What is a business model?
A business model is how a company creates value and turns it into profit. It covers: what product or service it offers, who buys it, how the price is set, when the money arrives (cash or credit), what the main costs are, and how much capital it takes to run.
Ratios and financial statements tell you “how much”; the business model tells you “why”. The same 10% profit margin can be excellent for one business and weak for another. Without knowing how the business works, you can’t ask the right questions of the numbers.
Picture two businesses in the same neighbourhood. The tea stall on the corner: little capital, cash sales every day, customers who come back daily, but a tiny profit on each cup. The cold storage next door: huge capital up front, big fixed costs such as electricity, income that comes in seasons, but large profits when it is full. Either can do well or badly; their risks and the way they make money are completely different.
Why it matters to an investor
- To make sense of the numbers: what level of margin, debt or ROE is normal depends on the kind of business.
- To spot risks: dependence on imported raw materials, one big customer, government policy or the seasons shows up in the model itself.
- To ask sensible questions about the future: whether profits can grow depends on room to sell more and on the cost structure.
- To know the limits of what you understand: in his 1996 shareholder letter, Warren Buffett wrote that you only need to be able to evaluate companies within your “circle of competence”; its size matters less than knowing where its boundaries are.
Questions to ask
- What exactly does the company sell, and which products or services bring in most of the revenue?
- Who are the customers: ordinary consumers, other businesses or the government? How much depends on a few large buyers?
- Does revenue recur (everyday goods bought regularly, monthly fees) or come from one-off sales (such as large projects)?
- When does the cash arrive: up front, or after long credit? Heavy credit sales can leave a company short of cash even when it is profitable.
- What are the main costs, and how much of them depend on imports or move with the dollar?
- How much new capital does growth need? A business that can grow on little capital can hand more of its profit to shareholders.
Fixed costs versus variable costs
Some costs move with sales (raw materials, packaging): these are variable costs. Others stay roughly the same whatever is sold (factory rent, salaries, loan interest, depreciation on machines): these are fixed costs. Where fixed costs are high, a small rise in sales lifts profit a lot, and a small fall cuts profit sharply or causes a loss.
Where to find the information
- The directors’ report and management discussion in the annual report: descriptions of products, markets and risks.
- Segment information: if a company has several businesses, how much revenue and profit comes from each.
- The prospectus of a newly listed company: a detailed account of the business, customers, raw materials and risks.
- Your own eyes: how widely the product is seen in shops, what shopkeepers and customers say. But one person’s experience is not the whole picture.
Worked example
- Say a made-up company, “Rupsha Foods Ltd”, sells biscuit packs at Tk 20. Ingredients and packaging cost Tk 12 a pack, so Tk 8 is left per pack. Fixed costs are Tk 40 crore a year.
- To cover fixed costs it must sell 40 crore ÷ 8 = 5 crore packs. This is the break-even point.
- Selling 6 crore packs gives a profit of 6 crore × 8 − 40 crore = Tk 8 crore. If sales rise 10% to 6.6 crore packs, profit = Tk 12.8 crore, 60% more.
- The reverse holds too: if sales fall 10% to 5.4 crore packs, profit drops to Tk 3.2 crore, 60% less.
Result: in a business with high fixed costs, a small change in sales makes a big swing in profit. Knowing the business model tells you how far profit could fall in a bad year. The numbers are only an example.
Common mistakes
- Thinking that knowing the product means understanding the business. Seeing biscuits in a shop is different from understanding the biscuit maker’s costs, debt and competition.
- Deciding on price or ratios alone without understanding what the company does.
- Mistaking a company’s name, sector buzz or a “new project” story for a business model.
- Assuming a good year will last, without checking whether the business is seasonal or depends on one-off orders.
If you can’t say in two or three lines of your own what a company sells, to whom, how it gets paid and what it costs, the ratios won’t mean much yet.