A doubt... addressed

The question:

Before doing my MBA I used to ask myself two questions:

1. If a retailer only has 5% margin, why does he do the business?
2. Is he not better-off investing in stocks and making higher return?

The Aha!:

Now, after my MBA, I wonder how stupid I was!

Below is why the retailer should still be in the business:

First of all, we need to define his return on his investment (RoI). This can be defined as:

RoI = Income/Investment

Now, RoI can also be written as:

RoI = (Income/Sales) * (Sales/Assets) * (Assets/Investment)
= Margin * Asset Turnover * Leverage

[An MBA would instantly recognize that I am talking about the DuPont formula here].

Now, we can see that we are not comparing apples to apples when we compare 5% to 10% return on stocks - 5% is his margin, whereas 10% is his RoI.

Thus, his RoI should be = 5% * Asset Turnover * Leverage

Now, a big retailer can take loans and hence his leverage will be > 1. If he finances half of the assets through his own money and half through loans, then his leverage will be 2.

Now, if he sells all of his assets in 1 year, then he will make 10%!. Thus:

RoI = 5% * 1 * 2 = 10%

For unorganized retailers, leverage may not be possible that easily. Hence, these guys make money as follows:

1. Higher margins (15%-20%), as they mostly sell private-label stuff.
2. Understatement of income tax
3. High Asset turnover - by reducing their working capital needs (buying on credit, etc.)