The current article aims to highlight the critical aspects of the business of trading companies. After reading this article, an investor would understand the factors that impact the business of trading companies and the characteristics that differentiate a fundamentally strong trading company from a weak one.
Key factors influencing the business of trading companies
1) Intense competition faced by trading companies:
Trading companies are involved in sourcing products from manufacturers and then selling them downstream to other traders/customers. Activities of most of the trading companies involve almost nil to very low value-addition and they only act as a small part of the supply chain. As a result, the trading business involves very low barriers to entry for new players.
Easy entry of new entities greatly increases the competition in the sector.
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Wholesale trading is a business which is generally characterized by low entry barriers and a competitive environment, both domestic as well as external.
Due to low entry barriers, numerous small trading entities enter the business making the trading segment a very fragmented area dominated by the unorganized sector.
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trading businesses have traditionally been dominated by a vast number of small, unorganized outfits largely in the form of family run businesses. Barring a few sectors such as oil & gas, energy, most of the trading business segments are extremely fragmented.
Intense competition in the trading business is not limited only to India. In almost all countries e.g. Japan, trading businesses face strong competition.
Rating methodology for general trading firms by Rating and Investment Information, Inc. (R&I), Japan, May 2021, page 3:
competitive environment for general trading firms is relatively challenging
The intense competition by numerous players fighting for customers’ business impacts the bargaining/pricing power of trading companies.
Also read: How to do Business Analysis of a Company
2) Very low pricing power of trading companies leading to low-profit margins:
Trading is a very low value-adding business as most of the trading companies only act as intermediaries between manufacturers and customers. Due to low-value additions, trading companies find it hard to differentiate their services from one another.
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Given the fact the trading business operates on wafer thin profitability and provides limited scope of differentiation or value addition,
As a result, a customer can easily switch from one trading company to another while sourcing any product. This low switching cost gives a very high bargaining/pricing power to customers.
Rating methodology for specialized trading firms and wholesalers by Rating and Investment Information, Inc. (R&I), Japan, April 2023, page 3:
Given that specialized trading firms and wholesalers do not develop and manufacture products themselves, achieving differentiation from a product standpoint is difficult and the possibility for customers to move to another company is essentially high.
Consequently, trading companies primarily compete on price to customers’ business leading to low profit margins.
Criteria for rating trading companies by CRISIL, October 2022, page 3:
Limited value addition and commoditised nature of business mean margins are thin for traders.
As a result of non-differentiable and commoditised services resulting in intense price-based competition in a thin-margin business, during economic downturns, many trading companies go out of business. However, due to low entry barriers, new players keep coming into the segment.
Moreover, despite challenges, the trading segment is essential for the economy as the trading segment as a whole serves important functions of expanding the reach for manufacturers, easing transactions for small retailers by dealing in small-sized consignments and reducing payment risks for manufacturers by acting as intermediaries.
Criteria for rating trading companies by CRISIL, October 2022, pages 3-5:
They can sell goods in small consignments and also reduce the credit risk for suppliers…they provide important services such as enhancing the distribution network and geographical reach of the supplier.
In addition, traders benefit the supply chain ecosystem by bringing in their knowledge of customers’ preferences.
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They add limited value to products but have a place in the supply chain because of their understanding of customer requirements in terms of quantity and quality.
Also read: How to analyse New Companies in Unknown Industries?
3) Working capital-intensive business of trading companies:
Trading companies usually do not invest money in fixed assets because they do not own manufacturing plants. Their business activity primarily involves buying goods from manufacturers and selling them further to other traders/customers and subsequently, collecting money from customers.
As a result, major capital investment by trading companies is in owning inventory so that they may supply goods quickly to customers and in the receivables pending from customers. It makes their business working capital intensive.
Criteria for rating trading companies by CRISIL, October 2022, page 3:
The bulk of their balance sheet assets comprises inventory and receivables, with fixed assets forming a small part.
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The inventory and receivables constitute majority of the assets of wholesale trading companies resulting into high working capital intensity.
