Thursday, September 15, 2011

What do Your Financials say About your Supply Chain?

imageWhat can a financial analyst tell about a company’s future by looking at its supply chain? What should they be looking for? How should they analyze such data? How does the supply chain competency affect the financial prospects of a company? These were some of the topics I discussed with Sherree Decovny of the CFA magazine a couple of months back. The interview is published in their Sep-Oct 2011 issue as an article on what should financial analysts know about the corporate supply chains to make better assessments of their financial future.

Sherree Decovny: Do you think research analysts have a good understanding of supply chain practices and the potential impact on performance?
Vivek Sehgal: When it comes to supply chain, most financial analysts will review things like the cash conversion cycle and inventory turnover as both of them relate directly to supply chain capabilities. However, other financial metrics such as return on assets, return on capital employed, cash from operating activities, asset utilization and profitability ratios also depend very heavily on how well a company manages its supply chain. However, many financial analysts may be unable to trace the links between supply chain capabilities and these financial metrics because they are not very obvious. Then there is another set of metrics that may be not be readily available to the analysts because such data is not public, but it reflects supply chain competency, for example number and frequency of clearance events or obsolete inventory that results from poor operational performance.
Analysts are definitely becoming more interested and knowledgeable in supply chain practices and understand how they influence the overall performance of a corporation and create sustained competitive advantage.
SD: What does the supply chain reveal about a company's performance? What should analysts be looking for?
VS: A well managed supply chain shows up in strong financials. It allows companies to be competitive in what they do best. For most companies, the competitive advantage comes from their ability to manage their costs or provide better customer service and supply chains can help in achieving both.
Visionary companies leverage this fact and pro-actively design their supply chains to achieve competitive advantage. But such transformation is not a short-term panacea to address weak financial results. The financial impacts aren't going to show up in the next quarter but will definitely show up in two to three years time. But many companies simply don’t understand how their supply chains enable their businesses. These companies continue to ignore building their supply chains competence and eventually start to lag behind their competitors.
For the analysts, inventory turnover is a good metric to start with, it is easily available in 10-K statements, and is a quick measure of how well a company manages its supply chain. Another item from 10-K is the cost of goods sold, since most components of cost in cost of goods sold (COGS) are directly or indirectly controlled through the supply chain processes. Therefore, COGS as a percent of revenues provides another quick measure of supply chain competence. Analysts should definitely compare these two metrics for a company with its competitors and the industry averages. Good inventory management also affects the current assets and in turn, the asset turnover and return on assets.
Less obvious metrics are the order fulfillment ratios, which indicate whether a company is experiencing backlogs or having difficulty fulfilling orders. For cash-and-carry retailers, analysts should look at stock outs. For a manufacturer, the analyst can enquire about the perfect order measure, which shows error-free fulfillment of customer demand. However, these metrics typically are not in the public domain and management may choose not to reveal them. These metrics show whether a company is having trouble managing their demand forecast, replenishments, and generally in getting the right stuff in the right place at the right time, which is the crux of supply chain.
Asset utilization is another great indicator of supply chain performance. A retailer's largest productive assets are warehouses, stores and trucks. A manufacturer's largest assets are plants, machinery and equipment. How efficiently a company uses its productive assets directly depends on how optimized its supply chain processes are.
Analysts should ask questions about labor planning and scheduling, production planning practices, plant utilization, shipping and warehousing costs, the number and frequency of clearance events, obsolete inventory write-offs, returns/defects and pricing practices.
Retail analysts routinely review the sales per square-foot, but supply chain efficiencies are better reflected in the ratio of total warehousing space to sales-floor space, and ratio of warehousing, shipping, labor costs, and manufacturing overheads to total revenues.

SD: What tools do companies use to model their supply chain to achieve optimal performance?
VS: There is a very wide variety of tools available to model, plan, and execute supply chain processes. Most companies start with modeling their network and simulating supply and demand flows across this network to optimize where their facilities, manufacturing plants, warehouses, and stores should be optimally located. Designing a supply chain network can provide sustained cost efficiencies for storage and distribution of goods and merchandise. It makes sense to plan that network rather than have it grow organically.
Supply chain network modeling tools allow the firms to simulate their storage and distribution costs. Then there are planning tools like supply and demand forecasting and inventory optimization that help companies design a replenishment strategy and optimally manage demand. Bid optimization tools leverage historical data and demand forecasts to help companies select the best suppliers. There are also tools for production planning and scheduling, labor scheduling and inventory management that help companies plan their operations within the constraints of available inventory and resources.
Finally, the execution tools are used for manufacturing execution, warehousing, and transportation optimization and have a direct impact on labor and plant utilization, storage, and shipping costs and therefore on overall operational efficiency.
Planning tools enhance a company's ability to manage inventory, resources, supply, and demand, and provide sustained cost advantages. On the other hand, the execution tools help control immediate operational costs. It's a toss-up between whether you want to see immediate cost reductions, or a more sustainable competitive advantage, which will accrue year after year.

SD: How can analysts build supply chain factors into their earnings forecasts? Can the analysts do anything to be more proactive instead of waiting for the numbers to come out?
VS: This is a harder question to answer because so many of the supply chain performance measures are internal to the companies and they have no obligation to report any of that information. Even so, analysts can gather a lot of informal data by following their target companies and learning more about their operations. Inventory clearance, order back-logs, expedited shipping, urgent manufacturing orders, unresponsive customer service, inability to track customer order statuses and so on: These are all symptoms of deeper supply chain issues and would result in weaker financial performance in the long run.
At the end of the day, about 70-80% of the operations of most retailers and manufacturers are going to be impacted by their supply chain practices or competences. Improving any part of that process is eventually going to show up in their financial performance.
Related Articles:
© Vivek Sehgal, 2011, All Rights Reserved.

Want to know more about supply chain processes and supply chain strategy? Check out my books on Supply Chain Management at Amazon.

No comments:

Post a Comment