The corporate sector clocked bumper profits in the September quarter (Q3) of 2020 mainly due to significantly lower spending on inputs compared to sales, according to the Centre for Monitoring Indian Economy (CMIE). Both sales and expenses plunged sharply during the lockdown quarters of June and September 2020, Mahesh Vyas, Managing Director and CEO, CMIE, said in an article, adding that expenses fell more sharply than sales did during the said period, which helped the corporate sector record bumper profits.
Purchase of raw materials and finished goods for resale accounts for the bulk of the cost structure of non-finance companies.
"Traditionally, its share has been well over 50 per cent," Vyas notes, while stating that if expenses on account of these grow at a slower pace than the growth in sales, it has a huge impact on profits.
"In the past two recessionary quarters when business has shrunk, the fall in expenses on raw materials and finished goods was significantly greater than the fall in the topline. The profits, therefore, did not shrink and in fact grew even though the business shrank," the CMIE chief says.
But, how can the growth in expenses on raw materials and purchased finished goods be lower than the growth in sales?
This, Vyas explains, can happen because of one or a combination of more than one of the following three factors: -
1. A shift in the terms of trade
2. By a drawdown of inventories, or
3. Through efficiency gains.
Elaborating on the first factor, he says that a favourable shift in terms of trade implies that the prices of raw materials and purchased finished goods rise at a slower rate compared to the increase in prices of the corresponding goods, sold, or they fall at a faster rate compared to the fall in prices of goods sold.
Talking about the second point, Vyas notes that in times of uncertainty such as the kind faced by the corporate sector during the lockdown, companies would prefer to use the raw materials and purchased finished goods available in their stock and not replenish them till these are drawn down substantially and the uncertainty of the business environment reduces.
During the lockdown, the logistics cost of replenishing stocks could have increased and this could be the cost companies would try and avoid which would directly lead to a fall in raw material and purchased finished goods stock. However, companies would try their best to sell in a difficult market to meet their fixed costs, this, Vyas says, positively impacted profits in the September quarter.
The third factor of efficiency gains usually plays out over the long run. "Efficiency gains are obtained by companies engineering structural changes including inventory management to reduce the effective working capital cycle," the CMIE chief remarks.
Speaking of the impact of a shift in terms of trade, Vyas says, manufacturing companies gained from favourable terms of trade in the September quarter. "The wholesale price index of manufactured products rose y-o-y by 1.19 per cent... Manufacturing companies had favourable terms of trade even in the June 2020 quarter. Prices of manufactured goods fell by 0.03 per cent...," he adds.
The companies have been drawing down inventories for two consecutive quarters, consequently, the need to replenish in the coming quarters will be correspondingly high, Vyas notes, adding that this could mean that sales growth would be lower than growth in expenses on raw materials and purchased finished goods.
The lockdown, he says, has taught business managers lessons to manage with lower stocks.
"We say this with some confidence because historically, companies have been systematically reducing the ratio of raw materials and purchased finished goods to sales," Vyas states.
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