Due to high working capital-intensive operations, trading companies primarily rely on working capital debt from lenders to run and grow their business.
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Consequently, traders rarely contract term debt for capital expenditure, and mostly have working capital debt.
Moreover, the working capital requirement of trading companies fluctuates significantly over times/seasons depending upon the industry. For example, agro-commodity traders experience significant seasonality in their business linked to crop harvesting period and see their working capital requirement increase sharply during such periods.
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volatility in the prices of commodities and changes in market demand and supply conditions, which results in fluctuations in working capital requirements. Business engaged in trading of agricultural commodities such as wheat, rice, sugar, cotton etc. tend to also have seasonality in their business, which also results in funding requirements being exceptionally high during the procurement season and relatively low during other parts of the year.
In addition, the working capital requirement of trading companies also depends on general economic cycles. For trading companies in sectors like steel, demand for working capital increases significantly during economic upcycle.
Rating methodology for specialized trading firms and wholesalers by Rating and Investment Information, Inc. (R&I), Japan, April 2023, page 7:
sectors such as steel trading firms, for example, where working capital swells and cash flow from operating activities becomes negative when the economy recovers and operations expand,
Due to a significant reliance on short-term financing to run their operations, trading companies have to manage their working capital efficiently. This is because losses due to inefficient inventory management or inability to collect receivables can have a serious impact on the business.
Criteria for rating trading companies by CRISIL, October 2022, page 3:
for traders, working capital management is paramount. Any stretch in the working capital cycle due to inventory pile-up (because of slowdown in demand) or write-down of receivables can wipe out margins
Also read: Operating Performance Analysis: A Simple & Complete Guide
Let us understand in greater detail how the management of inventory and receivables position is critical for the operations of trading companies.
3.1) Inventory management is key for the success of trading companies:
Trading companies are required to maintain a large amount of inventory with themselves so that they may meet customers’ requirements quickly and thereby enjoy a competitive advantage over their peers.
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As wholesale trading business is highly working capital intensive in nature, mainly on account of high level of inventory required to be maintained to ensure ready availability of stock
Due to carrying a large amount of inventory, trading companies are exposed to volatility in commodity prices. This is because any decline in the market price of goods can make the inventory held by the trader economically unviable. This is especially true because trading companies work on very thin profit margins and usually have a buffer of only a few percentage points before their inventory costs become more than market price.
Criteria for rating trading companies by CRISIL, October 2022, page 5:
Inventory risk arises because of fluctuations in product prices. Due to thin margins, any significant fluctuation in price can have a substantial impact on the trader’s credit risk profile
Most of the time, trading companies face inventory losses due to either of the two situations. First, the price of the inventory goes down or second, the inventory becomes obsolete i.e. unsellable.
Criteria for rating trading companies by CRISIL, October 2022, page 5:
The inventory value could decline due to a fall in the commodity price during the holding period, or because of product obsolescence.
Price fluctuations in the price of the inventory holding might be due to local demand-supply situation, general economic slowdown or international price changes in cases of import price parity.
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One of the key risks that trading companies face is the market risk arising out of volatility in commodity prices which may be influenced by trends in international commodity prices, demand-supply dynamics and macro- economic trends.
Whereas product obsolescence risk is primarily in the industry with rapid changes in technology or customer preferences.
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Obsolescence risk is common in industries with short product life cycle or dynamic markets…mobile phones and garments.
Inventory risk is especially significant for those trading companies, which need to keep inventory on their books for a long period i.e. have a long inventory holding period either due to transportation/logistics or processing. The longer the holding period, the higher the probability of commodity prices moving against the company.
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Business with relatively higher inventory holding periods owing to factors like processing, logistics etc may face higher market risk compared to the ones where turnaround is faster like trading in metals etc.
To protect themselves from inventory/market risk, trading companies follow many strategies like buying inventory only after getting a confirmed order from customers so that they do not face the risk of unsold inventory lying with them. In addition, companies do back-to-back contracts with customers and suppliers so that the price is fixed on both ends and there is minimal chance of a loss due to adverse price movement.
