Agriflation: Identifying Supply-Chain Problem Areas and Quantifying an Industry's Vulnerability to Credit Risk: Rising Prices for Food Commodities Have Ripple Effects on Industries Downstream. Lenders Can Evaluate How Rising Prices Affect Certain Industries and the Resulting Impact on a Firm's Credit Risk

Article excerpt

THE FIRST ARTICLE in this series, which appeared in the September issue, focused on the sharp increase in the price of agricultural goods and sought to distinguish the short-term factors that have pushed up prices from longer-term fundamentals. A key underpinning of this series is that price increases in one industry have ripple effects through an economic supply chain--with an associated increase in credit risk.

Monitoring and measuring the risk faced by companies along a supply chain is essential to sound bank-lending practices. Not all industries, or companies, are created equal and risk is rarely spread evenly. Separating the good risks from the bad risks is a significant challenge.

Understanding industry fundamentals and their inherent strengths and weaknesses will offer some indication of the robustness of companies that face a supply-chain price rise. In this article, we create two simple agribusiness supply chains that show the interconnectedness of industries (and thus the means by which risk is spread) and highlight the factors that can increase or mitigate credit risks.

The first article pinpointed corn, soybean, and wheat farming as major areas of interest, given that the supply chain from these three industries involves many agricultural producers, foodstuff manufacturers and processors, wholesalers and storage providers, as well as retailers. This article will focus on price increases in the corn, soybean, and wheat farming industries and the ability of industries in the animal production and food production supply chains to weather a supply-chain price shock. We will highlight industry characteristics that help determine the typical company's vulnerability to sharply rising input prices and offer benchmarks that lenders can use to quantify the relative risk level faced by the sector and the companies that operate in it.

The Supply Chain

Figures 1 and 2 each show eight key industries located downstream of the corn, soybean, and wheat farming industries. Figure 1 shows the animal production supply chain. Figure 2 shows the food production supply chain. These 16 industries rely on the goods sold by crop farmers and therefore are susceptible to the recent rise in agricultural input prices.

Purchase costs for animal production industries along the crop-growing supply chain total $114.7 billion. Average profitability along the chain is around 12.6% of industry revenue. The value of the food production supply chain is greater at $220.3 billion. Purchases from industries in this chain include a wider array of goods and services from sources other than primary producers, although this trend is not uniform. At an average of 20.4% of total industry revenue, the average profit margin of the food production industries is greater than that of the animal production chain.

Evaluating and Measuring Industry Vulnerability

Below is a summary of criteria used to evaluate and measure an industry's vulnerability to a supply-chain price shock. The checklists contained in Tables 1 and 2 establish industry benchmarks used to judge the robustness of an industry's typical company. Key factors a lender must consider are:

* Purchase costs as a proportion of total revenue. This quantifies the average company's overall exposure to input price shocks further up the supply chain. The bargaining dynamics of the supply chain can complicate matters. For instance, a bulk buyer or one with long-term supply contracts will secure a better price than a smaller company that purchases sporadically. Moreover, a company with an alternative supply source (or an alternative input), including the ability to import goods, will be able to strike a better deal to reduce risks associated with higher input prices.

* Average industry profitability. This indicates the size of the average firm's short-term financial buffer against higher variable costs. The buffer gives operators a chance to absorb input price rises by running down profit to avoid passing on costs to consumers (and risk losing market share) or failing to meet loan repayments. …