How can a Low Margin business create value for stakeholders?
By being really efficient in using their assets.
If a low margin business can generate more sales using a lower asset base, it is likely to generate good ROE and ROCE.
Think of a trading business. A company buys steel from a steel maker, and sells it to a customer in another market.
This is essentially a business with thin margins. Sometimes margins can be as low as 1-2%.
Let’s say this company has an initial capital of Rs 100 crore, and uses this Rs 100 crore to buy inventory and sells it for Rs 101 crore. They make 1% gross margin. If they can recover the money fast, and repeat the cycle, that can create better value.
If they do this 6 times a year, they make Rs 6 crore Gross Profit, on an investment of Rs 100 crore. But if they are able to do this 15 times, the return on investment jumps to 15%.
DMart is a classic example here. With nearly 8% OPM, the high inventory turnover (nearly 12-14x) ensures good return ratios.
If however the working capital cycle is longer, where receivables or inventory is high, it means the firm is either taking time to sell the inventory, or taking time in collecting money. This inefficiency is what destroys value.
Remember, some businesses have low margins. For a firm that operates in a low margin / highly competitive business environment, such as trading/ retail, working capital management is super important. The more number of sales cycles it can achieve in the year, the more return it would generate on its initial investment.
Happy New Year
This is our last newsletter of the year!
We hope 2022 was a fabulous year for you, and 2023 brings even more happiness, cheer and adventure.
We have a lot lined up in the coming year. Some new courses, new content on various platforms, competitions and much more. As always, do keep writing to us with your thoughts and suggestions.
Wishing you a very Happy New Year.
See you in 2023!