Britannia Industries Ltd’s June quarter results raises a question of whether profitability is levelling off or if this is a temporary phase. Sales grew by 13.6% in the June quarter over a year ago. If we assume volume growth was 10%—the company only said it grew in double digits—then price played a relatively small part. While revenue growth was decent, input costs provided a good boost to margins. Moderation in prices of key inputs such as flour, milk and sugar helped.

While that meant Britannia had a fat margin of sales left over, it saw a sharp increase in employee costs and other expenses. Still, its net profit rose by 19.4% over a year ago. The press statement indicated that sales growth in the dairy segment was subdued as the company shifted focus to value-added products, but the shift helped margins.

Also, the international business growth was flat. It plans to enter new categories to drive growth. For now, its plans are to sell croissants, cream wafers and similar snacks.

The past few years have seen Britannia increase its distribution reach and lower costs. While these have yielded significant gains, they are likely to reach a threshold. After that, the firm needs to drive more sales through its network. That’s where selling more premium products and new categories will help.

While Britannia’s performance has improved, its balance sheet has a problem of plenty and it is using the bonus debenture issue to fix that. As of 31 March, its bank balance and current investments together rose to 1,044 crore, up 3.5 times from a year ago. Free cash flow generated was 826 crore.

This depresses asset utilization ratios. In FY18, for example, the company’s return on capital declined to 31.3% compared to 35.2% a year ago, while its return on net worth fell from 36.9% to 32.9%. How do bonus debentures help?

In the first stage, the company will transfer money from one hand to another, with 721 crore or one-fifth of net worth being turned into bonus debentures. This will see net worth decline by this amount, while debt increases. Shareholders will get these debentures without having to pay for them. Britannia will pay 8% interest for three years, which is a tax-deductible expense for the company.

Its return on net worth will jump after the issue, even if profits remain flat (though they are not expected to be flat). In the short run, this is indeed an artificial way of boosting return ratios, but not in the longer run. After three years, the debentures will be redeemed and money paid to shareholders.

At that point, Britannia’s capital employed will also decline since debt is paid off (capital employed is net worth plus debt). At that point, its return on capital employed will also improve.

Why not simply pay the entire amount as dividend? The firm will then have very little cash left, either for a business exigency or to fund an acquisition. This way, it manages to make its ratios look better, even while the cash remains with it.

Britannia’s shares fell by 1% on Monday though they are up by 16% from its level three months ago. The results were broadly in line with the Street’s expectations but the levelling of margins is something to keep a watch on. If that prevails, sales growth has to be healthy for earnings growth to bring cheer.