Dealing with Financially Troubled Suppliers

July 1, 2010
Early identification of a troubled supplier can help you avoid a catastrophic supply chain disruption.

One of the most critical elements required to compete in a global marketplace is a world-class supply chain that delivers first-class components and materials on time. A world-class supply chain can be crippled, however, when one or more critical suppliers becomes financially troubled.

Identifying a Financially Troubled Supplier

Early identification of a financially troubled supplier can help you avoid a catastrophic supply chain disruption. The following circumstances may suggest that your supplier is in financial difficulty:

  • Requests for price increases, early payment, accelerated payment terms, or direct financing;

  • Late deliveries or changes in product quality;

  • Failure to update IT systems or failure to appropriately utilize existing technology;

  • Failure to cut costs during economic downturns (are their management and principals making any sacrifices?);

  • Delinquent taxes;

  • Poor money management;

  • Deteriorating accounts receivable and extended payables;

  • Negative publicity or press;

  • Unusual payments on insider debt;

  • Excessive related party transactions;

  • Deteriorating market position;

  • Recent rapid growth in sales volume;

  • Lack of focus by management or poor response to requests.

If one or more of these signs is present, you should monitor your supplier closely. These signs suggest that it may not be long before your supplier's instability affects your operation as well.

Assembling an Early-Response Team

Upon determining that one of your suppliers is financially troubled, assemble a team to deal with the supplier. Members of the team should include representatives from purchasing, engineering, treasury and legal. Consider also assembling a list of the names of experienced “turnaround” consultants.

Simultaneously, you should perform UCC, tax lien and judgment searches to determine who the supplier's secured creditors are, and study the supplier's current financial status by obtaining a Dun & Bradstreet report on the supplier. At this time, you should also assess other resourcing options. Changing suppliers can take significant time and staffing, so be realistic in projecting the time and costs associated with resourcing.

After you have completed your initial due diligence, schedule a meeting with the supplier to frankly discuss the situation. If the supplier allows, schedule a meeting with the supplier's lender to ensure a focused and cohesive approach to the situation. The lender may suggest solutions, and you must assess the viability of all of the proposals and their associated costs and risks.

After these initial meetings, prepare a cost-benefit analysis of staying the course with this supplier. There are numerous economic, workforce and legal implications.

A series of agreements may be negotiated to protect all parties. These agreements provide continued financial support to the troubled supplier from its lender or, in some cases, the customer, for a period of time. The customer receives a continued supply of goods and the lender receives legal assurances that the value of its collateral is protected.

The most common agreements include: a forbearance agreement; a financial accommodation agreement; and an access agreement. A forbearance agreement sets conditions by which the lender will forbear from exercising rights after a default by the supplier borrower. A financial accommodation agreement grants protection to the lender and its accounts receivable, and other collateral. An access agreement grants rights, depending on certain events, to the customer to operate the supplier's plant, ensuring a continuing supply of parts.

Due Diligence

The key to avoiding problems with financially troubled suppliers involves front-end due diligence and active monitoring during the term of the supply contract. The due diligence suggested below will ensure that the supplier is meeting the quality and delivery requirements of the customer. Early due diligence may permit the customer to identify potential areas of concern and communicate those issues to the supplier early enough to resolve them. Periodic due diligence can help convince a customer that its key suppliers are long-term players.

Ask the following questions:

What are the supplier's financial trends over the last two years? While financial information in isolation may not reveal issues, by looking at such information and trends over time you may identify potential problems. Maintain a spreadsheet on each supplier that would allow an easy view of trends. By adding information from each new year to the spreadsheet, you can track earnings, cash flow projections, related party transactions, contingent liabilities, assets and related party transactions. Changes over time should be carefully assessed.

Look at the supplier's current assets as a ratio to its current liabilities to determine if the supplier has adequate working capital. Another measure of adequate working capital is the ratio by which the cash flow covers required payments of interest for borrowed money. Working with appropriate internal financial personnel, develop a set of ratios and minimum standards that, if not met, will trigger further investigation. Working capital shortages are often an indicator of trouble ahead.

If the supplier has publicly-held debt, such as bonds or stock, review materials filed by the supplier with the U.S. Securities and Exchange Commission (SEC), such as Form 10-K reports, to elicit valuable information regarding the supplier, such as current financial statements and information regarding material litigation. These forms are available online. Review the footnotes to the financial statements. Often these give critical information about the company that may not otherwise be apparent by looking at the financial statements.

If the supplier's financial reports are certified, read the applicable accountant's letter to see if the certification contains any qualifications, such as a going concern qualification. See if the supplier's accounting firm has changed from prior reports. If so, find out why the change was made.

Ask the supplier for an aged summary of its outstanding payables and the average number of days payables are unpaid. Again, on a year-by-year basis, if there is a trend of more and more delinquencies in the supplier's accounts payable, this may indicate and predict working capital problems.

Review at least annually the company-wide organization chart showing divisions and subsidiaries and naming key personnel. If the supplier's key personnel have changed or the structure of the supplier has changed, investigate why these changes took place.

Determine and identify the supplier's customer base by industry and concentration of customers within the industry. A broader customer base in diverse industries is beneficial. It is also helpful if the supplier has operations and customers outside the United States.

Conduct periodic plant visits to see if they're clean and operating efficiently, whether the supplier adequately maintains machinery, and whether the supplier has dedicated necessary machinery to the customer's jobs. During the visit, the supplier should make available appropriate manufacturing and executive personnel to answer questions. Prepare reports and note specific concerns about the supplier to form the basis for the next visit. Understand the management team's strengths and weaknesses.

Order and review the supplier's UCC financing statements. The statements will identify the supplier's lenders and any changes over time. The financial statements should show whether the lender is in default.

A supply chain must be aggressively and proactively managed. Your ability to compete in a global marketplace depends on it.

John R. Trentacosta is a partner in the Detroit office of national law firm of Foley & Lardner LLP. He is a recognized expert in the field of supply chain law.