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entities undertaking trading against confirmed orders or on a back-to-back basis have relatively lower exposure to commodity price fluctuation risk, as against those entities, which maintain an inventory position (stock and sale).
Many times, trading companies also hedge their inventory position by entering into contracts at exchanges to reduce the market/inventory risk.
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risk may be hedged through back-to-back transactions or through counter purchase agreements on local/global exchanges.
Trading companies reduce their market/inventory risk by dealing in only the most liquid goods, which can be sold quickly reducing the probability of carrying unsold inventory.
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The traded commodity should be highly liquid (i.e. easily disposable / can be sold off in any market situation) in terms of it being easily traded on the local or global commodity exchanges.
The ability to manage inventory efficiently to avoid losses is a significant competitive advantage for trading companies as it allows them to price their goods lower and gain customers’ business in this highly price-sensitive business.
Trading & distribution industry – key success factors by Pefindo credit rating agency (Indonesia), November 2022, page 1:
a good inventory management will minimize slow moving and/or obsolete inventory so that there will be lower inventory costs, thus lead to lower and competitive merchandise prices.
Also read: Inventory Turnover Ratio: A Complete Guide
3.2) Timely collection of receivables is essential for the survival of trading companies:
As the primary business of trading companies is buying goods from manufacturers and selling them further to other traders/customers for a narrow profit margin; therefore, it is essential that trading companies do not lose money in non-recoveries. This is because a failure of payment by a single customer may wipe out the profits of a sizable portion of the whole business.
Criteria for rating trading companies by CRISIL, October 2022, page 5:
As receivables also constitute a sizeable proportion of the current assets of traders…Delays in receivables can impact business considerably, especially if the capital employed is small.
In order to protect the business against default by customers, efficient trading companies have well-defined credit policies regarding business limits with customers with respect to credit limits, trading volume limits, contract duration etc. This keeps the exposure to any single customer within limits and protects the company from bankruptcy if the customer fails to pay.
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The credit policies can broadly cover limits on credit lines extended to counterparties, method of computation of credit limits, limits on trade volume, duration of contracts, etc.
Another key strategy followed by trading companies to avoid bad debt is to only deal with financially strong customers or take security from customers in terms of letters of credit, bank guarantees, post-dated cheques etc.
Criteria for rating trading companies by CRISIL, October 2022, page 5:
It also matters whether the customers are large firms with good creditworthiness, or small enterprises with modest credit quality. Furthermore, sales against letter of credit (LC), bank guarantee (BG) or post-dated cheques are positive factors, as they reduce the risk of losses due to default.
At times, it becomes essential that trading companies secure their receivables with guarantees/security because in the unfortunate events when commodity prices see wild swings, even customers with good financial strength might intentionally default on making payments (called performance risk).
Commodities trading industry methodology by Standard & Poor’s (S&P), July 2023:
“performance risk,” where even creditworthy counterparties may refuse to honor the terms of contracts if market prices have moved against them, leaving the commodities trader with unhedged positions
Also read: Receivable Days: A Complete Guide
4) Risk of govt. regulations:
Trading companies are significantly exposed to changing regulations as govts. across the world interfere in the movement of goods across borders as well as their supply and price within the country to benefit local industry and population.
One of the key areas for such regulations is foreign trade policy interference by govt. via import and export duties. Due to the international trading of many goods, policy changes even in other countries also have a significant impact on Indian traders.
For example, any restriction by China on the import of textile products from India will impact exports from India. Similarly, any antidumping or safeguard duty levied by India on imports will help the domestic traders against cheaper imports.
Criteria for rating trading companies by CRISIL, October 2022, page 4:
government regulations come into play. For example, China’s domestic sourcing policy affects India’s textile export, or import restrictions on steel in India prevent glut of cheap imports.
