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KEY RETAIL RATIOS

Let me introduce you to Company PQR,  an imaginary company that sells better quality mens and womens apparel. This is a retail store located near the center of the continental United States in Kansas. 

Balance Sheet Company PQR
 
Income Statement Company PQR
         
Assets:     Sales
1,000,000
Cash
50,000
  Cost of Goods Sold
510,000
Accounts Receivable
100,000
  Gross Profit on Sales
490,000
Inventory
450,000
  Total Opertaing Expenses
410,000
Total Current Assets
600,000
  Operating Income
80,000
Furniture and Fixtures
1,400,000
  Interest Expense
75,000
Total Assets
2,000,000
  Interest Income
0
  Net Income before Taxes
5,000
Liabilities:
 
Accounts Payable
250,000
  Notes:
Long Term Notes Payable
1,000,000
  * Total Store space = 4,000 square feet
Total Liabilities
1,250,000
  * Store Initial Markup (Markon) = 55%
Owner's Equity
750,000,
 

Now, let’s start looking at some useful ratios for retail businesses and see what they can tell us. Following is a list of each item we will be looking at. For your convenience, if you wish you may click on the a single and just read about an individual ratio.

Current Ratio Cumulative Gross Margin
Quick Ratio GMROII (Gross Margin Return on Inventory Investment)
Debt Equity Ratio Return on Investment Percent (Net Worth Percent)
Gross Profit Percent Return on Assets
Operating Expense Percent Net Sales to Net Worth Ratio
Income (Loss) on Net Sales Sales Per Square Foot
Inventory Turn Rate Annual Sales Growth Rate Percent
Stock Turn Rate  

Current Ratio
Calculation:  Current Ratio =Current Assets / Current Liabilities
The current ratio measures short-term, debt-paying ability and serves as a dependable indication of a business’s solvency.  “Current,” in this case, means it is expected to be converted to cash within the year.  It deals with those liabilities due within the year and with assets that can be converted to cash within the year.  This ratio changes daily and is susceptible is wide fluctuations from day to day and month to month.  Generally, the goal for the current ratio is greater than 2.0.

Yesterday
Merchandise Received
Today
Current Assets
$600,000
$200,000
$800,000
Current Liabilities
$250,000
$200,000
$450,000
Current Ratio
2.40
1.78

Company PQR Information

Quick Ratio
Calculation: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The quick ratio, also known as the acid test ratio, also measures a company’s ability to pay its short-term obligations (it’s solvency).  Inventory is excluded from this calculation because inventory make take a full year or longer to convert entirely into cash.  The quick ratio offers a more strict test of solvency than the current ratio.  A ratio of less than 1 indicates that a company will have problems paying its short-term debts in a timely basis.  The optimum for this ratio is 2 to 1. 

In the case of our sample, the calculations would be as follows:
($50,000 + $100,000) / $250,000 = 0.60 to 1.  If our sample company fails to meet their sales goal or experiences any financial bumps during the next 90 days, they may find a temporary cash crunch and not be able to pay their bills on time.  Of course, that issue is compounded if it is a regular occurrence.  The Owner(s) need to be searching for ways to increase profit and cash flow.

Company PQR Information

Net Worth (Equity or Owner’s Equity)
Calculation:  Net Worth = Total Assets – Total Liabilities
It goes without saying, this needs to be a positive number.  If you have more liabilities than assets, your business is financial trouble or to put it bluntly, it is technically insolvent or bankrupt.  That means that if you liquidated everything, you still could not pay all  of your obligations. 

The Net Worth of Company PQR is $2,000,000-$1,250,000 is 750,000. 

Company PQR Information

Debt to Equity Ratio
Calculation:  Debt to Worth Ratio = Total Liabilities / Equity (Net Worth)
This ratio compares the amount invested in your company by creditors to that invested by the owner(s).  The more a company is supported by debt, the riskier it is.  In other words, the higher the ratio, the lower the staying power of the business.  This is a measurement of a business’s staying power.

Our sample company has a Debt to Equity ratio of 1.67 to 1.  Our sample company has some debt that is placing it in a rocky financial position.  In other words, for every $1 the owner has invested in the company, the creditors have $1.67 invested.

Company PQR Information

Gross Profit Ratio:
Calculation: Gross Profit Ratio = Gross Profit / Net Sales
Gross Profit Ratio identifies the average gross profit realized on each dollar of sales. In other words, it measures the efficiency of personnel and merchandise. Generally, it should always be more than 50%. Gross Margin (Total Net Sales less Cost of Goods Sold) is directly influenced by Initial Markup (or Markon) and Markdowns. If a retailer's Initial Markup is unusually low or Markdowns excessively high, Gross Margin will suffer. Gross margin must be high enough to yield an adequate net profit, after the deduction of all operating expenses and any interest expense. 

