Working Capital Considerations in B2B Commerce

In India and SEA, ~USD3.5B of capital has been invested in B2B Commerce platforms over the last 4 years. The thesis for these investments is that there is a fragmented ecosystem of SMEs and MSMEs on the supply side (i.e., that manufacture and distribute goods) and on the demand side (i.e., that sell to end consumers) and that there is scope for using technology to:

(a) make this supply chain more efficient (e.g., by removing a few of the middlemen);

(b) provide a higher quality of service (e.g., by improving fill rates and delivery timelines); and

(c) enable the SMEs and MSMEs in the ecosystem to access credit (by providing banks/NBFCs better quality data based on the data flowing through the supply chain).

The margin opportunity for the technology player lies in being able to: (i) earn a margin for cutting down a few layers in the supply chain; (ii) charge for the higher quality of service; and/or (iii) charge for the financial services offering.

Evaluating B2B Commerce Platforms

Piyush Kharbanda, partner at Vertex Ventures has a must-read piece on the 3 considerations that form part of his framework for assessing B2B commerce platforms:

1. Margin Structure: The true definition of margins in B2B Commerce is Logistics-adjusted and Net Working Capital-priced Gross Margin.
2. Operating Leverage: A key criteria in assessing a sound B2B Commerce business should be the speed of customer account growth with no growth in account managers.
3. Credit versus Commerce: Is the real value capture from lending/financial services or commerce. If it’s the former, investing in a lending play makes more sense than a commerce play, which eventually hopes to make money from lending.

I thought it might warrant a deeper dive into the (often elusive) nature of margins in the B2B Commerce business, given that working capital considerations are often not fully factored in while evaluating B2B Commerce businesses.

Margin Structure

Let’s evaluate a fictitious company in the B2B space that is in the business of buying and selling of construction materials. Here is the summary P&L (all workings that form part of this piece are laid out more clearly here):

#1: Summary P&L for our Company

The market size is large and the company is growing steadily month over month. It has been able to improve Gross Margin meaningfully since inception with a path to 12% Gross Margin in the next 2 years. So far, so good.

How does working capital change the way we look at this company?

Working Capital

Working Capital is Current Assets (cash, accounts receivables, inventory) minus Current Liabilities (accounts payable, short-term liabilities). The traditional wisdom on working capital is:

Response from ChatGPT to the prompt “What is working capital?” (May 1, 2023)

If you ask ChatGPT to go deeper, this is the response:

Response from ChatGPT to the prompt: “What is a healthy metric for working capital?” (May 1, 2023)

So let’s look into the B2B construction company’s working capital metrics to see what it says about it’s overall financial health. In my view, there are 3 additional factors that deserve to be evaluated:

(1) Build-up of Receivables: Accounts Receivables (AR) is the amount of cash the company has to receive from companies that it is selling materials to. Below is the chart that shows how AR has been growing vis-a-vis GMV:

#2: Growth of GMV versus Growth in Accounts Receivables

AR has grown 24x in a 1-year period versus GMV which has grown 16x. In simple words, this means that the Company is recognising GMV but is not seeing cash come into the business at the same rate. This is a red flag and deserves further diligence for the following reasons:

1. Growth in AR could indicate an inability to pay on the part of the company’s customers. This is not uncommon if the Company’s buyers are SMEs since churn in the SME space is quite high. Such churn would make the AR unrecoverable.
2. There might be a dispute in terms of the quality of products the Company is selling. Such disputes could also make some part of the AR unrecoverable.
3. The segment that the Company is selling to might have a long recovery cycle from its end customers (e.g. contractors for the B2B Construction company might be working on government projects that have a much longer project cycle and therefore a longer cash cycle at their end).

When faced with data of this sort, it is useful to conduct a DPD (Days Past Due) analysis to arrive at an assessment of how much of the GMV should be written off as unrecoverable since it is 60–90 DPD. So, as an example, if the DPD analysis looks like this:

#3: DPD Analysis for the Company

Of the pending receivables, 10% is more than 60 days overdue. This means if the Company is giving credit terms of say 30–45 days, these bills have not been paid to the Company for more than 90–125 days after GMV has been recognised. If we assume that this 10% is not going to be paid back and use that to discount the GMV for the Financial Year, it will impact profitability. Suddenly, the Gross Margin% does not look as attractive as it was previously.

#4: Recasting the P&L Assuming a % of the AR is Unrecoverable

(2) Industry Standard for Credit: Another consideration while looking at the working capital cycle of a B2B Commerce company is understanding what the industry usually operates at and whether this company is extending credit beyond industry standards.

For example, in the FMCG space it is usual for a distributor to extend 7–10 days of credit for certain brands. If the B2B Commerce Start-up is extending a longer tenure, we need to understand what gives the Start-up the ability to extend better terms. Is there, for instance, a bank partnership at the back-end that is fuelling a low-cost credit line? If there is no structural advantage, it might be worth asking: are the buyers buying from the Start-up only for this extended credit period? Once this period is shortened, will the buyers revert to their original source of supply?

(3) Cost of Funding Working Capital: Finally we come to the cost of funding working capital and how that impacts margins. This requirement i.e., in simple words the money needed to fund the business is calculated as Accounts Receivable + Inventory — Accounts Payable.

Since the business is growing and AR is building up for the Company in our example, it’s safe to assume that the Working Capital Requirement is also increasing. The graph likely looks a little like this:

#5: Cash Needed to Fund the Business of the Company since AR is Building-up

The Company needs to borrow cash from financial institutions at a rate of around 1.5%-2% a month to fund its operations. If the dollar value of the amount of borrowing keeps increasing (because the requirement is increasing), the impact on the P&L as “interest expense” will keep getting larger.

#6: PnL Restated to Account for the Impact of Funding Working Capital

In addition, there are also very few lenders (whether in India or Indonesia) that are willing to fund working capital requirements without some form of security (fixed deposit, bank guarantee etc.) to early stage start-ups. So the issue is one of access to capital as well.

We remain bullish about founders and businesses that understand these complexities in the B2B Commerce space. If you would like to exchange notes on the space or add something to help us understand it better, do reach out.

The Indian landscape for B2B Commerce is maintained and updated by Stellaris Venture Partners here and we, at Saison Capital have created a similar list for Indonesia here.