Another area that witnesses strong govt. interference is the essential commodities where govt. control pricing as well as supply. In addition, govt. itself enters into trading to control the market.
Rating methodology for trading companies by ICRA, 2012, pages 3-4:
In India, the regulatory environment is fairly stringent, restricting free trade, sourcing, warehousing and even pricing of essential commodities. … the Government also engages directly in sourcing and pricing (by setting minimum support prices) of essential commodities.
This is especially true for agro-commodities where govt. decides the price (minimum support price, MSP), and storage limits, and becomes buyer as well as seller depending upon the situation.
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regulatory risk becomes one of the prominent risks for companies engaged in the trading of essential commodities. There have been numerous instances when government has imposed the restriction on free trade of certain agro-commodities so as to maintain the pricing and availability in the domestic market.
Govt. policies can easily change the competitive scenario, entry barriers, and profit margins for any industry. Recently, govt. of India has restricted exports of wheat as well as rice, which has impacted the traders of agro-commodities across the world.
An investor should be cautious while evaluating the profitability of such trading companies whose profit margins are supported by govt. policies like import restrictions. This is because any relaxation by govt. in such restrictions may wipe out the profit margins of such trading companies.
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Government also implements restrictions in imports/exports from time-to-time depending upon the prevailing market conditions. Import duties are often altered to align with the interest of the local industries. Such risk expose companies engaged in trading of essential commodities to regulatory risk further
For example, at times, the profit margins of palm oil trading companies are impacted significantly by the import policies of govt. of India.
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often, businesses engaged in imports of certain commodities such as Palm Oil etc. tend to benefit from an import-duty cover, wherein substantial proportion of the profitability is driven by such trade policies, resulting in fluctuation in earnings with change in policies.
Apart from the impact of regulation related to foreign and domestic trade, companies are also impacted by environmental regulations. This is especially true for trading companies dealing in environmentally sensitive products that may require numerous licenses/certifications as well as investments in pollution control measures.
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Environmental risk is factored in credit risk assessment of polluting sectors wherein the expected cost to be incurred towards mitigants in the form of pollution control certifications, effluent treatment measures, etc.
These regulations may increase the risk for the companies as well as may act as entry barriers to new players.
Apart from environmental regulations, trading companies face social risks as well. This is because other than raw material buying costs, personnel cost is the major portion of overall costs. The labour-intensive nature of the industry exposes it to social risks.
Rating methodology for specialized trading firms and wholesalers by Rating and Investment Information, Inc. (R&I), Japan, April 2023, page 4:
Specialized trading firms and wholesalers have a cost structure where fixed costs such as personnel expenses account for the greatest proportion of total cost.
In addition, trading companies also face political risks where regime change, social unrest etc. can hurt their business.
To mitigate political risk, companies may resort to taking political risk insurance, which protects them from the impacts of events like war, and blockage of funds by govts. etc.
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In addition, political risk insurance provides cover for events such as war, export restrictions, seizure or blockage of funds, prohibition of transfers in foreign currency among others.
5) Diversification brings strength to the business model of trading companies:
As trading companies face various risks in their business model as well as in the operating environment, they tend to bring diversification in their business along multiple aspects to bring stability to the business and reduce risks.
Trading companies whose operations are spread across different markets/geographies and across a wide range of products are better placed because it protects them from adverse developments in any market or in any product segment.
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entities having diversification in terms of product portfolio and geography are viewed favourably, as it insulates them from regional demand-supply issues, and economic cycles in a particular product or market.
Trading companies focusing on diverse products show relatively stable earnings because each of the commodities has its own demand cycle and exposure to various commodities smoothens the impact of such commodity cycles on the earnings of trading companies.
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Each traded commodity has its own demand-supply dynamics and trading patterns, we believe, the entities having the diverse trading portfolio where, there is no co-relation between the prices of each commodity (traded by entity) exhibits stable earnings.
For example, products belonging to natural resources and chemicals sectors see huge cyclical fluctuations in demand-supply and prices whereas those belonging to sectors like food have relatively stable demand-supply and price situation. Therefore, the presence of any trading company across sectors smoothens out fluctuations in its earnings.
