debt. As the rate of growth slows, and then later shifts over to a steep decline, many indebted organizations will no longer be able to make the principal and interest payments that they were able to service in expansive times. Our economy is way overstretched and overcommitted when it comes to debt. Much of this debt will not be paid, but will instead be forgiven, dismissed in bankruptcy, negotiated down to pennies on the dollar, assumed as part of a merger or acquisition, or otherwise handled in non-standard ways. All organizations need to be seriously examining which of their business partners (sales network associates, raw materials suppliers, transportation firms, insurance companies, banks, utilities, etc.) might not make it through this upcoming period of rapidly declining business activity.
The very nature of solvency will also be redefined as we shift from expansive to contracting times. In expansive times, depending whose definition you go by, “solvency” may have been defined as the possession of assets which in total have a current value greater than the total existing debts (including contingent liabilities such as loan guarantees for third parties). But a significantly different approach is called for in contracting times. Financial markets will become increasingly driven by psychology rather than analytical valuation methodologies (as happened in 1929 with the stock market), for example many alarmed investors will want their money now (think runs on the bank). Thus it won’t matter if assets could be sold at a certain time in the future, what will matter is the cash that assets can generate now. This shift in investor psychology means that liquidity will become the primary factor determining solvency. Thus, instead of total assets, it be more important to calculate total liquid assets such as the sum of cash in banks, Treasury bills, money market funds, and the like. Solvency will then be defined as the ability of these liquid assets to service total existing debts on schedule. Avoiding any additional technical details, suffice it to say that accounting methods used to determine solvency by necessity will also be changing in the near future. The continued use of traditional models for determining solvency, models employed in expansionary times, will then be dangerous.
In light of this shift over from expansion to contraction, the process of strategic planning must now be radically changed. Traditionally, this work focused on expanding the size of operations, adding new product and service lines, gaining more market share, buying other firms, and the like. Now the practice of strategic planning needs to be incorporating both new adaptive business strategies appropriate for, and new contingency planning strategies related to, a contracting business environment. Strategic planners need to be asking questions like: “If our number one supplier of raw materials goes bankrupt, then what happens to our business?”
Such questioning is especially critical for those businesses that use inputs that are unique. Custom ASIC (application specific integrated circuit) chips, for example, cannot readily be provided by another supplier. This reality is painfully clear to many businesses that formerly were supplied by Japanese semiconductor companies, companies that are now hampered, if not fully out of business, thanks to the recent tsunami and nuclear disasters. In an expanding business environment, what was considered a business advantage (having a unique part that competitors could not easily copy), in a contracting business environment can become a liability (because no alternative supplier is readily available).
Unfortunately, what economic theory dictated in a prolonged expansion is going to be very different from what economic theory dictates in a steep and prolonged contraction. For example, in an up-slope phase of the business cycle, firms cut inventory in order to lower their holding costs, using models like just-in-time inventory keeping. In the down-slope phase, it will be important to keep extra inventory on hand, to be able to continue service when a supplier goes bankrupt, so as to provide some extra time to find another supplier. Similarly, during an expanding phase, it was prudent to use outsourcing, to reduce costs and focus on the core business competencies. But during the a contracting phase, having major dependencies on third parties, especially when they are overseas and subject to different laws and customs, and therefore not easily supervised, third parties that might go bankrupt with very little if any notice, that is a risk that many businesses won’t want to take in the years ahead. I expect that soon more businesses will start reversing the outsourcing trend, bringing essential operations in-house, where they can be better controlled, observed, and managed. Vertical integration of business operations will soon again become an attractive business strategy.
Top management at progressive firms can now get a competitive advantage if they perform what I call a “business partner solvency analysis.” This will yield a scorecard that indicates where business partners stand when it comes to being “going concerns,” when it comes to going out of business. Just as businesses in 1999 sent out questionnaires to suppliers asking them if they were prepared for the Y2K roll-over in computerized dates, so too should proactive management teams now be sending out questionnaires to important business partners asking them about their financial strength and ability to withstand major business reversals.
In some cases, for example for publicly held companies, a good deal of this business partner solvency information will be relatively easy to obtain, because it is already published publicly. Nonetheless, in many instances this information can be quite misleading. For example, the absence of mark-to-market accounting practices for assets means that many financial assets (like residential mortgages) are on the books at cost, when they should instead be significantly written down to reflect current market value. Thus standard financial statements may not accurately reveal insolvency risks. So even if standard financial statements are provided, that doesn’t mean the true risks of a business partner’s failure has been disclosed. Some other business partners will consider financial statements to be confidential, even for their major business partners. Alternatively, some businesses may deliberately lie about their financial situation, knowing full well that if they came clean about their situation, then they would lose that account.
So what should be done? This is where quantitative risk analysis can play an important role. Progressive management at organizations needs to numerically estimate the risks of a business partner bankruptcy, factoring in what they know about the partner’s current situation, and also the possibility that the supplier may be painting their situation in misleadingly complimentary colors. A variety of questions should then be asked. Maybe it’s time to get another supplier who would be more financially stable, and more forthcoming with its financial information? Maybe a series of contracts should be signed with several suppliers who all can provide the same essential input? Maybe it’s time to acquire this particular supplier? Perhaps it’s time to perform the operation in question entirely in-house? Maybe it’s time to get out of this line of business entirely, while somebody can still be found to buy it? Only after the numbers are prepared, can the best course of action be determined. What needs to be done now is to run the scenarios, and get some business impact numbers, to come up with some probabilities, to ask “what if this were to happen?” and “what if that were to happen?”
Organizations that do this type of business partner solvency analysis will not only be able to get out of harm’s way before something major happens, but they will also be able to monitor, track, and follow the status of business partner solvency over time. Modern business intelligence software now allows the collection of an unprecedented amount of information that was not for example available during the 1930s as people suffered through The Great Depression. Many of the solvency risks that business partners pose can now actually be known in advance, or at least immediately detected when a negative event takes place, even if the involved business partner refuses to disclose its financial statements. Credit reports, notices about collection lawsuits, Google alerts, electronic clipping services, and many other automated mechanisms can be used to create a real-time dashboard to indicate where major business partners stand from day to day.
It’s time that organizations discovered the truth about their major business partners’ financial situations. Transparency and additional financial information is very valuable at this stage in the business cycle. That additional information will in turn enable progressive management teams to do contingency planning, and then some informed maneuvering to establish back-up plans such as alternative suppliers. There is still time to set contingency plans in place, but during a full-out crisis, such as the severe financial crisis that we will soon be seeing, that is no time to start coming up with contingency plans. By researching business partner solvency information now, management can be proactively defensive, and avoid being caught blindly unaware and therefore thrown into a difficult situation, a situation from which it may later be impossible to recover.
Charles Cresson Wood, MBA, MSE, is a technology risk management consultant with Post-Petroleum Transportation. He assists organizations with strategic planning and contingency planning so as to deal with the many changes brought about by peak oil, climate change, ecological degradation, and financial collapse. He is the author of the book “Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action.”