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.
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.
In the case of our sample, the calculations would be as follows:
Net Worth (Equity or Owner’s Equity)
The Net Worth of Company PQR is $2,000,000-$1,250,000 is 750,000.
Debt to Equity Ratio
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.
Gross Profit Ratio:
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.
Operating Expense Ratio
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.
Net Income (or Loss) on Sales Ratio
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.
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:
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.
Stock Turn Rate:
For our sample Company PQR, the calculations would look like this.
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.
Cumulative Gross Margin
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.
Gross Margin Return on Inventory Investment (GMROII or GMROI-the second "I" is frequently dropped)
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.
Return on Investments Percent
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%?
Return on Assets
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.
Net Sales to Net Worth Ratio
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.
Sales Per Square Foot
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.
Annual Sales Growth Rate Percent
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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