CHAPTER 6 FINANCIAL STRATEGY ANNOTATED OUTLINE INSTRUCTOR NOTES • Financial objectives and goals are an integral component in every aspect of a retailer's strategy. Retailers can use financial tools to measure and evaluate their performance. • Financial analysis can be used to monitor the retailer’s performance, assess the reasons its performance is above or below expectations, and provide insights into appropriate actions that can be taken if performance falls short of those expectations. I. Objectives and Goals • The first step in the strategic planning process involves articulating the retailer’s objectives and the scope of activities it plans to undertake. • Three types of objectives that a retailer might have are: (1) financial, (2) social, and (3) personal. See PPT 6-3 A. Financial Objectives • The appropriate financial performance measure is not profits but rather return on investment (ROI). • A commonly used measure of the return on investment is return on assets (ROA), or the profit return on all assets possessed by the firm. B. Societal Objectives • Societal issues are related to broader issues about providing benefits to society – making the world a better place to live, such as providing employment opportunities for people in a particular area, offering people unique merchandise, providing an Ask students to provide specific examples of retailers meetings societal objectives (merchandise, services, events, etc.) they have seen in the current marketplace. innovative service or sponsoring events. • Regardless of the form the objective takes, performance with respect to societal objectives is more difficult to measure than financial objectives. C. Personal Objectives • Many retailers, particularly owners of small, independent businesses, have important personal objectives such as self-gratification, status and respect. • Whereas societal and personal objectives are important to some retailers, financial objectives should be the primary focus of managers of publicly held retailers (retailers whose stocks are listed on and bought through a stock market). II. The Strategic Profit Model • The strategic profit model, illustrated in Exhibit 6-1, is a method for summarizing the factors that affect a firm’s financial performance as measured by ROA. • The model decomposes ROA into two components: (1) net profit margin and (2) asset turnover. • The net profit margin is simply how much profit (after taxes, interest income, and extraordinary gains and losses) a firm makes divided by its net sales. It reflects the profits generated from each dollar of sales. • Asset turnover is the retailer’s net sales divided by its assets. This measure assesses the productivity of a firm’s investment in its assets and indicates how many sales dollars are generated by each dollar of assets. • These two components of the strategic profit model illustrate that ROA is See PPT 6-4 determined by two sets of activities, profit margin management and asset turnover management, and that a high ROA can be achieved by various combinations of net profit margin and asset turnover levels. • In fact, two different retailers with wide discrepancies in net profit margin and asset turnover could have exactly the same return on assets. See Exhibit 6.2 See PPT 6-6 A. Profit Margin Management Path • The information used to analyze a firm’s profit margin management path comes from the income statement. • The income statement summarizes a firm’s financial performance over a period of time. 1. Net Sales • The term net sales refers to the total revenue received by a retailer after refunds have been paid to customers for returned merchandise and payments have been collected from vendors for promotions: Net Sales = Gross amount of sales + Promotional allowances - Customer returns • Customer returns represent the value of merchandise customers return because it's damaged, doesn't fit, and so forth. • Promotional allowances are payments made by vendors to retailers in exchange for the retailer promoting the vendor’s merchandise. See PPT 6-7, 6-8, and 6-9 • Sales are an important measure of performance because they indicate the activity level of the merchandising function. 2. Gross Margin Gross margin = Net sales - Cost of goods sold. • Gross margin, also called gross profit, gives a retailer a measure of how much profit it’s making on merchandise sales without considering the expenses associated with operating the store and corporate overhead expenses. • Cost of Goods Sold, is the amount a retailer pays to vendors for the merchandise it sells. • Gross margin, like other performance measures, is also expressed as a percentage of net sales so retailers can compare (1) performances of various types of merchandise and (2) their own performance with other retailers. Gross margin / Net sales = Gross margin % See PPT 6-7, 6-8. and 6-9 Discuss the difference in gross margin percentage between Costco and Macy’s. Why is the difference to be expected? 