Rating methodology for general trading firms by Rating and Investment Information, Inc. (R&I), Japan, May 2021, page 2:
The earnings of some business sectors including natural resources and chemicals are easily affected by fluctuations in market and economic conditions, and others enjoy comparatively stable demand, such as food and foodstuffs
Similarly, sectors like steel and paper are mature industries with stable supplier-customer relationships. Therefore, in these sectors, trading companies enjoy strong customer relationships and their market shares do not fluctuate rapidly. On the contrary, sectors like electronics and semiconductors see rapid technological change and customers keep changing suppliers based on their preferences leading to quick changes in the market composition. Therefore, a wide industry focus of trading companies will help them bring stability to their business prospects.
Rating methodology for specialized trading firms and wholesalers by Rating and Investment Information, Inc. (R&I), Japan, April 2023, page 4:
Companies such as steel trading firms and pulp and paper trading firms operate in mature sectors and have long-established business relationships with users in many cases. The risk of a company’s share of sales changing abruptly within a short period is comparatively small…In sectors such as semiconductors, electronic materials and functional chemicals, on the other hand, the pace of technological innovation is brisk and there is a possibility that commercial rights will become less stable.
Similarly, in sectors like natural resources trading, a company might have to make larger investments leading to longer payback periods in comparison to non-natural resources sectors where payback of investment might be quicker.
Rating methodology for general trading firms by Rating and Investment Information, Inc. (R&I), Japan, May 2021, page 3:
for investments in a non-natural resource sector, a firm frequently will seek recovery over a timeframe that is shorter than in the natural resource sector.
Even within a single sector, the stage of the supply value chain where a trading company operates may bring in diversification in its overall business. For example, in natural resources, those trading companies that operate in the upstream phase i.e. taking out the natural resources from the ground/mine and then selling to processing players enjoy long-term contracts with customers and therefore, some degree of customer stickiness.
Whereas, as we move further down the supply value chain, the competition in the trading business increases and customer stickiness decreases.
Rating methodology for general trading firms by Rating and Investment Information, Inc. (R&I), Japan, May 2021, page 3:
When general trading firms are positioned upstream in the value chain and their customers have been decided from the procurement phase, they enter medium-term agreements covering both prices and quantities and their transaction relationships are stable. Further down the value chain the number of competitors increases, and customer continuity and stability weaken as a result.
Just like diversification in geographical presence/markets and product segments, trading companies with diversification in their suppliers also benefit from a stronger business model.
If any trading company relies on a single/handful of suppliers, then even though it might get goods at a lower price as it may order large quantities from a few suppliers; however, it poses a big risk. This is because any disruption of operations at the supplier’s end will force the trading company to buy goods from the spot/open market to make deliveries to its customers. This would have a significant impact on its profitability.
Criteria for rating trading companies by CRISIL, October 2022, page 6:
Excessive dependence on a few suppliers can expose traders to business continuity risk. Though they can get discounts by ordering in bulk, it is preferable to have a diverse supplier base to prevent slowdown in business because of problems at the supplier’s end
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supplier concentration risk arising out of limited number of suppliers. The risk is particularly evident during supply disruptions at supplier’s end, where trading entity has to rely upon spot purchases to cater its customer commitments, exposing it to the price volatility risk.
Another important aspect where diversification plays a significant role for trading companies is customer selection. Trading companies work on very low-profit margins. Therefore, default by any single customer in making payments can wipe out the profit margins of a substantial portion of its business.
Criteria for rating trading companies by CRISIL, October 2022, page 5:
Customer concentration is a significant risk as during downturns delay in payment by a single large customer may lead to severe stress on the trader’s financial position.
Therefore, diversification across a large number of customers is beneficial for the sustainability of a trading company.
Customer concentration of a trading company may represent its inability to win new customers and therefore, may indicate very low bargaining power of the company on its customers.