A steadily increasing Gross Profit Ratio means a company has more funds available to cover operating costs and for profit. A steadily decreasing Gross Profit Ratio indicates problems like substantial increases in merchandise costs that are not successfully passed on to customers or a poor choice of merchandise or buying too much then having to take high markdowns at the end of the season to clear out the excess inventory.

Unless the market is changing drastically, for example because of new technology or the introduction or deletion of a new product line, it should be fairly stable from period to period (that being month to month or quarter to quarter). In a healthy company, Gross Margin Ratio would be stable or increasing slightly over time and always greater than the operating expense ratio since the difference is the company's profit. 

Company PQR Information

Operating Expense Ratio
Calculation: Operating Expense Ratio = Total Operating Expenses / Net Sales
The Operating Expense Ratio (OER) indicates the portion of each sales dollar spent for running the business. Generally the lower the OER, the greater the efficiency and profitability of the company. While everyone wants their operating expenses to be as low as possible, store owners must be cautious to NOT reduce expenses to levels that cause a deterioration of sales. Stores should strive to keep their Operating Expense Ratio less than 40%.

Operating expenses include expenses related to properly running the day-to-day functions of the business. These include but are not limited to payroll, advertising, taxes-both property and payroll, office supplies, janitorial supplies, utilities, rent, security, postage, telephone, internet, insurance, travel, depreciation, equipment repair and maintenance and professional services. It does not include other expense or other income.

Obviously the goal of any company is to pass on its increasing operating expenses to its customers so that net income is not adversely affected. However, in times of economic crisis or catastrophic occurrences, that may not always be possible. It is always necessary to maintain a tight control on operating expenses and look for ways to cut costs without cutting customer satisfaction.

Company PQR Information

Net Income (or Loss) on Sales Ratio
Calculation: Net Income (or Loss) / Net Sales
The next ratio for consideration is the Net Income (Or Loss) on Sales Ratio. This ratio comes as close as possible to summing up how effectively managers and owners run their businesses.

It should be greater than 8, but of course, not a negative number because who wants to lose money? This ratio measures profitability after sales and all deductible expenses are recognized. It indicates the percent of original sales dollars remaining as profit which will be taxed as such. While the first 2 ratios are efficiency-based ratios testing how well various parts of the company are performing, this ratio is a pure profitability test.

Net Income to Sales Ratios vary widely across businesses as a reflection of the pricing strategy adopted by the store. Some stores adopt low-margin, high volume strategies whereas others go for high-margin, low volume strategies. Net Income to Sales Ratios will also be affected by how much debt is used to fund operations. Higher debt often leads to higher interest expenses and lower net income and net margins.

Companies with low profit margins may not survive recessions. Companies with high profit ratio have a "cushion" to protect themselves during times of economic stress. Sometimes, companies with those cushions are able to improve their standings with customers during the hard times leaving them in an even better position as the economy improves.

Company PQR Information

No doubt about it. If your business is a retail store, the biggest investment you have is your inventory. But, you cannot spend every available penny on inventory; you also have to pay for space, employees, heating and cooling . . . well, the list goes on and on.   You cannot stock a lifetime supply, or even a yearly supply, of every item. To generate funds for paying your other bills and return a profit, you must sell the merchandise you've bought as quickly as possible. The inventory turnover rate measures how quickly your inventory moves. This is an important step in evaluating your inventory's success.

Inventory turn rate:
Calculation: Cost of Goods Sold (from the Income Statement) / Inventory (from the Balance Sheet)
For our sample company, PQR, this would be 510,000 / 450,000 = 1.13. This tells us a few things. First, Company PQR has a lot of inventory in the store-almost 12 months worth. They keep a full-year of inventory on hand, in-store, all the time. Second, they have a lot of money tied up in their merchandise. Thirdly, even with the huge inventory investment, they are still missing sales occasionally because they don't have something a particular customer wants. Remember, you cannot make all of the people happy all the time. Not even all your customers. Don't try to stock to that goal. A good goal for the inventory turn rate financial ratio is 2.5 - 3.5.

If you have $5,000 to invest in underwear and you believe you will sell $5,000 in underwear this year, you have several options for your investment. You can make 1 purchase of $5,000 and when it sells out, you will have recognized a profit. There are a couple of downsides to this method. First, you have to tie up $5,000 in an annual investment. Second, your customers who purchase underwear in February and August, will see the same merchandise . . . again. They may wonder what other merchandise is old or how old the merchandise is.