3. Operating Expenses • Operating expenses are the selling, general and administrative expenses (SG &A), plus the depreciation and amortization of assets. The SG&A includes costs, other than the cost of merchandise, incurred in the normal course of doing business such as salaries, advertising and rent. • The operating expense category includes salaries for sales associates and managers, advertising, utilities, office supplies and rent. • Like the gross margin, operating expenses are expressed as a percentage of net sales to facilitate comparisons See PPT 6-10 Discuss the difference in expense to sales ratio between Costco and Macy’s. Why is the difference to be expected? across items, stores, and merchandise categories within and between firms. Operating expenses / Net sales = Operating expense % 4. Interest and Taxes • Two other major expenses are interest (which includes the cost of borrowing money to finance everything from inventory to the purchase of a new store location) and taxes. • Offsetting the interest expense is the interest income a retailer can generate through a variety of investments. • Most retailers incur these expenses. However, these costs of doing business may not reflect the retailer’s performance in its primary business activity which is selling goods and services. 5. Net Operating Income • Due to the lack of control over taxes, interest and extraordinary expenses, a commonly used overall profit measure is the net profit percentage before interest expenses/income, taxes, and extraordinary expenses. • This measure allows for a comparison of financial performance across companies or divisions within companies. See PPT 6-14 6. Net Profit • Net profit (after taxes) is the gross margin minus operating expenses and taxes: Net profit = Gross margin – Operating expenses – Net interest -- Taxes • Net profit is a measure of overall performance with respect to the profit See PPT 6-11 Discuss the difference in net profit margin percentage between Costco and Macy’s. Why is the difference to be expected? margin management path and can also be expressed before taxes. • Like gross margin, net profit margin is often expressed as a percentage of sales: • Net profit / Net sales = Net profit % after taxes • A commonly used overall profit measure is the profit percentage before interest and taxes. This measure is used because operating managers have little control over interest and tax expenses, so these expenses do not reflect the performance of operating managers or the retailer’s operating effectiveness. III. Asset Management Path • The information used to analyze a firm’s asset management path primarily comes from the balance sheet. • The income statement summarizes the financial performance over a period of time, while the balance sheet summarizes a retailer’s financial position at a given point in time, such as the last day of the year. • The balance sheet shows the following relationship: Assets = Liabilities + Owner’s equity • Assets are economic resources (such as inventory or store fixtures) owned or controlled by an enterprise as a result of past transactions or events. See PPT 6-15 A. Current Assets • By accounting definition, current assets are those that can normally be converted to cash within one year. In retailing: Current assets = Cash + Accounts receivable + Merchandise inventory + Other current assets • Accounts receivable are monies due to the retailer from selling merchandise to customers on credit. This current asset is substantial for some retailers. • From a marketing perspective, the accounts receivable generated from credit sales may be the result of an important service provided to customers. • The retailer’s ability to provide credit, particularly at low interest rates, could make the difference between making and losing a sale. • The money invested in accounts receivable costs the retailer interest expense and keeps the retailer from investing proceeds of the sale elsewhere. • Merchandise inventory is a retailer’s lifeblood. Exceptions to this generalization are service retailers, who carry little or no inventory. • Inventory turnover is used to evaluate how effectively managers utilize their investment in inventory: Inventory turnover = COGS / Average inventory at cost • Think of inventory as a measure of the productivity of inventory--how many sales dollars can be generated from $1 invested in inventory. • We can think of inventory turnover as how many times, on average, the inventory cycles through the store during a specific period of time (usually a year). See PPT 6-16 Ask students why retailers take third party credit cards like Visa. ( Because they don't want to tie up their assets in accounts receivable. They would rather get most of their money quickly to invest in more inventory. Also, they must offer credit since customers expect it.) See PPT 6-19 Average Inventory is always considered at retail because sales are in terms of retail as well. Ask students what a turnover of 1.61 means. (Answer: For every dollar in inventory the firm generates $1.61 in sales.) Ask students which firm has the highest inventory turnover and why they would expect this to be the case. Whose inventory turnover would be higher: a discount store or a specialty retailer? Why? B. Fixed Assets • Fixed assets are assets that require more than a year to convert to cash. In retailing, Fixed assets = Buildings (if store property is owned rather than leased) + Fixtures (such as display racks) + Equipment (such as computers or delivery trucks) + Long-term investments such as real estate or stock in other firms • Although fixed assets don't turnover as quickly as inventory, asset turnover can be used to evaluate and compare how effectively managers use their assets. • When a retailer decides to invest in a fixed asset, it should determine how many sales dollars can be generated from that asset. C. Asset Turnover • Asset turnover is an overall performance measure from the asset side of the balance sheet. Asset turnover = Net sales / Total assets See