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Customer concentration also indicates the limited bargaining power of trading entity against its customers.
Only those trading companies that are monopolies and deal in very niche commodities, which are very important for customers’ business can only survive with customer concentration.
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concentration risk can be alleviated for entities that are dealing in commodity catering to particular segment of customer (i.e. established niche). Typically, these are sole traders associated with global producers of niche commodity and catering to specific commodity needs of downstream customers or there are entry barriers in terms of knowledge of trading.
Still, investors must recognize the huge dependence of such trading companies on the fate of a handful of customers.
Also reading: Margin of Safety in Stock Investing: A Complete Guide
6) Integrated operations bring competitive advantages to trading companies:
Whenever trading companies integrate their business operations forward or backwards, they capture a larger portion of value addition over the supply chain, which improves their profitability.
Trading companies may enter into manufacturing/mining for backward integration leading to cost advantages over other peers who have to buy products from the open market.
On the other hand, trading companies do forward integration into supply chain/distribution by creating distribution assets like warehouses and transport equipment. When trading companies own distribution infrastructure, they are able to provide a better value to customers and in turn strengthen customer relationships leading to a higher bargaining power.
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integrate vertically by maintaining logistical assets such as warehousing facilities, storage and transport facilities. Higher level of integration helps traders to provide end-to-end solution to customers and garner better operating margins by catering services related to entire value chain. Further, providing incremental services improves the supplier / customer relationship
Having their own logistics infrastructure allows trading companies to meet the customers’ demand “just in time” and at the same time enjoy cost advantages over competitors.
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The entities with good supply chain management are more capable of understanding and meeting consumer needs better by offering the desired quantity and quality of the commodity at the desired price and time…Adequate transportation arrangements, either through own fleet or arrangement with other rail/road/shipping players gives an entity a competitive edge over others.
Methodology for rating general trading and investment companies by Standard & Poor’s (S&P), July 2022:
Strong distribution channels often act as an effective competitive strength.
An investor would appreciate that when any trading company goes for integration whether backwards or forward, its business model becomes more fixed capital-intensive. Then, the efficiency with which it utilizes its fixed assets becomes an additional evaluation parameter in analysis. This is because, if the company is not able to efficiently use its fixed assets, then it might be worse off than its earlier asset-light business model.
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the extent of integration, it also critically assesses the extent of investment made / required and return generated on those investments in terms of competitive advantage achieved. As a result, the traders achieving business integration with asset light model fare better as compared to the entities having asset heavy model.
Also read: Credit Rating Reports: A Complete Guide for Stock Investors
7) Large-scale operations help trading companies:
Trading companies’ business involves dealing in non-differentiable, commoditised goods with low to nil value addition. Therefore, their customers can easily replace one supplier with another taking away their bargaining power.
In such a situation, any commodity trader with a large size of operations benefits immensely from economies of scale benefits as it can lower its per unit overhead costs and as a result, it can gain cost advantages over its competitors in an intensely price-sensitive industry.
Rating methodology for trading companies by ICRA, 2012, page 3:
able to source products at competitive prices, spend less on logistics and provide quicker delivery of products.
In addition, trading companies with a large scale of operations may fill significantly large customer orders as well as procure large amounts of goods from suppliers, in turn, giving them some bargaining power.
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large-size trading entities have higher market share, which enables them to have relatively superior bargaining power with both suppliers and customer enabling them to earn relatively better trading margins over the period.
A large market share also makes such trading companies critical for the industry value chain. Customers and suppliers may face challenges in finding a replacement for a large trading partner, which increases the bargaining power of large trading companies.
Criteria for rating trading companies by CRISIL, October 2022, pages 4-5:
a trader with a large scale of operations (and hence, a considerable market share) is more critical to the value chain than a smaller entity, leading to more bargaining power with suppliers and customers, and consequently, better sustainability.
Large trading companies are able to better diversify their business operations and also have the financial strength to go for forward and backward integration leading to stronger business models.
