Financial Times

Threats facing the garment industry

By Prabath Jayakody (Specialist in Finance, Audit and Risk Management)

Many industry analysts have pointed out in the past and predicted some critical threats, which could affect the garment industry of Sri Lanka, for the past 20 years and these have become a reality now. Failure to implement appropriate timely measures to effectively deal with such threats has driven the industry into turmoil thereby putting the livelihoods of many hundreds of thousands of people directly at risk.

The government has a right to deny unnecessary foreign interference in the internal affairs of the country but it should endeavour to settle any differences by diplomatic means and if it’s not possible, it needs to take adequate remedial steps to ameliorate any unfavourable implications on society and the industry itself.

It was reported that the garment exporters will have to absorb an additional duty of nearly 8%-10% on their exports if the current GSP+ scheme is terminated. This will inevitably increase the selling prices of our garments in the European market, thereby making them uncompetitive when compared to some other low-cost garment exporters like China and those countries, which will continue to be part of GSP+. Currently, even with these GSP+ duty concessions, most garment exporters are still faced with enormous difficulty in remaining competitive and profitable due to the intensifying industry competition and the strength of bargaining power of buyers (direct buyers and buying offices), who set prices. Eventually this would reduce the demand for Sri Lankan garments in foreign markets thereby depriving the country of some of its foreign exchange earnings.

In a move to reduce the impact from these developments, the government is said to have proposed to provide funds to these companies while requiring them to issue redeemable preference shares in return. This obviously provides a source of funds for struggling firms to finance their cash flow shortfalls. While appreciating this constructive step taken by the government, we need to consider few other factors to determine the effectiveness of this move.

As these funds do not represent a government grant, the receiving firms will have to record this amount as a liability in their balance sheets. Since there’s no fixed date for redemption, it seems appropriate to treat this amount as a perpetual liability provided that the firms will be able to decide on the redemption date and even to postpone their redemption for the foreseeable future. On the other hand, since these shares do not carry residual rights on the assets of the firm (unlike ordinary shares), in consideration of the time value of the redemption value (present value), this would effectively have some characteristics of a government grant (assuming no premium on redemption). As in the case of any other preference shares, these shares would also require the firms to pay preference dividends to the government out of their profits (if profitable) before paying dividends to ordinary shareholders. Generally preference shares rank below ordinary shares and above debt finance in terms of the return expected by investors in consideration of their risks. However, the dividends to be paid, if any, on these government funds would be much lower than debt financing. In consideration of all these factors, these funds would be a very low-cost source of finance with least strains on their costs (profitability) and their cash flows. The magnitude of the benefits would be determined by the conditions of the share issue including the dividend rates, the premium on redemption, if any, and whether these shares will be subject to accumulation of dividends.

Firms issuing these shares will continue to show the amount received from the government as a liability (preference share capital effectively represents debt rather than equity) in their balance sheets. Assuming the government will not request their redemption in the foreseeable future and no obligation to pay dividends on these shares, still they would not be able to treat the funds as a revenue (or reduction in costs) unless the government explicitly waives its rights. Instead they can use those cash resources to finance their working capital needs, long term investments or discharge other costly or maturing liabilities with no worries over the cost and the repayment of the new finance. This will effectively reduce the cost of financing and hence, can be treated as a cheaper source of finance. On the other hand, it’s questionable as to what extent and how these funds (even if the government relinquishes its rights) will be able to provide a cushion against such impediments in the long term. Though this may be viable in the short term, it seems sensible to focus on increasing the scale benefits, long-term cost reduction and quality (through innovations) in order to sustain the industry’s competitiveness.

Garment exporters would undoubtedly benefit from the expected depreciation of the external value of the rupee (SLR) either through a reduction in selling prices of our products in foreign markets in terms of their foreign currency equivalents or through an increase in the SLR value of their foreign currency earnings thereby strengthening their competitiveness and profitability. A considerable portion of industry costs consists of imported raw materials, which will also increase in line with exchange rate depreciation whereby only the local value addition would eventually benefit from such currency conversions. Further, any resultant effect on domestic inflation of such SLR depreciation would affect the industry costs of locally purchased inputs and labour costs later. What I emphasise here is that no industry should depend on such temporary and artificial measures in the long term for their survival and growth.

The cost structure of the garment industry is characterised by a considerable portion of imported (and locally purchased as well) raw materials (e.g. clothing, thread, trims, etc) and direct labour costs, the total of which represent a vast majority of total costs. Other overhead costs are no much different from other industries. However, many small and medium scale firms have had to incur increasing finance costs due to their excessive dependence on short-term sources of finance like bank overdrafts, which are costly, even for long-term investments (probably due to lack of access to long-term sources of finance or bad financial management).

The US financial crisis is rapidly heading towards Europe as well and could turn into an economic crisis thereby reducing their demand for imported items whereas it could also exert increasing pressure on selling prices of our exports. Thus, these developments should also be treated as possible threats to our garment industry as we export more than 90% of garments to US and EU markets (this shows high concentration and vulnerability).

It’s in this backdrop that the planned cost reduction has become most important than ever as selling prices are determined by factors beyond our control whereas pressure is mounting on costs of all industries. Here cost reduction does not mean ad hoc short-term cost cutting. Irrespective of the scale, all organisations should identify activities, which are repetitive and do not add value, and need to be eliminated. Unnecessary managerial layers need to be removed thereby making the organisations as efficient as possible. Jobs of all employees should be redesigned so that excess labour can be identified and resources allocated efficiently. It’s the top management who should create a culture encouraging cost reduction at all levels. Space and energy usage should be optimised. All major capital investments and acquisitions should be subject to comprehensive investment appraisals (cost-benefit analysis) by competent people without leading to a kennel of “dogs’ (acquisitions), which will become a burden of existing operations.

There should be independent risk management functions focussed on strategic cost reduction. Strong internal control systems should be established covering all areas of operations with continuous support and monitoring by top management. Many small and medium scale organisations get into financial difficulties due to lack of proper control systems and monitoring over activities and costs.

omprehensive budgeting and forecasting should be made necessary for all major activities like sales and marketing, cash and treasury, purchasing and capital expenditure. Cash budgets and monitoring reports should be prepared on a monthly or quarterly basis and periodic financial statements should be prepared for all factories and units to assess and profitability and behaviour of financial position. All material expenses should be subject to centralised authorisation while all capital expenses should be strictly monitored against budgets.

All firms should find strategies to maximize the utilization of factory and machine capacity. However, many firms are facing a shortage of direct labour as there’s higher labour turnover in the industry. Changes to HR and leadership styles at factory environments would alleviate this issue to some extent although this is mainly affected by macro-economic factors.

Many small firms are struggling with increasing financial difficulties. Increasing finance costs have worsened the issue. Therefore, the government assistance would be needed to recover from this. Industry-specific long-term concessionary loan schemes should be launched under the Central Bank refinancing through the banking sector and rescheduling of current loans should also be considered. Granting additional special tax concessions should be considered for a specified period while resultant saving being encouraged for reinvestment in growth of the industry. If we fail to protect this industry, it would result in a series of social problems due to loss of a large number of jobs within the industry itself and in supportive industries.

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