PPT 6-16 Ask students which firm has the highest asset turnover and why they would expect this to be the case. D. Return On Assets • Overall performance, as measured by ROA, is determined by considering the effects of both paths by multiplying the net profit margin by asset turnover: Net profit margin x Asset turnover = Return on assets • Return on assets is a very important performance measure, because it shows how much money the retailer is making on its investments in assets and how good that return is relative to other investments. • The strategic profit model assumes two important issues: • First, retailers and investors need to consider both net profit margin and asset turnover when evaluating the retailer’s financial performance. • Second, retailers need to consider the implications of strategic decisions on both components of the strategic profit model. IV. Evaluating Growth Opportunities • To illustrate the use of strategic profit model for evaluating a growth opportunity, consider Gifts To Go, a two-store chain in Chicago. Gifts To Go is considering an internet channel called www.Gifts-To-Go.com. • Review Exhibit 6-8 and Exhibit 6-9. The Gross Margin percentage will be the same in both channels (50%), but the Net Profit % will be higher in the Internet channel (15.9% vs 14.3% in stores). • Inventory turnover will also be higher at Gifts-to-Go.com (3.1) versus in-store at 2.0. • Asset turnover for Gifts-to-Go.com will be 2.09 instead of 1.84 in stores. • The ROA for Gifts-to-Go.com will be 33.25% versus 26.29% in stores. See PPT 6-21, PPT 6-22 V. Analysis of Financial Risk and Strength • Since 2000, some large retailers have gone out of business. See Exhibit 6-10. This section discusses some of the measures of financial strength and risk of retailers. A. Cash Flow Analysis • Retailers can be forced into bankruptcy even when they show a profit. Profits are now the same as cash flow. • Cash flow is calculated by making adjustments to net profit involving adding or subtracting differences in revenue and expenses that occur from one period to the next. See PPT 6-23 B. Debt-to-Equity • The debt-to-equity ratio is the retailer’s short and long-term debt divided by the value of the owners’ or stockholders’ equity in the firm. • Liabilities are a company’s debts, such as its account payable which is the money it owes vendors for merchandise. • Owners’ equity is the owners’ (or stockholders’) investments in the business. See PPT 6-24 C. Current Ratio • The current ratio short-term assets divided by short-term liabilities. See PPT 6-24 D. Quick Ratio • The quick ratio (also called acid-test), is short-term assets divided by short term liabilities. Inventory is not included in this ratio. See PPT 6-25 VI. Setting Performance Objectives • Performance objectives should include: (1) the performance sought, including a numerical index against which progress may be measured, (2) a time frame within which the goal is to be achieved, and (3) the resources needed to achieve the objective. Performance objectives are illustrated in PPT 6-26 A. Top-Down versus Bottom-Up Process • Top-down planning means that goals are set at the top of the organization and filter down through the operating levels. • In a retailing organization, top-down planning involves corporate officers developing an overall retail strategy and assessing broad economic, competitive, and consumer trends. • The overall strategy determines the merchandise variety, assortment, and product availability plus store size, location, and level of customer service. • This top-down planning is complemented by a bottom-up planning approach. Buyers and store managers are also estimating what they can achieve. Their estimates are transmitted up the organization to the corporate planners. • Differences between bottom-up and top-down plans must be resolved through a negotiation process involving corporate planners and operating managers. Describe a situation where management has set a higher sales goal for a particular period but has also cut employee hours and eliminated over-time for that same period. Ask students to explain how they would resolve this difference. For a comparison of top-down and bottom-up planning, refer to PPTs 6-27 and 6-28. B. Performance Objectives and Measures • The measures used to evaluate retail operations vary depending on: (1) the level of the organization where the decision is made and, (2) the resources the manager controls. • For example, the principle resources controlled by store managers are space and money for operating expenses (such as wages for sales associates and utility payments to light and heat the store). Store managers focus on performance measures like sales per square foot and employee costs. C. Types of Measures See PPT 6-29 • Retailers' performance measures are broken into three types: input measures, output measures, and productivity measures. • Input measures assess the amount of resources or money allocated by the retailer to achieve outputs, or results. • Output measures assess the results of retailers' investment decisions. For example, sales revenue results from decisions on how many stores to build, how much inventory to have in the stores, and how much to spend on advertising. • A productivity measure (the ratio of an output to an input) determines how effectively a retailer uses a resource. • In general, since productivity measures are a ratio of outputs to inputs, they can be used to compare different business units. Productivity