Rating methodology for trading companies by ICRA, 2012, pages 1-2:
Apart from having a diversified portfolio, most often such players also strengthen their business through vertical integration measures.
As large companies benefit from geographical diversification; therefore, due to their superior market knowledge, they are able to take advantage of short-term pricing as well as demand/supply gaps across markets and earn a better profit margin.
Rating methodology for trading companies by ICRA, 2012, page 3:
companies with larger market share are able to generate higher margins over time by exploiting any regional discrepancies in price and short-term imbalances in supply and demand.
The greater financial strength of large trading players helps them in sustaining adverse business environments, economic downcycles and liquidity crises better than their smaller competitors.
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large scale of operations are viewed favourably since they are considered better equipped to withstand any external shocks.
Nevertheless, if companies grow too large, especially in commodity trading, then they face challenges of a different kind. If a global commodity trading company becomes so large that it becomes almost a market maker for any particular commodity, then it faces liquidity issues in the market because it is not able to find counterparties to quickly adjust/liquidate its trading positions.
Commodities trading industry methodology by Standard & Poor’s (S&P), July 2023:
having too large a presence in a commodity may ultimately prove detrimental: If a commodities trader “makes the market,” it may lack the flexibility to adjust its trading positions as market conditions change.
Also read: Self Sustainable Growth Rate: Inherent Growth Potential of a Company
8) Key parameters/ratios to analyse trading companies:
While analysing the business efficiency of trading companies, an investor may focus on the following ratios.
The operating profit margin (OPM) of any trading company provides a good benchmark to assess its competitive position. Companies with a strong market position and a higher bargaining power over customers and suppliers would have a higher OPM than competitors.
Criteria for rating trading companies by CRISIL, October 2022, pages 4-5:
CRISIL Ratings also compares a trader’s operating margin with that of its peers because it will reflect its bargaining power and market position.
Trading companies invest a significant amount of money in working capital; therefore, measuring the efficiency of working capital management becomes very important. Investors may assess parameters like inventory turnover/days, receivables days or the cumulative parameter of gross current assets (GCA) days.
Criteria for rating trading companies by CRISIL, October 2022, page 7:
An indicator of working capital intensity, GCA days signify how quickly an entity can convert its current assets into cash. A large value signals either inability to sell inventory or stretched receivables.
Similarly, an assessment of the overall operating cycle is also very helpful in assessing the working capital efficiency of a trading company.
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Elongating trend in the operating cycle indicates that higher capital is being blocked in funding inventory or debtors.
An inefficiency in inventory utilization i.e. inventory losses due to obsolescence or commodity price decline or mishandling and inefficient collection of receivables from customers may have a very significant impact on the financial position of a trading company.
Therefore, while doing a risk assessment of any trading company, it is essential to understand the maximum loss that it can face on its inventory or receivables. Thereafter, an investor should look at the net worth (tangible) of the company (called risk coverage) to assess whether it would be able to survive if the maximum anticipated risk materializes.
Criteria for rating trading companies by CRISIL, October 2022, page 7:
Risk coverage is designed to assess how well a trader can absorb unanticipated shocks due to fall in commodity price or stretch in receivables, without materially impacting its financial position.
Risk coverage = Tangible networth/ (Potential loss on inventory + Potential loss on receivables + Potential loss on forex exposures)
Trading companies, especially those dealing in commodities with very fluctuating prices, need to have a large net worth to survive through down cycles of commodities.
Criteria for rating trading companies by CRISIL, October 2022, page 5:
Traders of commodities with highly volatile prices, or with long inventory holding period, are expected to have a larger networth to absorb the impact of price decline.
Trading companies apart from directly taking bank financing for their working capital requirements, also take loans from promoters as well as discount receivables from customers (factoring). Some of these items may not reflect as debt clearly on the balance sheet; therefore, it is advised that investors should consider them as well while assessing the overall financial position of trading companies.
