Profitability : Textile ( Retail )

Your client is a leading textile company in India. Recently it has been experiencing a decline in its return on capital. Could you analyse why?

I would like to begin by understanding more about the company and its products. What geography does the company cater to? Could you please tell me about its product portfolio?

The client sells different types of menswear and womenswear through retail outlets. Their stores are spread out across India, mostly in Tier-1 cities.

Alright. So that implies that the client buys clothes from wholesalers and sells it to consumers through retail outlets, is that right? Is the decline related to a particular store or region?

Yes, the client procures from suppliers and sells to final consumers. The decline is across all the stores in India.

Noted. Do we have any information about the quantum of the decline and since when this happened?

There has been a 4% decline in the last year.

Are other players in the industry facing this same issue?

No. It seems to be a problem specific to the client’s firm.

Right. Are we considering the returns to just the equity shareholders or the overall return to the firm?

The decline is based on the overall long-term capital.

Great! I would now like to dive into the case and structure it to get to the bottom of theproblem. I will begin by breaking down Return on Capital into its component parts: Operating Profits and Capital Employed. Next, I will identify which of these are a problem and further look into factors that may have changed to alter either of these. Would you like me to proceed in this way?

Yes, that sounds like a good start. Why don’t you go ahead?

Since ROC is a function of profits and capital, I would like to know if the profits have decreased, or the capital has increased or both.

The capital employed by the firm has increased.

Okay. This implies that the firm is requiring more capital than last year to earn the same amountas operating profits, am I correct?

Yes, that is right.

To analyse why more capital is being used to generate the same profits, I would like to break down capital into its constituents. If we look at which assets are being financed, we can divide the capital into two parts- fixed capital and working capital. Fixed capital is the permanently deployed capital in the business, that would have been used to fund the land, buildings, machinery and other such assets of a long-term nature. On the other hand, working capital is used to meet the day-to-day operational cash requirements of the firm. Can we compare the balance sheet as on date with last year to understand if one or both of these components have increased?

That’s a good idea. On comparing the two balance sheets, we find that the working capital invested in the business has increased.

Right. Since working capital equals current assets less current liabilities, we can further break down working capital by analyzing current assets and current liabilities separately. Current assets would include cash and bank, inventories, trade receivables, prepaid expenses, short-term investments, and advances. There can be other elements as well, but I am assuming these are the major heads. Is this assumption valid?

Yes, you can proceed.

Great. Similarly, we can segregate current liabilities into trade payables, short-term loans, accrued expenses, bank overdrafts and unearned revenues.The next step would be to find out if any of the constituents of current assets or current liabilities have seen a pronounced change from last year. Alternatively, multiple constituents might have changed in small amounts resulting in a large aggregate change. Do we have numerical data that can help confirm either hypothesis?

From the balance sheets once again, we can say that there is a stark difference between the trade payables in the two years.

For working capital requirement to have increased, trade payables would have to fall given the relationship defined earlier. Now we could look into possible reasons why the firm’s creditors have decreased. Can I proceed with this approach?

Sure, go ahead.

Some reasons why this might happen are as follows:-

First, the firm’s suppliers might have changed, and the new suppliers have allowed a smaller period of credit than the earlier ones. However, this would have possibly had an impact on the cost of goods sold as well and thereby the profits, unless the price levels between suppliers are fairly similar.

Second, the existing suppliers might have changed their credit terms resulting in a shorter credit period and thereby lesser payables.

Have either of these events occurred?

Not really. Are you aware of how credit terms are framed in such contracts usually? Maybe that could help you pin-point the issue.

From what I know, suppliers usually allow retailers a certain period, say ten days, within which they have to make the payment for supplied goods. If the retailer makes the payment before that, he may be eligible for a cash discount, which is calculated usually as a percentage of the purchase price.

Correct. So what might have happened here?

The client may have changed its policy of payment to the suppliers. Earlier, the client would have been paying them the dues beyond the stipulated payment period. However, to avail the cash discount this year, the client could have reduced the credit period. In all probability, the benefit from the cash discount was outweighed by the increased working capital requirement as a result of the decrease in credit period from the suppliers.

Alright. That makes sense. Let us wrap it up here. Thank you.

Thank you. It would a pleasure interacting with you.

Interviewee Notes 

• It is important to understand whether the cause of decline is due to profits or capital.

• Balance Sheet structure and retail-specific purchase contracts need to be focused on

• Decline is because of higher working capital requirements. 

• Trade payables have reduced due to change in firm’s policy towards supplier credit terms.

Case Facts

• Leading textile company in India (retail)

• Decline in return on capital (4% decline last year)

• Problem specific to the firm and not industry

• Focus on overall return on capital (not equity)

• Capital employed by firm has increased

Recommendations

• Shift back to the old policy of the extended credit system rather than availing the cash discount.

• Another alternative is to negotiate with the suppliers in order to extend the period within which cash discount can be availed.

• Negotiate with customers in order to reduce trade receivables or avoid selling before payment (zero-debtor policy). This would free up some working capital.

Observations / Suggestions

• It is important to be aware of the different components that constitute capital.

• Textile industry-specific knowledge could help to ascertain forms of contracts and thereby reasons for the decline.