measures are a ratio of outputs to inputs. Ask students to demonstrate how productivity measures can be used to compare different business units. E. Assessing Performance: The Role of Benchmarks • The financial measures used to assess performance reflect the retailer’s market strategy. • In other words, the performance of a retailer cannot be accurately assessed by simply looking at isolated measures because they are affected by the retailer’s strategy. • To get a better assessment of a retailer’s performance, you need to compare it to a benchmark. • One useful approach for assessing a retailer’s performance is to compare its recent performance with its performance in preceding months, quarters or years. See PPT 6-30 • A second approach for assessing a retailer’s performance is to compare it with its competitors. V. Summary • Basic elements of the retailing financial strategy and how retailing strategy affects the financial performance of a firm are explained in the chapter. • The strategic profit model is used as a vehicle for understanding the complex interrelationships between financial ratios and retailing strategy. • The chapter also presents some financial performance measures used to evaluate different aspects of a retailing organization. ANSWERS TO GET OUT AND DO IT! 2. Internet Exercise- Go to the latest annual reports, and use the financial information to update the numbers in the net profit margin management model and the assert turnover management model for Costco and Macy’s. Have there been any significant changes in their financial performance? Why are the key financial ratios for these two retailers so different? Depending on the time of year, this information might not be different from what is already in the textbook. Once new information is available, students will obviously observe differences in sales and revenue. Costco also includes membership fees in revenue. Students should explain why the gross margin percentage is higher for Macy’s than it is for Costco, even though Costco has greater sales. This is due to a higher markup on merchandise at Macy’s versus Costco. Students should also look for any noticeable differences in the financial information for the two firms from the previous years. 3. Go Shopping-Go to your favorite store, and interview the manager. Determine how the retailer sets its performance objectives. Evaluate its procedures relative to the procedures presented in the text. After the interview, students should be able to articulate whether or not the store uses a top-down or bottom-up approach in setting objectives. A top-down approach involves planning at the corporate level. Yet, if the store the student is interviewing is an independent retailer, there may not be a corporate level and the manager or owner may set the objectives. In this case, that is still top-down planning. Bottom-up planning involves collecting information and objectives at the individual store level and from buyers and store managers. This is often more common in a large firm than in a smaller or independent retail firm. Students should compare the methods the manager explains and apply the concepts from the text to determine if the approach is top-down or bottoms-up. ANSWERS TO DISCUSSION QUESTIONS AND PROBLEMS 1. What are the key productivity ratios for measuring the retailer as a whole, its merchandise management activities, and its store operation activities? Why are these ratios appropriate for one area of the retailer’s operation and inappropriate for others? One key measure for assessing the productivity of the retailer as a whole is the return on assets (ROA). ROA is the profit generated by the assets possessed by the firm and is a comprehensive picture of firm performance. Other general measures are net profit margin. For buyers, gross margin is one of the most important performance measures as it calculates how merchandise performed in relation to sales while excluding other operating costs. For store managers, gross margin might be less important. Many factors contribute to the overall performance of a retailer. Thus it is difficult to find one measure that adequately evaluates performance. For instance, sales is a global measure of how much activity is going on in the store. However, a store manager could easily increase sales and inventory turnover by lowering prices, but gross margin would suffer as a result. Clearly, an attempt to maximize one measure may lower another. Managers must therefore understand how their actions affect multiple performance measures. It is usually unwise to use one measure since it rarely tells the whole story. The measures used to evaluate retail operations are different depending on the level of the organization where the decision is being made and the resources that the manager controls. For example, the principle resources controlled by store managers are space and operating expenses such as the wages paid to sales associates and the electricity used to light and heat the store. Thus, store managers focus on performance measures like sales per square foot and employee costs. 2. What are examples of the types of objectives that entrepreneurs might have for a retail business they are launching? Retailers can have three types of objectives: 1) financial, 2) societal, and 3) personal. Examples of financial objectives for an entrepreneur might include sales or profit. In the first year, an entrepreneur might just hope to break even. Societal objectives for an entrepreneur might include offering a unique product or meeting the needs of an underrepresented audience. Finally, many entrepreneurs start a retail organization to achieve personal objectives like self-gratification, status, respect or autonomy. 