Financial Distress –
Have you spotted the red flags?

The Resilient Enterprise | The riskmethods Blog
red triangular flag

Financial experts predict that an economic shipwreck will follow in the wake of the coronavirus pandemic. So, are your suppliers waving red flags of financial distress from the stormy ocean of COVID-19 disruption? If so, they may be hoping that you as their customer will throw them a lifeline. Learn more here about red flags that could signal financial distress, in particular force majeure.

Read on to learn how mitigating risk can keep your business afloat.

What is financial distress?

Put simply, a company is in financial distress when it is unable to generate enough revenue or income to meet its financial obligations. As shutdowns, lockdowns and quarantines interrupt the normal flow of income, debt and cash flow out are exceeding the cash flow and revenue coming in.

In the first quarter of this year, more than half of coronavirus-related threats to the supply chains of riskmethods’ customers indicate financial distress and instability (56%). This is a 45-fold increase since January 22, 2020. Such warnings can identify your risky suppliers before they become actual threats to your business. The costs of financial distress in your supply chain include business closure, loss of revenue or income, or coping with debt stress, all of which will probably cause financial stress in your own organization.

Four red flags of financial distress

1

Force majeure

2

Changes in labor

3

Changes in management

4

Underperformance / profit warning

Some financial clues rely on indicators from the past, such as credit rating or payment behavior. For more timely information, riskmethods monitors crisis-related events and will alert you if they point to financial distress. These include force majeure, “short-time work” – government-subsidized reduction of working hours – or layoffs, changes in management, slow growth or poor revenue.

1. Force majeure

Translated literally, the French term means “superior force.” In business and law, a force majeure event is beyond anyone’s control that prevents parties from fulfilling their contract. You’ll find a force majeure clause in contracts with businesses that supply parts or services, to provide some wiggle room should something unmanageable happen.

As reported by riskmethods' risk intelligence, the monthly growth rate in force majeures is 123% from December to March with a dramatic increase of 200% in March over February. Force majeure generally considers events including wars, riots and certain strikes beyond reasonable control of a business. A special category covers natural disasters – earthquakes, hurricanes, lightning strikes and extreme weather, which fall under a force majeure “act of God.” An act of God clause in a contract refers to violent acts of nature that occur without human influence.

2. Changes in labor (short-time work, layoffs)

Changes in labor (short-time work, layoffs) are bright red indicators of financial distress. Particularly in Europe, during a downturn companies may apply for government assistance so they can continue to employ staff at reduced working hours. Our research shows 1,040% increase in cases of short-time work announcements. Another option is to offer unpaid leave, allowing businesses to shed costs while retaining talent. Yet the coronavirus has also triggered massive layoffs, particularly in the US. Between mid-March and mid-April, more than 26 million Americans applied for unemployment benefits.

3. Changes in management

Another personnel-related SOS is loss of key staff. When C- level management abandon ship, it can signal loss of trust in the company’s future. Particularly when the chief financial officer leaves the organization, the company may be looking for solutions to unanswered financial questions.

4. Underperformance/profit warning

Missing sales or profit targets will be widespread throughout virtually all industries in the wake of COVID-19 restrictions. However, when companies miss a sales or profit target, it is important to determine how financial distress affects the value of the firm, for example, whether it was a temporary disruption from production stoppages, such as with automakers during the coronavirus outbreak, or drop in demand, which has hit the airlines. Continuous tracking and monitoring of supplier financial health beyond annual profit reports provide a clearer picture of viability. Investigate the financial from the previous quarter, along with earnings expectations in the upcoming quarters to see whether suppliers believe that demand will recover.

How does suppliers’ financial distress affect your supply chain?

financial distress graph

Financial distress in your supply chain probably will lead to a negative risk event for you as the customer. The primary risk is that you suffer a lack of supply, such as raw materials or components, from one or more suppliers.

Along with lack of supply, you may be coping with uncertainty, as financial distress may not yet have triggered a supplier collapse. This not only affects future delivery targets, but whether the supplier will be able to continue at all.

And the financial distress could lead to commercial risk through non-adherence to contracts, should the supplier file for Chapter 11, insolvency, or bankruptcy to get out of obligations.

With an overview of the financial situations in your supply network, you are less likely to be surprised by the worst-case scenario of insolvency or bankruptcy. Investigate options that let you secure your supply at least short to mid-term, if necessary while you look for replacements or alternative suppliers.

