Financial Statements at a Glance

Financial statements describe pertinent pieces of information to understand the well-being of a company, which includes the income statement, the balance sheet, and the cash flow of a company. The metrics described over the course of this chapter are what help a company measure its financial health. The income statement shows the company’s revenue (referred to as top line) and expenses during a certain period, usually once a year. Although you usually have to report once a year to the IRS, performing this analysis once a month gives you a better perspective on your business activities. It shows how to calculate the income and earnings before income, tax, depreciation, amortization (EBITDA), but if a company does not grow or maintain its profit, then the company may be in debt. This statement emphasizes whether the company made a profit or loss during a certain period as indicated.

The balance sheet is a “snapshot in time” of financial balances. It is usually analyzed for a company monthly, quarterly, or six times per year. It refers to the assets, liabilities, and equity ownership of a company for a nonpublic company. The total asset is equal to the total liabilities plus its owner’s equity. The assets are financed by the liabilities (borrowed money) or equity (owner’s or shareholder’s). A company’s desire is to have the equity large and the liabilities as small as can reasonably be expected—that is the company’s profits).

The cash flow statement illustrates the money that flows in or out of the business during any given measured time period, typically monthly. This statement categorizes the sources of revenue and expense into areas useful for the company such as revenue from investing versus revenue from operations, or debt-related expenses versus operations-related expenses. This can give the observer a clearer perspective on whether funds and resources are being allocated effectively.

Retail Math Basic Metrics

Basic metrics are also known as key performance indicators (KPIs) of a company. Basic metrics introduce how the basic functions of a company are working by its gross sales, net sales, average order value, units per transaction, ticket price cost of goods sold (COGS), initial markup and gross profit percent, average unit cost, average unit retail, operating profit, and net profit. These KPIs assess whether a company is achieving its basic goals and performances.

The book will now go over each basic metric and give the formula for the KPI, relevant information about the KPI, why it is important, and the values from the financial statement for the dress merchandise company:

Gross sales = Gross revenue or at times referred to as top-line sales.

Gross sales are relevant to retail business and show how much merchandise the business is selling. Gross sales are the total proceeds of all the sales within a time period. To calculate gross sales, the company needs to sum up all the sales receipts. Gross sales do not include the operating expenses, tax expenses, or other charges. This metric is on the income statement.

The gross sales increased from 2XX0 ($1,130,000) to 2XX1 ($1,408,455), which shows that the company is expanding its top-line form of sales. This is always a good marker with which to start.

Net sales = Gross sales – (Discounts + Returns + Allowances)

Net sales is the revenue earned by a company for selling its products related to the company’s pertinent operations and reveals the strength of a company. This metric is sometimes referred to as revenue and is used to calculate many other KPIs because a company must bring in revenue in order to turn a profit. This is the retail value of any product after discounts, returns, and allowances for missing or damaged goods are removed. The sales reported on the income statement are net sales. Some of the ways to increase revenue are by distinguishing the business product from others in the market, increasing the customer traffic via advertising, increasing the frequency of transactions and the quantity of product in every transaction via recommendations and cross-selling, and post-purchasing email reminders. You may also increase the average unit sale or average sale, increase the price of the popular merchandise, or even better negotiate with the wholesale companies about instituting better terms for the cost of the goods sold and allowing the company better terms to sell the product at a more competitive price. Anniversary sales, shopping holidays, and other special events provide regular opportunities to showcase your brand value and acquire new customers.

Net sales are increasing, which is a good initial sign, from 2xx0 ($1,072,500) to 2xx1 ($1,336,842). Although this is a first sign that the company is doing well, there are many other factors with the other metrics that will need to be assessed before coming to a conclusion about the well-being of the company.

It is good to graph gross sales against net sales and see if their movement is going in the same direction and both are improving. The owner of the company can then see if the sales after all the discounts, returns, and allowances are still increasing.

For both years, the gross sales and net sales are increasing, which indicates just by eyeing the numbers that sales are increasing and thereby improving.

Average order value (AOV) = (Net sales in dollars) / (Number of transactions)

The average order value measures customer behavior and looks at the average amount of money a customer spends every time a customer places an order. This variable describes the average dollar per transaction in a period of time and helps you evaluate the pricing strategy of your retail product and its long-term value. In other words, once the company has an idea of how much customers will spend on average for a product, the company can develop strategies to increase the number of items sold per transaction and use promotions and bundle the products together in order to increase the number of goods sold. This metric shows the average amount earned from a customer over a period of time, usually monthly, weekly, or daily.

From 2xx0 ($536) to 2xx1 ($637), the average dollar per transaction increased. This is a good sign and shows the company is learning how to increase the volume per sale.

Units per transaction = (Quantity sold) / Number of transactions

This measures the average number of items that customers purchase in any given transaction. The higher the number, the more items customers are purchasing per transaction in a visit. It is usually recommended to calculate this metric daily, weekly, monthly, and yearly, and to see if there is a change from year to year.