3. Buyers' performance is often measured by their gross margin percentage. Why is this figure more appropriate than net profit percentage? A buyer can impact the gross margin percentage because he/she can, to some extent, control the sales and cost of goods sold. Expenses, which do not play a part in determining the gross margin percentage, are often out of the control of the buyer and therefore should not be counted when assessing a buyer’s performance. 4. A supermarket retailer is considering the installation of self-checkout POS terminals. How would the replacement of cashiers with these self-checkouts affect the elements in the retailer’s strategic profit model? The machinery involved in self-checkout POS terminals would be counted as a long-term asset for the retailer. When adding additional assets, retailers have to maintain higher sales and margin numbers in order to achieve a higher return on assets. However, the overall operating expenses for the retailer may go down as a result of having fewer cashiers, thus actually saving the retailer money over time. 5. Neiman Marcus (a chain of high-service department stores) and Wal-Mart target different customer segments. Which retailer would you expect to have a higher gross margin? Higher expense to sales ratio? Higher inventory turnover? Higher asset turnover? Net profit margin percentage? Why? Gross margin gives a retailer a measure of how much profit it is making on merchandise sales without considering the expenses associated with operating the store and covering corporate overhead. Neiman Marcus should have a significantly higher gross margin than Wal-Mart. Because Neiman Marcus is a high-end department store, providing a high-end image through upscale merchandise and services to customers, operating expenses are significantly higher than Wal-Mart which is renowned for its low cost, highly efficient operation. Neiman Marcus relies on its higher gross margin to cover its significantly higher expenses. Like the gross margin, operating expenses can be expressed as a percentage of net sales to facilitate comparisons. Again, Neiman Marcus may be expected to show a significantly higher percentage here than Wal-Mart due to its higher selling and operating expenses. Wal- Mart has built its global reputation on keeping expenses throughout its organization under tight control. Due to the fact that Wal-Mart deals with low margins, it is imperative to have high inventory turnover and high asset turnover to yield a profit. These figures should be much higher than those of Neiman Marcus. On the other hand, Neiman Marcus will have a much higher net profit margin percentage because they sell high ticket, high markup items such as brand name clothing and furnishings. Since department stores don’t typically have high turnover, they rely on margin to succeed. Conversely, Wal-Mart focuses on high turnover to succeed. 6. Why do investors place more weight on comparable store sales than growth in sales? Comparable store sales growth compares sales growth in stores that have been open for at least one year. Growth in sales can result from increasing the sales generated per store or by increasing the number of stores. New stores don’t represent growth from the previous year’s sales but rather new sales that were created that didn’t exist before. Growth in same- store sales assesses true sales growth and indicates how well the retailer is doing with its core business concept. 7. What metrics should be used to measure the financial risk of a retailer? How is each metric used? There are four measures to assess the financial strength of retailers include cash flow, debt- to-equity ratio, quick ratio, and current ratio. A cash flow statement is the measure of the flow of cash in and out of the retailer, evaluating receipts and expenditures. A cash flow statement is a good indicator of the financial strength of the firm. The debt-to-equity ratio is the retailer’s short and long-term debt divided by the value of the owner’s equity in the firm. The debt-to-equity ratio measures how much money a retailer can safely borrow over long periods of time. The current ratio is the retailer’s short-term assets divided by short-term liabilities. It evaluates the retailer’s ability to pay its short-term debt obligations. Finally the quick ratio is similar to the current ratio but it removes inventory. The quick ratio is a more stringent test of financial strength as retailer’s can’t always rely on inventory to pay liabilities. 8. Blue Nile is a jewelry retailer that only uses an Internet channel for interacting with its customers. What differences would you expect in the strategic profit model and key productivity ratios for Blue Nile and Zales, a multichannel jewelry retailer? On the profit margin path, Blue Nile and Zales might have very different sales numbers, as Zales is a much larger company than Blue Nile. Also, we would expect to see lower operating expenses for Blue Nile as it has less overhead and labor costs than Blue Nile. Perhaps the biggest difference between the two would be on the asset management path. Zales will likely have a more current and fixed assets as it has physical store locations and Blue Nile does not. This means, that in order for Zales to have a competitive ROA with Blue Nile, it needs to sell more merchandise than Blue Nile to offset the higher assets. 