A very happy 2014 to all of you! I was hoping to post this last year, but events conspired to prevent this post. Well, even if I am lazy, I can always blame the lack of posts on some phantom event… 🙂
In my previous post about the Value Add of Distributors (Part – 2), I had mentioned the inflated working capital (WC) at some of the key distributors highlighted (Ingram Micro, Avnet, Tech Data etc). This is a key characteristic of distributors.
Let’s look at the key elements of WC (Working Capital). Broadly, these can be split into Assets (Accounts Receivables (AR) and Inventory) and Liabilities (Accounts Payables – AP). A little side-note on distributor inventory. Inventory is almost always purchased on credit with terms like net-30, net-45 or net-60. Most suppliers will lean towards net-30 or net-45 payment terms. These negotiated payment terms have leverage built in to them. Meaning, a new supplier with very little market share is likely to be saddled with a net-60 (or even a net-90 in extreme cases). A heavyweight supplier who has a dominant market position or brand, will likely get more flexible terms. A distributor on the other hand will try to buy more time to pay up – meaning they’ll shoot for net-60 on average. But, they have to be careful with these terms as it could bloat up their AP’s. In my experience, despite these contractual terms, often, distributors and suppliers are willing to let these terms slide (on a case by case basis). Meaning, payments or credit-extended will always have some tolerance built around them.
While I digress from the main topic of WC, these payment terms have implications for the distributor, supplier and resellers/dealers. Distributor AR is a component that represents credit extended to it’s customers. Almost always, their customers will never use cash to purchase (just like the distributor) and like everyone else, they’d like credit. AR/credit management is a skill that distributors excel at in addition to being experts in logistics. They have to – they don’ t have a choice. That’s their business model. Their AR is diversified across thousands of customers at any given moment. Hence, the AR risk is mitigated to an extent. AR’s are assets from an accounting perspective as it comes to pass that revenues reported by distributors were AR’s at some point.
Unlike AR’s, inventory is cash in hand as it can be sold at a moments notice (not really, but it can). Hence it is clearly an asset. So, we have two assets in this equation – AR and Inventory.
From an inventory standpoint, this is also a component that is closely managed at the SKU level. Buyers/SCM and marketing are tasked to keep inventory dollars are optimal levels. IT distributors typically don’t consign inventory, but for large buys, suppliers will have skin in the game.
In any case, going back to WC – WC is the net difference between current assets and liabilities. And, like I mentioned before, this number is very high for distributors. Why is that so and what does that mean?
Why? Mainly due to high AR’s. And this means, that distributors have to allocate large amounts of capital to generate an average of x% returns. Their AP’s will always roll on to the next period and so will their AR’s. Unless they hit a patch of exceptionally strong growth, their inventory levels will remain quite steady as well. In other words, to spin a certain net return, distributors need to apportion a good part of their assets (inventory) pretty much on a near constant basis to generate the required return.
Another way to look at this is that their AR’s and AP’s almost cancel out, leaving only inventory. Yet another way to abstract this equation is to strike a balance between selling and buying. Selling would equate to AR’s while buying would be denoted by AP’s and Inventory. And this aspect not only represents the distributor business model, but also controls to a good extent their working capital.