Ever since launching our online two-course series "Finance For Strategic Procurement," I've had many practitioners approach me about the topic and its importance in today's modern procurement world. This week, I separately met with executives at two totally unrelated companies who learned from me that they were making the same mistake.
What was that mistake?
Well, it relates to the evaluation of supplier financial health. I introduced them to four methods of evaluating supplier financial health. One of those methods involved using the Altman Z-Score.
Have you ever heard the phrase "I know enough about it to be dangerous?"
Well, that applied in both of these situations.
You see, the Altman Z-Score calculation has three variations: one used for publicly-held manufacturers, one used for privately-held manufacturers, and one used for non-manufacturers. Each Z-Score calculation is performed using slightly different coefficients and variables to arrive at a number used to compare against a scale that determines the financial health of the supplier.
Well, not only is the calculation different for each of the different variations, but the scale against which a supplier's Z-Score is compared is different for each variation. So, beyond just using the wrong calculation, by using the wrong variation, you could be getting a totally opposite reading on the financial health of a supplier!
For example, let's say you calculated the Z-Score for a publicly-held manufacturer as 1.7. But let's also say that you used the comparison scale of the variation for non-manufacturers.
The comparison scale of the variation for non-manufacturers indicates that a 1.7 puts the supplier right in the middle of the "grey zone." This means that there is not a severe likelihood of imminent bankruptcy.
But what does the comparison scale for the publicly-held manufacturer variation - the correct variation, in this case - say?
It says that a score of 1.7 puts the supplier in the lowest category, meaning bankruptcy has a high likelihood. If you don't apply the right variation to the type of supplier you are evaluating, the Altman Z-Score will not work!
Obviously, Finance For Strategic Procurement (Part II, specifically) covers how to correctly apply the Altman Z-Score for each type of supplier. Though I know that not enough procurement professionals utilize the excellent tool that the Altman Z-Score is, I didn't realize that applying the wrong variation appears to be a very common mistake among those that do attempt to utilize it.
Perhaps that's what happens when googling is used instead of getting authoritative purchasing training: learning enough to be dangerous. And, make no mistake, miscategorizing a healthy supplier as a financially distressed supplier or failing to recognize a supplier's impending bankruptcy are both dangerous procurement mistakes.
"Epic fail" kind of mistakes.
To Your Career,
Charles Dominick, SPSM
President & Chief Procurement Officer
Next Level Purchasing, Inc.
Struggling To Have A Rewarding Purchasing Career?
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4 comments:
Hello Charles,
Is running a Dunn and Bradstreet a more viable means of determining a company's financial health?
Thank you,
Victoria Rios
Hello Charles,
Is running a Dun and Bradstreet report a more viable means of determining a company's financial health?
Thank you,
Victoria Rios
Hi Victoria,
I have used D&B failure/risk scores for suppliers across the globe. I have noticed suppliers in some countries just don't have the data to enable D&B to provide a accurate financial health score so depending on the countries in which you intended to operate you might want to investigate further.
Also consider if you want to look at all suppliers in your db or just those suppliers that are considered strategic to your organisation.
For those suppliers where a risk score is available you will also want the ability to monitor your chosen suppliers throughout the year (who will do this and where will the data be held to alert the relationship manager of a potential problem). You might want to check cost options with continued monitoring (cost benefit etc).
The main problem I faced was with inaccurate data or when the supplier was late submitting its accounts, in this case the score was adjusted to high, this takes time in correspondence with stakeholders (contingency planning just in case) and the supplier to get to the hub of the issue.
In four years of using D&B we had one supplier in financial difficulty; D&B didn't pick this up as the owner had been 'cooking the books'.
Best regards,
Daniel.
A D&B is one of the tools you can use to evaluate supplier financial health but by no means should be the only tool used.
The Altman Z-Score is a very broad indicator of financial health, taking into account multiple aspects of financial health, and is perhaps the most useful tool. However, it needs to be applied properly to work. As you can understand from reading the above post, you really need to know what you're doing with it or you risk doing it wrong.
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