9. Using the following information taken from the 2012 balance sheet for Urban Outfitters, develop a strategic profit model. (Figures are in millions of dollars.) You can access an Excel spreadsheet for SPM calculations on the student portion of the book’s website. Net sales $2437.8 Cost of Goods Sold $1316.2 Operating Expenses $575.8 Inventory $250.1 Accounts Receivable $36.7 Other Current Assets $68.9 Fixed Assets $690.0 Asset turnover Net Sales = 1.43 Total Assets Asset Turnover - The Asset Turnover measures how efficiently a company uses its assets to generate sales. Net profit margin % = Net Profit = 3.78% Net Sales Net Profit Margin - The percentage represents the amount of each dollar of Revenue that results in Total Net Income. Return on assets % Net Profit = 5.40% Total Assets Return on Assets (ROA) - A measure of profitability, ROA measures the amount earned on each dollar invested in assets. 10. Using the following information taken from the 2010 balance sheet and income statement for Urban Outfitters, develop a strategic profit model. (Figures are in $ millions.) You can access an Excel spreadsheet for SPM calculations on the student side of the book’s Web site. Net sales $1,937.80 Cost of goods sold $1,151.70 Operating expenses $447.20 Inventory $186.10 Accounts receivable $78.00 Other current assets $422.70 Fixed assets $540.00 11. A friend of yours is considering buying some stock in retail companies. Your friend knows that you are taking a course in retailing and asks for your opinion about Costco. Your friend is concerned that Costco is not a good firm to invest in because it has such a low net operating profit. What advice would you give your friend? Why? When compared to Macy’s, Costco has a lower net operating profit but it is because the margins on items sold at Costco is much lower than the margin on items sold at Macy’s. Students should understand that fashion and apparel items like those predominantly sold at Macy’s have much higher gross margins than consumer packaged goods like those sold at Costco, making the operating profits lower for warehouse clubs like Costco, as well as supermarkets and discount stores. However, Costco has a much higher asset turnover than Macy’s, making the return on assets for Costco almost the same as the return on assets for Macy’s. Thus, students should probably conclude that they would advise their friend that an investment in Costco is as sound as investing in Macy’s, even though the profit margins are lower. Costco is still achieving a healthy return on its assets. ANCILLARY LECTURES AND EXERCISES ------------------------------------------------- LECTURE # 6-1: THE STRATEGIC PROFIT MODEL (SPM) Instructor’s Note: Instructors may wish to use this ancillary lecture in lieu of the annotated outline. This is fairly complex material for students to grasp. This lecture is presented with a simple example. Instructors might want to use this exercise as a stimulus to a class discussion on the topic. The chapter 6 Power Point slides can be used with this lecture. ------------------------------------------------- Background • Also known as the DuPont model, it was developed by the DuPont family around 1920. • The DuPonts developed the model because they needed to find a basis for evaluating the financial performance of complex organizations. Purpose of the SPM • The SPM serves two managerial purposes: • Specifies that a firm’s financial objective is to earn adequate or target return on owner’s equity—also known as return on net worth. • This does not mean that a retailer wants to necessarily maximize return on Owner’s Equity (O.E.). This method is only one of many financial objectives. For example, maximizing shareholder wealth is another very important objective. • Identifies three profit paths a firm can take to increase O.E. by increasing: 1. profit margin 2. rate of asset turnover 3. financial leverage • The preceding performance ratios are related to the following three areas of decision- making: 4. margin management 5. asset management 6. financial management • Let us take each of the three categories and break them down. Margin management • This information is taken from the income statement: • Net sales means after adjusting for returns and allowances • Gross sales - Returns = Net sales • Cost of goods sold • Invoice cost + freight in + work room costs - vendor’s cash discounts • Cost of goods sold: • Invoice costs • Freight in (transportation cost of bringing in merchandise) • Workroom costs (alterations, set up) • Vendors—cash discounts. For example, 2/10 n 30 provides incentives to get retailers to pay quickly for the vendors’ accounts receivable reasons. • Why are these adjustments made to cost of goods sold? • Directly affect landed cost of merchandise • Gross margin: • Gross margin = Net sales - Cost of goods sold • Can be expressed as a percentage of sales: • Gross margin = Gross margin percent • Sales • Gross margin, gross margin percent, and inventory turnover are extremely important in the world of retailing. They represent aspects of the business with which buyer has direct control. • Total expenses (two types—variable and fixed): 1. Variable—(varies with sales) -- the cost of doing business; e.g., sales commission and is thus variable with sales). 