Cash reserves: A hedge against supply chain risk
The recent wave of devastating hurricanes and earthquakes has put supply chain risk in the forefront. Consumers have felt it in their pocketbooks, as many refineries in the Houston area shut down due to flooding related Hurricane Harvey, spiking gasoline prices across the country. Hurricane Irma devastated parts of Florida and, at one point, more than six million electric customers, consumer and business alike, were without power. Hurricane Maria landed a direct hit on Puerto Rico, and the destruction is far-reaching. The September earthquake in Mexico destroyed killed hundreds and devastated buildings and infrastructure, including manufacturing plants.
The human and economic toll from these natural disasters is still being calculated, but they are life-changing events for those in harm’s way and for area stakeholders. In addition to the dislocation of large segments of population, businesses have shut down and created problems up and down the supply chain. Transportation has been interrupted, labor forces displaced, the cost of building materials, albeit all materials, skyrocketing. It may take months, or even years, to return to a level of normalcy in these hard-hit areas. The shock waves continue to be felt across global supply chains, with many buyers now realizing that critical sources of supply were right in the middle of a natural disaster’s ground zero.
The human and economic toll from these natural disasters is still being calculated but they are life-changing events for those in harm’s way and for area stakeholders.
Supply Chain Dive
These massive and far reaching events have transcended the definition of supply chain risk — from primarily tactical to strategic — and has elevated logistics to the front page. The world now knows about the Jones Act, the seemingly minor regulation that goods moving between US ports need to be on US flagged ships. Containers are stacked up at ports in Puerto Rico without trucks, and without diesel fuel, to move them across damaged roadways. Entire power grids need to be rebuilt from scratch, and we see highways full of power crews from across the United States traveling down I75 in Florida to help. Elected officials in Texas are negotiating with carting companies whose debris hauling businesses are suddenly in high demand and threatening to go to the crisis that will pay them the most.
How to financially prepare for supply chain risk
How do companies prepare for this new extended level of supply chain risk? It seems that some have already begun, not with the traditional methods of increased inventory, qualifying secondary suppliers, reaching for a dusty risk assessment plan, or even keeping their collective fingers crossed, but according to Dr. Shawn Thomas, the University of Pittsburgh Professor of Finance and J. R. Allen Faculty Fellow, with cash.
Dr. Thomas’s research has found that companies have increased their cash position over the past forty years or so, while inventory has decreased in almost the same percentage, thus keeping cash plus inventory nearly constant. And that cash is a hedge against the results of large-scale supply chain risk, the kind we are seeing now.
His research found evidence that companies are building cash reserves to address potential supply chain disruptions. These disruptions, however, are more than the traditional disruptions of product loss, buffer stock, production disruptions, factory overtime, premium payments to suppliers and penalties owed to customers. They include enhanced risk borne by a complex global supply chain, accelerated product development cycles and changing consumer tastes. Long term disruptions, like we are seeing now, have long-term business ramifications.
Long term disruptions have long-term business ramifications.
Supply Chain Dive
While addressing the recent disasters, Dr. Thomas tells Supply Chain Dive that larger cash reserves certainly allow firms to respond better to natural disaster risk.
“For example, apparel shipping rates increased by $0.30-$0.50 per item via water and $2-$3 via air,” he said. “Given the continuing problems at the Port of Houston, retailers with cash holdings available to cover the up-front costs are in better position than competitors with less cash.”
Dr. Thomas adds that seasonality and changing fashion trends make it difficult to mitigate such disruptions with increased inventory holdings alone, with cash as the preferred option.
Global supply chains are 'increasingly complex'
Some may yearn for the good old days of “old fashioned” supply chain risk, where a blizzard might stop traffic for a day or two, or a flu outbreak might impact a production schedule, or the threat of a shipper strike may send shipping managers back to their black books to search for alternate carriers. But the disasters of the past few weeks have put us all on notice about the extent and depth of supply chain risk, where safety stock or a distribution center full of inventory may no longer be the sole answer to save a business.
Given the continuing problems at the Port of Houston, retailers with cash holdings available to cover the up-front costs are in better position than competitors with less cash.
Professor of Finance and J.R. Allen Faculty Fellow at the University of Pittsburgh
“Increasingly complex global supply chains, accelerated product development cycles, and more rapidly changing consumer tastes have made it more difficult to completely mitigate supply chain disruptions with targeted buffer stocks given the variety of causes of disruption and rapid obsolesce,” said Dr. Thomas. “Given the evolution of supply chain disruptions over time, our research indicates that 'deep pockets' now offer an advantage over holding large stocks of inventory.”
While stockpiling cash may work for some larger companies, Supply Chain Dive asked Dr. Thomas what advice he may have for small business to address supply chain risk, especially if they cannot accumulate extra cash. According to Dr. Thomas, prearranged lines of credit are one potential alternative to accumulating cash, but he has a warning. “Operating losses associated with supply chain disruptions would likely concern lenders and could trigger renegotiations of covenants or even revocations of commitments under ‘material adverse change’ clauses,” he said.
Cash reserves could be key to buffering disaster
Dr. Thomas notes that surveys of executives regarding building cash versus establishing lines of credit show that cash held in excess of transactions needs is a hedge against the possibility that they might not have access to capital in bad times. Lines of credit are held to fund future, unexpected growth options.
Given the evolution of supply chain disruptions over time, our research indicates that 'deep pockets' now offer an advantage over holding large stocks of inventory.
Professor of Finance and J.R. Faculty Fellow at the University of Pittsburgh
“Given supply chain disruptions reflect a need to fund operations in bad times, it seems likely that cash holdings rather than lines of credit would be the preferred source of precautionary financing for such risks,” he said.
Supply chain risk is a subset of business risk. Sure, supply managers are on the front lines of ensuring continuity of supply and managing a global supply base. But as these natural disasters show us, risk includes the ramifications of business interruption, changing consumer behavior, product changes, fluctuations in market share, and financial modeling. These elements may be new ground for supply chain managers, but it is important ground. It deserves their full attention.
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