You can also make 2 purchases of $2,500 each. This way, you can use a portion of the profits to help pay for the second purchase. Plus, you have the added bonus of your customers seeing new merchandise. (Yes, some even notice new underwear in the store and it makes the impression that all merchandise is the newest, latest and greatest.)

Or, you can make 4 purchases of $1,250 each and fill in as needed. The good side is a smaller investment frees cash for other things and your customers see more new merchandise. It depends on how hard you make your money work for you.

Too high a turn may mean inventories are too under-stocked and you are losing sales. A good indication of this shows up when you continually lose sales because of a lack of basic sizes or colors. Too low a turn will usually create excessive markdowns and reduce gross profit or entice some store owners to store merchandise until next season which still usually results in higher than planned markdowns and a reduction in gross profit, plus your regular customers will recognize the older inventory and they'll tell someone, and so on, and so on.

Again this is considered a financial ratio and is not as important as our next ratio, the true stock turn rate.

Company PQR Information

Stock Turn Rate:  
Calculation: Net sales / Average retail inventory (13 months)
There are as many methods to calculate average inventory as there are statisticians. I recommend using 13 months to obtain the average, the Beginning of month inventory for each month 1 through 12 and the ending inventory of month 12. Then divide this sum by 13.

For our sample Company PQR, the calculations would look like this.

MONTH
RETAIL INV
BOM MO 1
850,000
BOM MO 2
775,000
BOM MO 3
825,000
BOM MO 4
900,000
BOM MO 5
1,200,000
BOM MO 6
1,000,000
BOM MO 7
800,000
BOM MO 8
825,000
BOM MO 9
850,000
BOM MO 10
825,000
BOM MO 11
850,000
BOM MO 12
850,000
EOM MO 12
1,000,000
SUM
11,550,000
AVG INV
888,462

The Company-wide stock turn rate would be 1,000,000 / 888,462 = 1.12. This needs improvement. A stock turn rate of 2.0 would be an excellent starting place but this turn rate indicates a store that has excessive amounts of inventory left from last season (maybe from the last decade).

The stock turn rate represents the number of times that average inventory on hand has been sold and replaced. The goal for stock turn rate is 2.5 - 3.5 as it is with the inventory turn rate.

Stock turn is the second most critical ratio in determining the overall profitability of a store. If both the stock turn rate and sales per square foot (we will look at sales per square foot in detail in July) are relatively high, then the possibility of store profitability is greatly enhanced. This position is supported by the fundamental concepts of the two ratios. For example, a higher than average stock turn rate indicates that inventory is being sold to the customer rather than accumulating in the store or storeroom. Therefore, the dollars invested in inventory are earning the retailer a return on his investment. However, the stock turn rate is directly influenced by the dollar volume of average inventory. If average inventory is kept at lower than usual levels, then naturally inventory turnover will be much faster. A disadvantage to maintaining a reduced inventory is the failure to maximize sales potential. Therefore, before evaluating a store's performance solely on the merits of its stock turn rate, it is essential that sales performance be considered. If sales per square foot are healthy, then one can almost be certain that the stock turn rate is not being manipulated by maintaining unusually low inventory levels.

Another consideration in maintaining a healthy stock turn rate is the reduction of inventory carrying costs and occupancy costs. With business' costs soaring, it is important for retailers to get rid the slow-moving inventories which act as leeches on a store's profit. By presenting to your customer only the inventory which is profitable or necessary, the retailer will have taken great strides to improving their overall inventory productivity. In other words, inventories must be managed in such a way that shoppers are enticed to purchase now and enticed to return to browse (and buy) again.

If you have an item that is not moving and does not, at least, serve to bring in customers, it may be time to rid yourself of the item and bring in something with a value for the store and a higher value to the customer.

Company PQR Information

Cumulative Gross Margin
Calculation: Gross Margin % * Stock Turn Rate = Cumulative Gross Margin
You may remember that our calculated gross margin percent for Company PQR was 49% and our stock turn rate for the business was 1.12. Therefore, CGM = .49 * 1.12 or 55.

The goal for the CGM is 125 - 150. Cumulative gross margin measures the effectiveness of inventory planning and control. This ratio merges two ratios (gross margin % and stock turn rate) into one. The "merged-ratio" concept enables a retailer to analyze the combined strength of two previously separate financial measures. This is a merchandising report card for the store. In the case of Company PQR, the company is burdened by debt and, probably, old merchandise. Some tough decisions will have to be made soon.

