Understanding the source of profits

Doing business in India is not easy. Indian entrepreneurs have to deal with an overbearing excessive bureaucracy, infrastructure bottlenecks, archaic labour laws and scarcity of capital. Many Indian entrepreneurs have built successful businesses despite these challenges. Due to the high cost of capital, Indian companies have learned to do more with less and have one of the highest rates of capital efficiency in the world. The capital efficiency of Indian companies, as measured by Return on Invested Capital, is 12 per cent compared with six per cent for Chinese companies.

Despite Indian companies’ ability to generate high return on capital, it is not evident if Indian management teams always know the true source of profitability. Questions such as who is your most profitable customer and which is your most profitable business segment are rarely answered convincingly by management teams. While some of the largest Indian businesses have been built by the founder’s passion and persistence, I believe these factors will not be enough to compete in the current environment.

Several examples illustrate the perils of not knowing where the profits come from. One company was generating negative operating margins from domestic customers, who were effectively being subsidised by international customers. Soon enough the company ran into financial problems, which prompted the management to take a deeper look at its customer base and source of profits. With great reluctance, the management team had difficult conversations with domestic customers and stopped providing them with its services. Fortunately, this shift in focus towards international customers allowed the company to get back to strong profitability from the brink of bankruptcy.

Another company had generated a strong track record of growth, but lacked systems to measure the quality of receivables in their evaluation of project profitability. After going through the pain of significant write-offs of receivables, the company has now moved to a project evaluation system that incorporates the likelihood of payments and their timing in project pricing. Not surprisingly, the receivables are now well under control. While these problems are easy to diagnose and fix, in our experience, these challenges are endemic across small and mid-sized companies in India. The main reason is that in these entrepreneur driven businesses, the entrepreneur/CEO is used to running the business on gut instincts, not with data.

Of course, in certain circumstances, there may be strategic reasons to justify loss making customers or business segments. But it is important for management teams to understand the financial impact of such ‘strategic’ decisions.

I believe private equity and venture capital investors can play a significant role in helping entrepreneurs and management teams who lack financial acumen. Below are some steps:

1. Ask your investee or potential investee companies questions like where’s the profit coming from? Very often, the answer will be fairly simple. In cases where the answer is not clear, help your companies find the answer. A basic analysis of the costs will often yield surprising results. If the company is unable to even roughly estimate the sales and profits associated with important customers/projects/segments, the company may significantly benefit from an improvement in internal systems and processes.

2. As a private equity investor, understanding of financial matters is your strength. Play the role of the financial sounding board for your “big picture” CEO. Let this be one of the value-add you promised the company.

3. Understanding how a company prices its projects or services provides a good sense of the financial literacy levels of the management team you are about to invest in. Beware of pricing traps such as excessive focus on gross margins. Focus on the return on capital. Educate management on the same.

4. Identify management teams that can marry “big picture” thinking with sound financial understanding of their business. Despite my general criticism of the lack of financial awareness of Indian entrepreneurs, several management teams show an exceptional understanding of where they make money. Find such a team and invest in them.

5. Educate the management teams regarding the difference between a CFO and an accountant. Several large Indian companies tend to undermine the role of a CFO and primarily require them to perform an accountant’s role. A CFO should play the critical role of ensuring the CEO’s strategic thinking ties in with long-term financial benefits for the company. Ensure that the management team has resources that can play the role of the CFO. If not, go hire them.

I believe Indian businesses are set to play a larger role on the global stage in the next decade. Indian management teams have developed skills of operating in resource constrained environments and are thus most likely to succeed in a globalised market place. However, the success of these businesses will largely depend on how well they learn the lessons of sound financial management.

(Amit Mantri is an associate with Zephyr Peacock and part of its investment team in Bangalore.)

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