When directors consider insolvency risk, attention naturally focuses on their own organisation’s cash flow, profitability, debt levels, funding facilities and ability to meet liabilities as they fall due.
But financial distress does not always originate within the business. One easily overlooked risk is supplier insolvency, particularly where a business has become dependent on a small number of suppliers for critical goods, materials or services.
A company can be financially sound and still face serious operational and cash-flow difficulties because a key supplier has failed. Knowing the warning signs of a supplier in trouble, and what to do if a business-critical supplier fails, is an important part of managing that exposure.
Risks associated with supplier insolvency
Most businesses rely heavily on third parties for raw materials, manufacturing, logistics, IT, specialist subcontractors and other essential components. That means that if a critical supplier suddenly enters administration or liquidation, several consequences can materialise at once, including:
- Interruption to production.
- Inability to complete customer orders.
- Loss of deposits or advance payments.
- Shortages of essential materials.
- Increased replacement supplier costs.
- Contractual penalties or customer claims.
- Severe pressure on working capital.
So, although it might be the supplier that has become insolvent, the consequences can quickly become the customer’s problem.
How to safeguard against supplier failures
Understand concentration risk
A useful question for any board to answer is which suppliers could it not operate without for the next 30 days.
Supplier concentration often develops gradually. When a supplier performs well, the relationship strengthens, volumes increase and preferential terms may be negotiated. But when that supplier starts to struggle, what began as an efficient purchasing decision can eventually become a significant operational dependency.
This is particularly important where the supplier provides something bespoke, technically specialised, regulated or difficult to source elsewhere. In these cases, an alternative supplier may exist, but finding one that could supply quickly enough and at an affordable price may be difficult.
Management should also consider dependencies further down the supply chain. Several apparently independent suppliers may themselves rely upon the same manufacturer, logistics provider or specialist component.
Watch for early warning signs
Supplier distress is not always apparent from published accounts, which may be historic by the time they become available. Operational behaviour can sometimes provide earlier warning signs, such as requests for accelerated payment or deposits, reduced credit terms, persistent delivery problems, declining service levels, loss of key employees or unexplained management changes.
None of these necessarily indicates imminent insolvency, but a combination should justify further enquiry.
Protect advance payments and plan for continuity
Deposits and advance payments can potentially become unsecured claims if a supplier enters insolvency before delivering the goods or services. Contractual protections help, but contractual rights against an insolvent company may ultimately have limited economic value. Contingency planning, including approved alternative suppliers, dual sourcing, strategic stock levels and access to essential technical specifications, may provide better protection in practice.
To further anticipate and safeguard against supply shocks, management should be able to answer the following questions about each critical supplier:
- How dependent are we on this supplier?
- How much money, stock or work in progress would be at risk if they collapsed?
- How quickly could we move to an alternative, and what would it cost?
- What additional working capital would we require to move forward?
Insolvency risk extends beyond the balance sheet
One lesson from dealing with businesses experiencing financial distress is that the event that leads to the crisis is not always the underlying cause of it.
A business may be profitable and apparently stable, but insufficient resilience can leave it exposed when something unexpected happens elsewhere in its commercial ecosystem. A customer fails. A supplier collapses. Credit insurance is withdrawn. A lender reduces facilities.
For directors, this reinforces that financial resilience is about understanding what could threaten solvency tomorrow as well as the risks it faces today.
Identifying critical supplier dependencies, monitoring risk and planning alternatives can make the difference between managing another company’s insolvency and being drawn into financial distress because of it.
At Opus, we can help assess exposure to critical suppliers, review contingency arrangements and identify the working capital implications of a supplier failure before it happens. Contact us at rescue@opusllp.com or call 0203 995 6380 to arrange a call with one of our specialists to discuss your next steps.