We recommend calculating each classification's performance in the areas of gross margin and stock turn rate as well as cumulative gross margin annually. This information can be compared and contrasted using a common denominator (the cumulative gross margin) to aid the retailer in his decision-making and future planning for merchandise.

This also allows the Cumulative Gross Margin to be used to compare the profitability of one class to another. Because of this, a poor performer in either Gross Profit % or Stock Turn Rate could be offset by the relative strength of the companion ratio to yield an acceptable result. For example, a class with a 2.50 Stock Turn Rate and 50.00% Gross Margin % would have a Cumulative Gross Margin of 120. A class with a higher 3.3 Stock Turn Rate but lower Gross Margin % of 36.50% would also have a Cumulative Gross Profit of 120 and could therefore be considered just as productive. Once the cumulative gross margin has been determined for each classification, we recommend ranking all classes from best performing to worst. Those classes with the highest CGM are the most productive and should be considered for an expansion of styles or colors to maximize future sales. Conversely, the lowest performing classes, based on their Cumulative Gross Profit, should be considered for a reduction in assortment or perhaps even elimination. Obviously, a poor Cumulative Gross Margin in a high-volume class is more significant and alarming than it is in a low-volume class. After all, you have a store to make money, not to collect merchandise.

Company PQR Information

Gross Margin Return on Inventory Investment (GMROII or GMROI-the second "I" is frequently dropped)
Calculation: Gross Margin / Average Inventory at Cost
For our sample Company PQR, we would first calculate Average Inventory at Cost by taking the inventory, excluding lease departments or special order classifications, for 13 months.

MONTH
INV COST
BOM MO 1
410,000
BOM MO 2
375,000
BOM MO 3
400,000
BOM MO 4
450,000
BOM MO 5
575,000
BOM MO 6
490,000
BOM MO 7
390,000
BOM MO 8
360,000
BOM MO 9
415,000
BOM MO 10
400,000
BOM MO 11
425,000
BOM MO 12
415,000
EOM MO 12
510,000
AVG INV AT COST
431,923

The Gross Margin from the income statement is $490,000. The GMROII is $490,000 / $431,923 = 1.13. As you can see, our Company PQR has another indication of trouble. They are only making 13 cents on each dollar of investment which is not enough to cover all the cost involved. 

The GMROII answers the question "for each dollar at cost, how many dollars of gross profit will I generate in one year?" GMROII is traditionally calculated by using one year's gross profit against the average of 12 or 13 months of inventory at cost. A ratio higher than 1 means the firm is selling the merchandise for more than what it costs the firm to acquire it. The opposite is true for a ratio below 1. Keep in mind that merchandise does not, unfortunately, sell itself. After the cost of the merchandise, there is still the cost of the store, salaries, utilities, etc; therefore, the GMROII must be significantly greater than 1 to cover cost and produce a profit.

GMROI can be calculated at the organization level and, if the proper data can be collected, all the way down to an individual item. We recommend that you review the GMROI by class at least annually. If this is information readily available to you on your existing system, review it as often as possible.

While most organizations have some "loss leaders", it is important to understand which items/groups are under-performing. Once the loss leaders are determined, choices are to live with the poor performance, improve the margin, improve the turnover or in extreme cases, discontinue the poor performing product.

A short-coming of GMROII driven analysis is that items with high sell-offs (i.e. the final stock level falls towards zero) appear better than basic items with constant inventory supplies. Fashionable items that totally sell out will appear better than basic items such as black socks that are regularly replenished by reorders. This is particularly evident when analyzing shorter time periods instead of the recommended 12-month time frame or item level information rather than higher level (classification) information.

Company PQR Information

Return on Investments Percent
Calculations: Net profits (before taxes) / Net Worth
This is a profitability ratio. It indicates the earning power of a company's net worth. Net worth is the equity the owners have in the business and is calculated by subtracting Total Liabilities from Total Assets.

Companies that show high ratios in this area over a sustained number of years are the most highly regarded for financial stability.

With interest rates well above the median firm's return on equity, retailers must become increasingly cognizant of "negative" or "reverse" leverage. This condition is created when an individual cannot reinvest borrowed funds to yield a rate of return equal to or greater than the rate at which the funds were borrowed. Unfortunately, this is exactly the position our company PQR is in. They have borrowed money to remain open and operational, but now the liability is greater than the income they are able to generate. Morale suffers as does customer service and even merchandise selections. This store is in a downward spiral unless drastic changes are made today.

In our sample Company PQR, the Return on Investments % is 5000 / 750,000 or 0.67%. Something to consider: Would you invest in a company that reasonably expects a return of only 0.67%? 