Check out our webinar Supplier Financial Analysis: Tips to Achieve Operational Excellence to learn how to avoid common mistakes companies make when analyzing supplier financials.

Six options for mitigating risk when you suspect financial distress in your supply chain

Our early alerts sound the signal horn of financial distress prediction, so you know what’s coming at you. We're seeing a 119% increase in warning signs of financial distress for suppliers this year, with 63% of all cases this year happening in March alone. So, how to deal with financial distress as the COVID-19 consequences linger?

#1 Raise questions about supplier health and force majeure

First, raise the question within your company regarding your supplier’s financial health and examine their short-term resiliency. If you suspect that suppliers may be struggling financially, or another event such as sub-tier insolvency could affect their ability to deliver, begin a thorough review of your contract. Seek legal guidance to find out the exact legal definition of force majeure, along with any natural disaster clause in the contract, is the first step. When you can manage financial distress, you can reduce your own financial stress.

#2 Evaluate who pays for financial distress costs

To claim force majeure, suppliers will usually have to show that they have exhausted all alternatives, such as shifting to manufacturing lines in a different location. Whether the claim is valid may also depend to the wording in the contract, or on whether the legal system follows civil law (such as China and the EU) or common law (the UK and US). While you are at it, check your force majeure insurance coverage as well.

# 3 Ask your supplier what actions they are taking

Ideally, your supplier has notified you at first signs of delivery delays or logistic bottlenecks. If not, initiate the conversation. Contact members of you supply network and find out their financial situation. Also try to determine whether any short-term difficulty endangers their long-term viability. Most important is whether they have a strategy to overcome financial distress. This can include a turnaround plan, temporary production stops, restructuring, renegotiation of loans, or exploring other liquidity options.

#4 Can you/do you want to provide support?

If you are dependent on a single supplier, you may feel you have no other immediate option than to support your partners and master the crisis together. Financial support can include paying their invoices faster, for example, which can avoid making their cash flow problems worse. Collaborate closely on making sure you both can ensure business continuity – and insist on transparency. Here you are well advised to investigate their sub-tier suppliers, to avoid surprises further down the line. Working to keep your tier 1 supplier solvent is no use if their suppliers are not able to deliver.

#5 Can you resource supply?

This better-late-than-never option is to identify alternative suppliers located in regions not affected yet, or that are recovering. Relying on single-source suppliers is like being aboard a cruise liner without lifeboats. Should your suppliers slowly sink towards bankruptcy, there is nothing heroic about going down with the ship.

#6 Can you manufacture yourself?

Enterprises rely on (sole) suppliers for a long list of reasons. In many cases, manufacturing certain parts yourself is not feasible. However, recent months have witnessed businesses revamping entire production lines to make personal protective equipment or medical devices, with accompanying shifts in sourcing and in staffing. As the coronavirus has caused huge disruptions in supply chains, it may be worth revisiting the idea.

And one more option that may keep your suppliers onboard in the current situations is to hang on in anticipation of emergency low-interest loans, stimulus packages and bailouts – by mid-April worth more than $8 trillion globally – that are being floated by governments trying to buoy up businesses and keep the global economy from sinking. If your supplier has sound turnaround plans and is in line for some support, they may be able to weather the storm.

How to protect your supply chain from financial distress

The current coronavirus crisis mode may be easing, but as we all know, the effects are far from over - nor are the threats to your suppliers’ financial viability. This is why you need the most up-to-date information possible to support your decisions as you search for financial distress solutions. Watch our webinar Respond, Recover, Prepare: Why digitizing procurement now is critical to your post-corona strategy to learn how procurement can take a data-driven approach to responding to this crisis, how to recover, and ways to prepare for the coming economic crunch.

How can you quickly, easily and effectively protect your supply chain? riskmethods supply chain risk management technology raises red flags when there are financial problems in your supply chain. We monitor multiple sources, including financial agencies, international organizations and consultants. The warnings cover international events, country-level risks along with company-level risks such as financial viability, to support your financial stress management, so you can navigate back to calmer waters.

To learn more about what drives supply chain financial risk, the consequences for customers, along with suggested actions and mitigation strategies, fill out the form below to read our whitepaper.

Supply Chain Financial Risk

Fill out form to download case study
Back to top