Often, my friends and my blog readers ask me the question “Tell me the one parameter you value the most while analyzing a stock idea?” I tell them that normally the stock analysis process involves a step by step in depth analysis of quantitative ratios and quality of business and it is very difficult to pin it down to one particular aspect. But this unanswered question kept on bothering me and I decided to look within myself and find the answer.
I give a lot of weightage to quantitative ratios such as ROE, ROCE and Growth. But eventually how can companies improve on their ROE or ROCE? Companies usually adopt multipronged strategies such as improving operational efficiency, carrying out financial re-engineering and improving quality of business. Among all these approaches, what really leads to a multibagger situation is when there is a genuine improvement in the quality of business. Now again, how does one come to know that the underlying business quality is improving? Afterall, we are not domain experts in each and every field of business. How does a common investor approach such a situation?
How would I tackle such situations? I have realised that any improvement in the quality of business can be identified by observing the behaviour of the customers for that particular business. So who are these customers? For example, the distributers who distribute the company’s products can be classified as primary customers of the company. How and when the distributers pay to the company is a true reflection of the strength and demand for the company’s products, which is reflected in the debtor days.
If we track the debtor days, we can have a prima facie view of the underlying quality of business. Companies with lower debtor days typically command higher valuations. Let us take the example of Nestle India.
Nestle India, a subsidiary of the Swiss multinational food and drink processing conglomerate Nestle, operates in the Fast-Moving Consumer Goods (FMCG) industry. Since this sector is characterized by high volume but relatively low-margin products, having lower debtor days is highly crucial as this would mean that the company is more efficient in converting its sales into actual cash in a shorter period. This is particularly important in Nestle’s case, where efficient receivable management and subsequent cash inflow significantly impact the company’s ability to reinvest in its operations, pay dividends, or reduce debt.
This is how lower debtor days lead to higher valuations for companies like Nestle India. The operational efficiency achieved from lower debtor days reduces financial risk and signals strong management practices, making the company more attractive for investing. Therefore, investors apply a premium to such companies that demonstrate superior cash management capabilities, as these companies are perceived to have a more stable and predictable financial outlook. Thus, Nestle India’s ability to maintain lower debtor days directly contributes to a higher valuation in the form of PE Ratio expansion, reflecting investor confidence in the company’s financial health and operational efficiency.
Consider the figure below which shows how Nestle India has maintained lower debtor days of 3-5 days range over a last 11 years.
But how do we know that Nestle India’s debtor days are low? Let us compare Nestle India’s debtor days to its closest competitor Britannia Industries. Consider the Debtor Days for Britannia given below.
It can be clearly seen that Nestle India’s debtor days are much lower when compared to Britannia. The subsequent impact of debtor days on valuation can be clearly seen in the following figures which show how Nestle India has sustained its high PE ratio over a certain period and how during the same period, Britannia Industries has witnessed a relatively lower PE and hence lower valuations.
From the examples discussed above, we can clearly see the impact of maintaining low and sustainable debtor days on investor perception and subsequent impacts on stock valuations.
How does the efficiency reflected by lower debtor days translate into an upward trajectory for its stock price? Let us explore this with the help of an example. Consider Gokul Agro, a company engaged in manufacturing and processing of various kinds of edible, non-edible oils and meals. The debtor days of Gokul Agro are given below.
It can be clearly seen that in March 2016, Gokul Agro had high debtor days of 30, which means it took an average of 30 days to collect payment after a sale. This figure rose slightly to 33 days in March 2017, suggesting a temporary decrease in collection efficiency. However, from March 2018 onwards, there is a consistent decrease in debtor days, with a significant drop to 7 days in March 2022. Currently, although the company’s debtor days have risen slightly to 14, they remain very much lower than levels experienced from 2016-2021. This decrease in debtor days has boosted investor confidence and has ultimately resulted in increase in stock price for Gokul Agro, as can be seen below.
Again, this reminds us of the importance of debtor days in analyzing stock ideas. So far we have looked at the consumer staples sector. What about other sectors? What about the hot IT sector?
In certain sectors such as IT, we can see that the debtor days are high. But, for last 15-20 years, IT sector was going through a boom and the profit margins were very high. Hence, the companies could maintain high profitability despite higher debtor days. But as the sector matures, the margins shrink and high debtor days can pose a difficult time ahead for the IT sector.
Some people might ask questions about banking sector where controlling Non-Performing assets becomes important. But again these non-performing assets in a way are very similar to high debtor days and associated non-recoverables in a traditional business. Both high debtor days and high NPAs indicate potential issues in liquidity and cash flow management. Therefore, whether it is a bank evaluating its loan portfolio or a business assessing its account receivables, effective management of debtor days/receivables is crucial for maintaining liquidity, ensuring profitability, and boosting investor confidence.
Even in capital goods sectors, companies which can manage their debtor days have traditionally survived for a longer period of time and have fared well on browsers.
India is a growing economy where cost of capital will remain high for next foreseeable period. Hence, managing debtor days and keeping cost of capital in control remains the key to success. High quality businesses owing to the pricing power and demand for their products are able to maintain this. Hence, tracking the debtor days could be that one factor which sort of combines quantitative and qualitative investment approaches.
The information provided by Finance Voyager is for information purposes only and is not intended for advice. Finance Voyager also does not make any recommendation or endorsement as to any investment, advisor or other service or product. The information is only for educational purposes and not buy or sell recommendations.