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A Case for Incessant IT Vendor Financial Risk Monitoring

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“If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky business.”

– Gary Cohn

“Economics always wins” may not hold true in all cases. However, it did work, at the end, in case of all the hullaballoo that was created around protecting jobs from outsourcing in the US. Donald J. Trump after his surprise win in 2016 had created an uncertainty in the outsourcing world. Nevertheless, since then, he has done very little on the issue. Even with the new executive order to bring in stringent H-1B Visa restrictions, it is unlikely that many jobs will return to the US. Cries to bring in harsher outsourcing/immigration policies in other developed nations such as Singapore, Australia, and Canada are not gaining traction either. Global outsourcing is here to stay.

However, the entire episode will not end without leaving few bruises on the service outsourcing industry. Many of the technology companies are promising to hire more local people in the US in their attempts to reduce the growing outcry. Both Infosys and TCS have stated that they will hire more US citizens in next two years. Other companies are expected to follow suit. In case of the Indian IT service companies, which depend heavily on labor arbitrage for their margins, it will have a direct impact on the bottom-line. Although they may resort to automation and hire less people to reduce costs, the money saved would still not compensate for the high salary to be paid to the newly hired US employees.

Most of the Indian IT vendors record operating margin in the range of 20%-25%. In all likelihood, this will decline in the coming quarters. This coupled with inability of some IT companies to move to digital technologies, resulting in lower revenue growth rates, could further erode the profitability. According to the National Association of Software and Services Companies’ (Nasscom) forecast, the Indian IT industry will grow at 7%-8% in 2017-18 which is the lowest in decades. It will result in lower earnings and hence lower investment in growth opportunities.  If continued, it may result in jeopardizing the continuity of service which will not just have monetary implications on the clients but also reputational repercussions. It is in this context that we need to re-look at the financial risk of IT vendors.

Traditionally, clients look at financial risk at the time of vendor selection. This is not sufficient anymore with the increase in volatility. Although incidents like bankruptcy are unusual, they can have serious impact on the clients’ operations. In January 2017, Avaya Inc., a business collaboration and communications solutions provider, filed for bankruptcy. Since then the company has gone through a debt restructuring plan and has reduced debt. There were no reports of service disruptions in this case. Yet, this must have put a lot of pressure on its clients. To avoid such situations, it is necessary to continuously monitor the financial strength of the suppliers for any red flags.

Now let us look at the financial risk for India’s top four IT firms. To analyze the risk we will use the Altman Z scores. Altman Z score is a technique that uses five different financial ratios to estimate the probability of the company going bankrupt in the next two years. Any score that is more than three is considered good. Higher the score, lower the probability of going bankruptcy. Z scores indicate that these companies are safe and there is a very low probability of these companies declaring bankruptcy in the next two years. However, this may not hold true for smaller and medium scale IT vendors that have higher debt in their balance sheet.

So, it is indispensable for companies to monitor financial risk of these suppliers.

Supply WisdomSM uses a combination of more than 30 financial parameters to arrive at a financial risk score and ~200 parameters to arrive at a supplier’s composite risk score. Different parameters such as governance structure, legal issues, service maturity and human resources are monitored in real-time, so the clients can understand business risks and leverage emerging opportunities. Contact us for more information or to get started with a free trial.