Credit Analysis of Trading Companies

In India, trading businesses have traditionally been dominated by a wide number of small unorganized players, largely in the form of family run businesses. Barring a few sectors such as oil & gas and energy, most of the trading business segments are extremely fragmented. However, the participation of organised players has been increasing gradually with relaxation in Government’s trade and investment policies. Some of the organised players have strong parentage, including large global players, that has recognized India as an important emerging market and its positioning in the global commodity trade. Besides having benefits of diversification, such players benefit from the strong risk management practices, deep understanding of global commodity markets and ability to withstand inherent business risk, given the considerable parentage support

A trading entity faces plethora of risks relating to price fluctuations, foreign exchange fluctuations, counterparty risks as well as market risks relating to competition, change in government policies etc. Risk management is a dynamic process and wholesale trading entities need to be prepared for constantly managing both physical and financial flows to sustain their business position over the longer term. The risk management systems should broadly encompass management of operational risks, commercial position, and financial position of the entity.

Moreover, despite challenges, the?trading?segment is essential for the economy as the?trading?segment as a whole serves important function 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.? 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.

Key factors influencing the business of?trading?companies

Intense competition        

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. 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. The intense competition by numerous players fighting for customers’ business impacts the bargaining/pricing power of?trading?companies.?

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. As a result, a customer can easily switch from one?trading?company to another while sourcing any product.

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.

This low switching cost gives a very high bargaining/pricing power to customer. Consequently,?trading?companies primarily compete on price to customers’ business leading to low profit margins.

Limited value addition and?commoditized nature of business?mean?margins are thin?for traders. As a result of non-differentiable and commoditized 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.

Working capital-intensive         

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. The bulk of their balance sheet assets comprises inventory and receivables, with fixed assets forming a small part. Due to high working capital-intensive operations, trading companies primarily rely on working capital debt from lenders to run and grow their business. 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.

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.

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.

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.        

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.

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. 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.

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. 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.

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. 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. 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. 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.

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. 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.

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.

?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. 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.

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.

Risk of Government 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. 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. 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

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. These regulations may increase the risk for the companies as well as may act as entry barriers to new players.

Diversification         

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.

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.

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.

?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.

?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. Therefore, diversification across a large number of customers is beneficial for the sustainability of a trading company. Customer concentration also indicates the limited bargaining power of trading entity against its customers.

Integrated operations         

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?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.

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.

Large-scale operations        

Trading?companies’ business involves dealing in non-differentiable, commoditized 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. 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.

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. 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.

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.

MANAGEMENT PROFILE        

All CAM necessarily incorporate an assessment of the quality management, as well as the strength and weaknesses. In case, the company is among the stronger entities within the group, its past track record and future plans in supporting other group companies are analyzed. Resourcefulness of promoters also plays a key role in assessing the creditworthiness of the entity. Usually, a detailed discussion is held with the management to understand the business objectives, plans and strategies, besides the outlook on the issuer’s industry.

Some of the other points assessed are:-

• Experience & Commitment of the promoter/management in the line of business
• Management’s policies on leveraging and hedging commodity & foreign exchange risk
• Growth plans, investments/acquisition plans in new areas/projects
• Business & Financial strengths of other companies within the group

Apart from quality and experience of management, assessment of corporate governance, quality of financial reporting and information disclosures are given considerable weightage while assigning ratings. The assessment of these factors can be highly subjective and variable over time. Ratings may include additional factors that are difficult to quantify or that only have a meaningful effect in differentiating credit quality in some cases.

INDUSTRY REVIEW        

• Characteristics
• Key Factors
• Linkage with Global Market, if any
• Performance
• Outlook

Depending on the company profile, whether in single product or multiple products, the major industries are evaluated in terms of characteristics like whether fragmented or being managed by few players and the key factors in terms superiority or limitations. It is also evaluated as to whether the particular industry is domestic oriented or it has linkage with the global market, in which event the demand-supply situation and its implications in the overseas front impact the particular industry.

Key parameters/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.

Trading companies invest a significant amount of money in working capital; therefore, measuring the efficiency of working capital management becomes very important.

Analysist may assess parameters like inventory turnover/days, receivables days or the cumulative parameter of gross current assets (GCA) days.

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.

?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 Analysist 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.

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.

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 Analysist should consider them as well while assessing the overall financial position of trading companies.

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.

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. Analysist 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, a credit analysist should analyze it operating profit margin, and working capital efficiency ratios like inventory turnover, receivables days, gross current asset days, operating cycle etc. She should analyze 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 Analysist 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, a credit analyst 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

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