Company PQR Information

Return on Assets
Calculations: Net profit (before taxes) / Total Assets
Return on Assets is a measure of profitability and productivity.  Return on Assets includes the benefit from loans and credit accounts. As money is provided from these outside resources, it becomes an asset which subsequently earns a return on the investment.  If a company has no borrowed funds, the Return on Assets and the Return on Investments is the same.  Generally, in a healthy store, this should be at least 15% or higher.

Management's job is to use all available assets wisely. Although customer service is an important component of any successful retail business, it is only one step of the many that must be performed to nurture a thriving, growing business. Financial discipline is also a must. If a retail business ignores financial discipline, it probably won't be around long. Strong retailers understand that every store and every item or employee in the store must work together to produce profit.
      

In our sample company, PQR, the return on Assets is 5,000 / 2,000,000 or 0.25%. Our sample store is definitely in trouble.  The earning are very low when compared to the amount of assets in the company.

Company PQR Information

Net Sales to Net Worth Ratio
Calculation: Net Sales  / Net Worth
This ratio, a key profitability ratio, measures the turnover of invested capital.  Furthermore, it provides an indication of how productively management is deploying the store’s equity.  For example, if the store’s equity is heavily invested in dormant inventory which is not generating sales revenue, then invested capital is not being turned over to create profit and there will be a very low return on investment.  Should this condition persist over an extended period of time, the store will inevitably fail.  On the other hand, if invested capital is being turned over regularly, the business will most likely be prosperous, assuming other facets of the store’s operation are functioning smoothly.  If owner’s equity is turned over too slowly, profitability suffers.  If equity turns over too rapidly, it can indicate the amount owed to creditors has become a substitute for owners’ funds.

In our sample company, this ratio is 1,000,000 / 750,000 or 1.33 to 1  Generally in a healthy, thriving retail store this ratio should be 5 to 1.  Ways to improve this ratio would be to increase sales, reduce the debt load or cut expenses.

Company PQR Information

Sales Per Square Foot
Calculation:  Net sales divided by total square footage
The ratio measures the efficiency and productivity of each square foot of the store’s total area by identifying the amount of sales generated by each square foot of the store.  This ratio is one of the most critical in determining the overall profitability of a store.  If sales per square foot are strong relative to the industry’s performance, there exists the likelihood for improved expense ratios as a percent of net sales.  If sales per square foot are weak relative to the industry’s performance just the opposite effect will result. 

Once you learn the sales per square foot for your retail industry (best place to find this is the reference desk of your local library, but retail associations also have this information), compare the results for your store to averages.  But, do not be surprised if your business does more or less in sales.  Location, competition, store layout, economic conditions of the area and price level of inventory all greatly influence your store's results.  The main goal is to generate more sales from existing space and constantly improve sales per square foot.

Looking at five (or more) consecutive years in a healthy retail environment, this percentage should be on a slight but steady increase.  Of course, in times of high inflation, since costs are rising quickly, sales need to also rise quickly to cover the corresponding inflationary costs associated with the store’s operations.  Looking at a five year comparison of your store’s sales per square foot is much more informative than a comparison to industry averages.  Your sales per square foot should be growing slightly above inflation rates. 

In our sample store this ratio would be 1,000,000 / 4,000 or 250 to 1.  If other similar stores have a sales per square foot ratio of $302 it would appear that our company PQR is okay.  However, consider the table below.  Our company PQR hit an economic “bump” in the form of a recession in 2009 and 2010.  Money was needed to stay afloat.  Now the company is struggling to get back to it’s best (2007) position while contending with high inflation.  Will they make it?  Maybe.  But more tough decisions will have to be made. 

2011                      $250
2010                      $175
2009                      $196
2008                      $287
2007                      $300

Company PQR Information

Annual Sales Growth Rate Percent
Calculation: (this year’s sales – last year’s sales) / last year’s sales * 100
This ratio measures the increase in sales volume during the current fiscal year as a percent of last year’s total sales.  If a retailer reduces sales growth rate by the inflation rate for retail goods, real sales growth is determined.  Real sales growth represents that portion of the sales increase which was created by causes other than inflation.

Our company PQR had sales last year of 700,000 and this year of 1,000,000.  They have substantially increased sales over the past year.  The calculation for company PQR is:  (1000,000 – 700,000) / 700,000*100 or 42.86%!  Great!  So much to look forward to and still the store is in trouble because of outstanding financial obligations.

We hope you have enjoyed this review of Key Retail Ratios. As always, if you would like further information on any of these, please contact us.

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