Managing Working Capital Amid Product Shortages
Distributors can't seem to catch a break. First they faced a liquidity squeeze when COVID-19 raged onto the scene, triggering a dislocation in the supply and demand for products. Now, as they enter the third year of the pandemic, distributors are grappling with wide-ranging shortages of goods and commodities across the supply chain that show no sign of abating.
The reasons for these shortages vary and are well-chronicled, but a critical question remains: How can distributors manage their strained working capital? To understand the alternatives at hand, let's examine what the current situation is forcing many distributors to do.
Rethinking Inventory Management
Product shortages are spurring an inventory management shift away from just-in-time(JIT) and toward just-in-case (JIC). Many distributors have abandoned their effort to minimize inventory—by which they reorder products only to replace the ones they've already sold—and are instead stockpiling products just in case they need them.
Underlying this shift is the realization that any cost savings and efficiencies achieved through lean inventory would be more than offset by lost sales opportunities due to the unpredictable time it could take to replenish stock amid shipping delays and product scarcity.
We predicted the shift from JIT to JIC in 2021 when shortages began to percolate across supply chains globally. Yet even we have been surprised by the extent of the shift: Not only are products being hoarded, but also warehouse space.
As widely reported, logistics companies are devising new methods of dealing with a dearth of storage by choosing inland locations away from coastal ports—and by building multi-story warehouse facilities.
Inventory is now "in."
Implications for Working Capital
The strategic decision to pursue JIC and increase buffer stock amid product shortages certainly has benefits, but it can also weigh on a company's finances.
Apart from the cost of maintaining additional storage capacity, JIC usually entails longer inventory carry (the amount of time inventory is held on the balance sheet), longer inventory turn (the time it takes to clear the shelves through sales) and longer cash-conversion cycles until the items are finally paid for and monetized.
Consequently, many distributors who embrace JIC could find themselves making larger cash outlays to their suppliers while having to wait longer for repayment from the buyers to whom they sell their products. They thereby experience greater pressure on their working capital.
Optimizing Working Capital
With the increase in inventory, distributors will look for levers to pull in order to reduce their cash conversion cycle as much as they can.
One strategy is to match their inventory turn with payables and receivables by trying, through negotiation with their counterparties, to extend the timing of payments they owe their suppliers when the number of inventory days goes up. But suppliers face similar liquidity pressures and may not be willing or able to accommodate later payments.
An alternative for distributors is to enroll in a traditional supply chain finance program—assuming one is available to them—that would allow them to sell their receivables to a program provider (such as a bank) in exchange for immediate cash.
The program provider would then collect payment from the buyer at the later date in accordance with the payment terms established between the buyer and the distributor.
Yet given the high uncertainty surrounding product availability, demand, inventory turn, and the pace at which inventories can be replenished, distributors must contend with variability in cash flow.
Enter Dynamic Discounting
Fortunately, supply chain finance programs have been evolving to include options such as dynamic discounting, which gives a buyer the flexibility to choose when to pay its supplier in exchange for a lower price or discount on the goods purchased. The "dynamic" component refers to the option to provide discounts based on the date of payments.
Uneven supply/demand a benefit
Dynamic discounting can work particularly well for uneven supply/demand patterns, which favor contractual payment terms that are more flexible and may help distributors increase their net income by optimizing their working capital.
Of course, there are also distributors who are resilient enough to withstand product shortages and the supply chain issues they're causing. But those who are feeling the pinch will need to find solutions for husbanding their capital wisely in anticipation of continued shortages in the foreseeable future.