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Importance of ‘Terms of trade’ in wealth creation In its 11th Annual Wealth Creation Study, Motilal Oswal Securities Ltd corroborates the role of ‘terms of trade’ of a business entity, in its wealth creation process. It opines that favourable ‘terms of trade’ is fundamental to winning in business. Here’s a brief analysis of this concept and how it aids companies to create wealth.

Every year, the Motilal Oswal Wealth Creation study looks at the capital markets over the past 5 years to discover trends in wealth creation. And every annual study follows a unique theme. Previous studies have looked at price and value, business cycles, transitory or enduring wealth creators, value of a stock and so on. The theme for this year’s study is “Importance of ‘Terms of Trade’ in wealth creation”.

Theme 2007 - ‘Terms of trade’
The working capital requirements of a company are determined by the ‘terms of trade’ that the business enjoys. Better ‘terms of trade’ not only brings down the cost of working capital but also enhances the company’s RoCE (Return on Capital Employed).

Understanding ‘Terms of trade’
‘Terms of trade’ refers to the ratio of debtors to creditors, where, the lower the ratio, the better. A company enjoys favourable ‘terms of trade’ if its debtors are lower than its creditors while, conversely, an adverse ‘terms of trade’ could mean very high working capital requirements, rendering the business unprofitable.

Bargaining power determines ??Terms of trade?
The study stresses that a company with a very strong brand or a dominant position in its business enjoys high bargaining power vis-??-vis its suppliers (creditors) and customers (debtors). This bargaining power impacts its ??terms of trade? positively or negatively. Where a company has a short debtors? cycle, the ??terms of trade? are favourable

Favourable ‘Terms of Trade’ enables wealth creation
A company which falls into the best ‘terms of trade’ model has low or zero working capital requirements and in turn, is able to fund its fixed capital needs, which significantly reduces the capital intensity of the business and leads to higher profit margins and greater cash flows than their competitors.

Such cash rich entities reward their shareholders handsomely. It has been ascertained that 70 of the 85 non-banking wealth creating companies included in the study enjoy favourable ‘terms of trade’ (refer to table below) whereas 70 per cent of the wealth destroyers had adverse ‘terms of trade’.

Adverse ‘Terms of trade’ is an impediment to wealth creation
The study also points out that those companies with a high ‘debtor to creditor ratio’ require huge amounts of capital to stay in the business and when their operations fail to prime the pump of free cash flow, they are left at the mercy of financial institutions to run the business. Such an adverse model usually hampers a company’s ability to create wealth.

However, there are some exceptions to this rule, such as IT service companies that have adverse ‘terms of trade’ but are compensated adequately by higher margins, ultimately leading to higher RoCE and strong cash flows. It brings out the fact that if adverse ‘terms of trade’ are not accompanied by higher margins, then such businesses stop creating wealth. ‘

‘Terms of trade’ remain stable
An interesting aspect brought about by this study is that ‘terms of trade’ usually remain constant over a period of time. If they are favourable in the beginning, they remain favourable in the end. Similarly, if they are adverse, they do not turn favourable easily. This observation holds true for most of the wealth creating companies that are included in the study.

It further states that when ‘terms of trade’ changed from adverse to favourable for few companies during the 5 year study period, it led to a considerable increase in their RoCE and a commendable appreciation in the value of their stocks. On the other hand, only two companies have been able to create wealth despite a significant deterioration in its ‘terms of trade’.

The study says that while favourable ‘terms of trade’ is an important characteristic of a wealth creating company, an adverse scenario is not conducive to wealth creation. To sum up, favourable ‘terms of trade’ is one of the enablers of high RoCE and should be looked for in the search for winners in the stock market.

“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is consistently employ ever greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find. Most high return businesses need relatively little capital” - Warren Buffett

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