Rating methodology for trading companies by ICRA, 2012, page 4:
most of trading businesses in India being family run tend to rely on promoter funding (usually in the form of loans) in addition to bank borrowings. As part of working capital management, companies also discount receivables. In most cases, such trade receivable financing is not recognized on a company’s balance sheet.
Also read: How to do Financial Analysis of a Company
Summary
Trading companies operate in an intensely competitive environment due to low barriers to entry and low capital requirements leading to easy entry of new players. As a result, the industry is highly fragmented.
Trading companies usually just act as intermediaries between manufacturers and customers, doing very little value addition in between. Therefore, their products are non-differentiable from one another and customers can easily switch from one trader to another, which takes away pricing power from trading companies. Low pricing power coupled with intense competition results in low-profit margins for traders.
To gain customers’ business and be more value-adding than competitors, trading companies have to be ready to supply material “just-in-time” to the customers, which requires them to hold a large amount of inventory. In addition, they have to give a longer credit period to customers. This leads to a large portion of their capital getting stuck in inventory and receivables making their operations working capital-intensive.
Trading companies have to necessarily manage their inventory efficiently and collect their receivables on time. This is because, if companies are stuck with slow-moving or obsolete inventory and the price of the commodities declines, then due to low-profit margins, they do not have a large buffer to maintain profitability. Very soon, the inventory held by them becomes a loss-making resulting in an impact on their net worth.
Similarly, if a single customer defaults on payments, then it can wipe out profits earned by a significant share of their overall business. Therefore, it is essential that trading companies control their working capital as efficiently as possible.
Trading business faces high interference from govt. in the form of regulations like foreign trade regulations, minimum support price, storage limits etc. as well as by direct participation of govt. in the market as a buyer/seller to maintain prices and supply of products, especially essential commodities.
Most of the time, tariffs (import/export duties) are levied to protect domestic industry helping domestic traders against cheaper imports, which might be one the biggest contributors to their profit margins. Investors should be cautious in their analysis because any change in such govt. policies may take away the profit margins of traders.
Govt. policies play a major role in the competition levels, profit margins, entry barriers etc. in each segment of trading business. Business situations for traders can change overnight (stroke of a pen risk).
To protect themselves from adverse regulations as well as fluctuating commodity price/demand cycles and regional economic cycle variations, traders who are diversified by presence in various markets and cater to wide product portfolios enjoy relatively stable earnings.
Similarly, diversification in suppliers/procurement sources as well as customers brings stability and sustainability to a trading company’s business model.
Trading companies that are large and integrated players with manufacturing or distribution assets are more critical and higher value-adding for the market. Therefore, they enjoy a higher bargaining power over customers and suppliers than their smaller peers. It leads to cost advantages, which helps in higher profitability.
Large trading companies also have a higher financial strength to face downturns. They are also able to bring in better diversification and integration in their business, thereby, improving sustainability.
In order to assess the strength and efficiency in the business model of a trading company, an investor should analyse it operating profit margin, and working capital efficiency ratios like inventory turnover, receivables days, gross current asset days, operating cycle etc. She should analyse the risk cover indicating whether the company has a sufficient net worth to take a hit from inventory loss and bad receivables.
In addition, the investor should be careful in assessing the leverage of the company by factoring in loans from promoters as well as off-balance sheet items like receivables discounting.
Therefore, an investor should always keep in mind these multiple aspects of trading companies to understand their business position.
- Intense price-based competition due to a fragmented industry
- Very low pricing power leads to low-profit margins
- Working capital-intensive nature of business
- Efficient inventory management and timely collection of receivables is the key to success
- Very high risk of changing govt. regulations
- Diversification strengthens their business model
- Integrated operations bring competitive advantages
- A large scale of operations makes their business model stronger
- Profitability, working capital efficiency and leverage ratios are essential for an analysis
We believe that if an investor analyses any trading company by keeping the above factors in mind, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
Disclaimer
Registration status with SEBI:
I am registered with SEBI as a research analyst.
Details of financial interest in the Subject Company:
I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.