The number of units per transaction decreased slightly from 2xx0 (4.26) to 2xx1 (3.98). This is an important metric. It indicates from the AOV that customers are spending more per transaction but with fewer items in their shopping cart. Therefore, the reason may be that customers are buying higher-priced goods but fewer items. It is important to look at this daily to see what is going on, why it is happening, and what you can do about it. Here, the company may want to bundle products in order to reduce the price of the products that are selling together and/or work with the company that is producing the goods to see if the popular products could get a better price for the cost of goods and thereby lower the price of the merchandise.

Ticket price = Quantity sold * MSRP

This ticket price is the sum of the tickets of all the products in the store. MSRP stands for manufacturer’s suggested retail price or original ticket price, and the average ticket value takes into consideration any markdowns and discounts on items sold. The Average ticket price can be used instead of MSRP.

The ticket price has increased from 2xx0 ($1,193,500) to 2xx1 ($1,461,250), which illustrates an increase in potential profitability based on the growth in initial markup year over year in our example. If the initial markup remains the same and the retail value increases, it indicates a higher quantity of items available for sale. The company needs to make sure that their retail product is essential to the buyer and different from its competitors so that it will sell more products at its maximum possible ticket price.

Cost of goods sold (COGS) = (Beginning inventory valuation at full price + Net purchases + Cost of labor + Material and supplies + Other manufacturing costs like freight and shipping) – End-of-period inventory at full cost

Advertising, fees to website hosts or other technology vendors, agencies, and other sales-related costs often go into a separate line item from COGS but are important to include when calculating EBITDA and cost of sales. COGS and EBITDA are in the Income Statement.

This is an important variable to the retailer because it usually is the largest expense and it includes how much it costs the company to produce the items in the store.

The cost of goods increased from 2xx0 ($184,000) to 2xx1 ($200,000). The object is to keep this number as low as possible. It is a good idea after the company is more comfortable with the distributor that it tries to reduce this cost and negotiate a better price for the supplies and materials, etc.

Initial markup percent = [(Ticket price– Cost of goods sold)/Ticket price]* 100

The initial markup percent needs to cover the wholesale cost, as well as payroll, taxes, and day-to-day expenses, and the cost of running the business of the company. Chapter 3 discusses calculating markups.

The initial markup percent increased from 2xx0 (85 percent) to 2xx1 (86 percent) in response to the cost of goods also increasing to compensate for the additional cost. This may have slowed the volume of sales (Quantity sold) from year 2xx0 (8,525 units) to year 2xx1 (8,350 units), but resulted ultimately increased profit margin dollars. A goal of the company is to bring the cost of goods down without lowering the quality of the product.

Interesting enough, for both years, the markdown percentage remained constant at 5 percent from 2xx0 to 2xx1. And, with this markdown and discounts included, the amount for 2xx1 ($1,190,827) was better than 2xx0 ($939,077). This amount indicates that perhaps the company under-priced the goods in year 2xx0 and gave the products a better initial price in the second year so that there were fewer markdowns and discounts.

Gross profit = (net sales) – (cost of goods sold)

Gross profit margin = [(Net sales) – (Cost of goods sold)]/ (Net sales)*100

Gross profit margin includes the direct cost of the company’s profit and is an important metric to determine the company’s profit because the cost of goods—the largest expense—is subtracted from the equation. Direct cost includes labor expenses and material expenses. It does not include the indirect costs such as advertisements, which is a sales and marketing expense, or rent and utilities, which would fall under capital expenditures or operations. The goal is to make the cost of goods less expensive and the gross profit higher. The company wants to see this metric increase.

The gross profit margin is used primarily as a mechanism for managing top-line pricing. The gross profit margin should not fluctuate but at times does due to changes in pricing and retail markdowns. If it fluctuates too greatly, it may be a sign of poor management. It should be relatively stable unless the company is liquidating products at a lower negotiated price, e.g., wholesale liquidation. In this case the gross profit margin would decrease based on negotiated wholesale or dropship arrangements with fixed commissions. For each business sector, the gross margin needs to be determined based on industry standards for your type of company. A good gross profit margin for online stores is thought to be around 46 percent to 65 percent.

Even with the cost of goods sold higher, the gross profit increased from 2xx0 ($888,500) to 2xx1 ($1,136,842) and so did the gross profit margin from 2xx0 (83 percent) to 2xx1 (85 percent). This is a positive position the company is in. It shows that the gross profits of the company are improving.

Average unit cost = (Cost of good sales)/ (Quantity sold)

This is the average amount paid per unit of an item. A company will want to lower the cost of an average unit in the end. They can do this by figuring out the average unit cost and then seeing where they are able to cut costs. Each product has fixed costs that do not change and variable costs that could be adjusted. It is good for the company to always be on the lookout for better ways to adjust the variable costs.

The average unit cost increased from 2xx0 ($22) to 2xx1 ($24). The amount did not increase too much, but the company needs to find a way to decrease this cost per unit by trying to reduce the amount the company has to pay for the cost of goods.

