Seeking Moats: Efficient Working Capital

Navigating the building blocks of moats

This write-up is a follow-up to the previous two articles covering moats: 'Seeking Moats: Higher Price' and 'Seeking Moats: Lower Costs.' In this one, we will be going over the final competitive advantage: efficient working capital.

I wrote an article called 'Profit Realities' that covered some aspects of this advantage, and suggested that efficient working capital can be a significant advantage that it can compensate for tighter margins. That article explained the main outcome of having efficient working capital: a low cash conversion cycle. With a well-structured working capital framework, it can create a compounding cash machine. In this one, we will show how a company gets there through the following three drivers: experience, economies of scale, and network effects.

Experience

Have you ever wondered how the big players in the market have so much leverage when it comes to pricing and terms? It’s quite obvious that they wield power due to their size and scale (i.e. experience).

For example, if you have a bread business and you approach SM Retail or Puregold, they will likely negotiate hard on several fronts: price, payment terms, and other placement fees. Why? Because they buy in bulk and possess the experience to move your product through their vast network of stores (network effects are another aspect we'll discuss in the final driver). When they first started their businesses, they probably lacked this power and experience to negotiate with suppliers, but as those companies grew, they realized they could dictate terms. As they gained experience and started to scale, per-unit costs dropped (which includes fixed administrative and marketing expenses), and working capital gaps decreased, leading to a shorter cash conversion cycle and more efficient working capital.