2. Fixed—cost of being in business. We have fixed expenses whether or not we sell anything. For example, rent, electricity, administrative salaries, etc. • Net profit (after tax): • Treat tax as a variable expense—a retailer always needs after tax profit for decision- making. Net profit margin is net profit as a percentage of sales, just like gross margin is a percentage of sales. So, if a retailer has $10,000 net profit before tax, and the tax = 40%, the net profit after tax will = $6,000. • The key in understanding net profit lies in the kind of retail establishment in which one operates. For example, a grocery store having a 1 % net profit after tax would be considered normal. The key is knowing what is good or bad for a retailer compared to competition. • How to evaluate profit margin 3. Firm’s past history 4. Compare with similar stores or departments. Should be really much better than average for industry considering there are many bad stores. Asset Management • To obtain a better idea of what asset management is about, examine the Asset Management Model. • All of these elements come from the balance sheet except for sales. • The balance sheet is a snapshot of a retailer’s financial position on a particular day, usually the end of the year. • The income statement represents the performance over a period of time, generally a year. • Objective: The objective in asset management is to turn inventory into accounts receivable or cash by making sales rapidly. • Current assets—“cycle” 1. cash to inventory 2. inventory to cash or 3. inventory to accounts receivable 4. want to minimize assets relative to sales • Inventory—strive for best selection which 5. minimize inventory investment 6. maximize sales through selection (depth + breadth) minimize stock-outs (service level) • Accounts receivable = Merchandise sold on credit. Want to minimize accounts receivable because may be an unproductive asset. Most retailers offer credit because: 1. tradition 2. part of services mix 3. may be important in making people buy 4. can make some money if charge interest but usually sold to a factor (will define below) -- most retailers aren’t in business to be a financial institution, so they would rather sell their accounts receivable to a factor. • Bankcard—Visa, MasterCard, or American Express (T&E—travel and entertainment card); can be converted to cash immediately, but card company charges retailer a percentage of sales. • Factor—accounts receivables are sold to private-label credit card companies known as “factors.” When a retailer’s accounts receivable is sold to another firm, it allows the retailer to get money up-front and retain its own store identity. Also, information from the credit cards can be used to target customers. Factoring is very popular now because an intermediary company takes care of accounts receivable hassles for the retailer. • Proprietary—when a retailer keeps its own accounts receivable (private credit card, like “Sears” card). The most common reason for doing this is to collect interest from customers. • The first two types of credit cards are the most popular with retailers because they generally prefer to stay away from accounts receivable. Naturally, their main interest is converting inventory into sales and profits. • Cash: keep to a minimum Fixed assets: 1. fixture 2. store (if owned, not rented) 3. delivery trucks 4. much slower to change than current assets Asset turnover: • Net sales/ total assets = Asset turnover. • Similar to inventory turnover in that it is like a cycle of assets to cash to assets to cash ... • Asset turnover rate always has to be less than inventory turnover if there are any fixed assets. • Inventory turnover = Net Sales / Average Inventory Return on assets • ROA uses both asset management and margin management. • Used for evaluating and programming performance of profit centers (like stores), used to evaluate managers, not owners because owners also have control over financial leverage—to be discussed below. • Firms can get their return on assets in many ways. For example: 1. discount stores have low margin and high turnover 2. boutiques have high margin and low turnover • Return on assets (ROA) = Net profit • Total assets • The question here is, how much profit are you able to generate from retailer’s assets? • Return on assets is an extremely important measure of how a retailer is performing. • The instructor may want to slow down here and give examples all the way through the model like those in the text of high margin/low turnover operations versus low margin high turnover operations. Financial leverage management • Leverage ratio = Total assets/O.E. or (Total liabilities +O.E.)/O.E. • How to manage leverage: 1. Too leveraged (too much debt) means financial instability, i.e., too much risk. 2. If not leveraged, then return on owner’s equity suffers • To illustrate financial leverage, take the case of leveraged buyouts. • Leveraged buyouts (LBOs) occur when a firm takes on extra debt to finance a buyout. • More debt means higher leverage. Conclusion • Depending where one is in the firm, different managers will use different performance ratios. • Top management will use leverage to get return on O.E. • Lower executives will use margin and assets management to get return on assets. • During the rest of the course we will be concentrating on these ratios, and others that will help the retailers control the financial side of their business. Solution Manual for Retailing Management Michael Levy, Barton A. Weitz, Dhruv Grewal 9780078028991
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