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  • Rohit Musale, CFA

How to Spot an Incredible Business

When I am investing in the stock market, my goal is to identify an incredible business.


If I am investing in an incredible business, I am going to get incredible returns.


Two things I have identified about a business, which tell me whether I am dealing with an incredible business or an average business:


1) Cash Conversion Cycle


Let's say I own a manufacturing business.


I need raw materials to create the finished goods.


Let's say, on day zero, I order raw material from my supplier.


That supplier supplies me the raw material, and is okay to accept payment from me after 90 days.


I have to pay him after 90 days.


The supplier is willing to give me the goods on these terms.


I have got the raw material now.


And I can pay him after 90 days.


Once I get the raw material, let's say, it takes me around 30 days to process that raw material and create the finished goods.


It takes me another 15 days to sell those finished goods in the market.


And then it takes me another 15 days to collect my receivables.


Customers pay me after 15 days from the moment they collect the finished product.


So, my inventory period is 30 days and my collection period, after I have sold the items is another 30 days.


I am getting my money back in 60 days.


However, I have to pay to my supplier in 90 days.


30 days before I have to make a payment, I have already got back the money.


This money, I can keep it in a bank and earn interest on it, right?


This is called as the cash conversion cycle.


Every business goes through this kind of a cash conversion cycle.


This is called as a negative cash conversion cycle.


Inventory days plus receivable days, minus the payable days.


I am looking for these kinds of businesses, where the cash conversion cycle is negative or in short, I am getting my payment from my customer, before I have to pay to the supplier.


You might ask, why would the supplier accept the 90 day credit period.


It is because, I have established such a brand in my business that, my supplier shows trust in me, and he knows that, I am going to make the payment after 90 days.


Even if it is 90 days, he is okay to wait.


He is confident of getting paid.


I have products with a very good brand equity.


So, I am going to collect money from my customer.


My supplier knows that.


So, he waits.


He sticks with me and doesn't go to my competitor.


It’s all about brand value and bargaining power.


Dr. Lal PathLabs in India is one such business.


I think Nestle and Colgate too, fit the criteria.


2) Inventory Turnover Ratio


If my revenue is INR 1,000 crore and my inventory is INR 100 Crore, my inventory turns over 10 times each year.


If you look at companies like VST industries, which is a cigarette manufacturing company, their inventory turnover ratio is roughly four.


Their entire inventory turns over only four times in a year.


If you look at companies like Dr. Lal PathLabs, their inventory turnover is more than 15.


The faster your inventory turns over, the more profit, you are likely to make.


And the faster you are converting your invested capital into profits.


I want to look at a business where inventory is turning over, fast.


My capital is not getting stuck in my business.


In the case of VST industries, for an entire quarter, my inventory remains in the business.


I have to wait that entire quarter.


That's the cash conversion cycle.


One cycle is like one turnover.


I want this cycle to happen, over and over again, in a given year.


The more times it happens, the better it is.


My capital is not getting stuck in the business.


Regards,


Rohit Musale, CFA


3 January 2023

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