As mentioned, the MSRP is the initial price recommended by the producer or brand to maximize revenue.

Average Ticket price or retail price is the final price that the product sells for to the end customer, including any markdowns or discounts.

It is important to reduce additional costs or expense that are not necessary to get the merchandise into inventory and ready for sale, like shipping and handling fee. Accurate stock prices are important for a company, and moving the product from the stock room into a sale is imperative.

The average ticket price of the goods increased by only $10 from 2xx0 ($135) to 2xx1 ($145). Customers do not want to see the price of their clothing jump too high, which is a way to maintain and increase the number of customers who buy the product.

Average unit retail = (Net sales or revenue in dollars) / (Quantity sold)

This metric is the average selling price of an item and informs the company about the microeconomics of the product: how much a buyer is willing to spend on the product, how many items the customer is willing to buy, and if the cost of the item is too high or too low.

The average unit retail increased from 2xx0 ($126) to 2xx1 ($160). It shows that the customer is willing to buy the higher-priced product.

Operating profit = gross profit – total operating expenses

The operating profit is the income earned from the performance of the core business operations of a company. This means it excludes from the calculations interest and taxes, as well as earnings in which it may be invested in other businesses or other investments. In other words, the direct and indirect costs of the business are included. This metric should be watched closely to see if it is improving, which shows how the company is operationally profiting. If the company needs to borrow more funds to keep it working, this will negatively impact operating profit metric and will show up in this KPI.

The operating profits increased from 2xx0 ($548,500) to 2xx1 ($718,642). This signals that when interest and taxes are excluded from the calculations, the operating expenses are improving and the core business is doing well.

Net profit = net sales – (cost of goods sold + operating expenses + taxes + interest)

Net profit margin = (Net profit) / (Net sales)*100

Net profit is also referred to as net income and is the money left over after expenses are paid. This measure tells the company the amount left over at the end of a period of time.

The net profit margin metric, which comes from the income statement, shows how much profit the company makes after the cost of goods sold, taxes, and operating expenses (both fixed and variable cost) are subtracted from the net sales in the numerator. In other words, it is how much of every dollar in sales a company keeps from its earnings. The net profit margin is subject to fluctuation based on both the promotional and discounting activities and seasonal investments in marketing and other operations expenses such as software subscriptions, shipping and warehouse costs, and head count. The net profit margin becomes EBITDA when depreciation and amortization are added into the calculation; EBITDA will be discussed in the next section.

The net profit margin shows the profits a company would have to use if the company had to cover increases for some of the fixed costs of the company, as well as cover the variable costs of the company. A fixed cost is a cost that remains stable over the business activity. A rent expense is a good example of a fixed cost because it is usually a set amount at each quarter. And, that amount will not change as the market may change.

A variable cost is an expense that changes as the business activity changes. The raw material to manufacture the product may vary each time the company purchases the material.

The goal of a company is to make a net profit month after month. This metric is essential to track because it shows if the company is making enough money for the sales and contains the operating costs of the company. It will also show that the company is stable and on a trajectory with growth in the future. A company wants to see at least this metric maintain itself and increase over time.

A good profit margin is around 20 percent; 10 percent is considered acceptable, and 5 percent is a low percentage. The higher the better. The net profit margin remained stable and was very high from 2xx0 (48 percent) to 2xx1 (47 percent).

Inventory/Stock Metrics

Managing the inventory of the store is no easy task, and the stock control needs to be reviewed often. This section discusses inventory management metrics, which aids in helping management decide how to make informed decisions on the inventory. The metrics included in this section are start of period inventory, units on hand, stock dollar EOM, fill rate, stock/sales, week unit sold, weeks of supply, beginning week on hand, and sell through. Inventory turnover is in the financial ratio chapter. It is essential for a company to know what is happening with the inventory and how the stock is handled and sales are produced.

Start of period inventory = This measure tells the retailer the total inventory at the beginning of a period and can be calculated in units, cost, or retail dollars depending on the audience for the report. Units are typically used by retail planners to allocate shipments to retail stores, warehouses, or wholesale customers. Cost is typically used by finance to estimate inventory liability, while retail dollars on hand indicates risk to sales revenue as well as sales potential and is used by the sales and marketing teams. It is generally assessed at the beginning of the week or month.

For the year, this number remained the same from 2xx0 ($5,000) to 2xx1 ($5,000).

End-of-period inventory = This is a measure of the total inventory a retailer has at the end of a period and can be calculated in units, cost, or retail dollars. It is generally assessed at the end of the week or month. Typically retailers would use the start of period or end of period for their reporting, but not both. The difference between the starting and ending inventory for any period is the sell through, whether in units, cost, or retail.

In general, when referring to inventory or stock, it is the value of goods and is referred to in terms of dollars.

Units on hand = Starting inventory – Quantity shipped + Quantity purchased

Units on hand lets the company know how much merchandise the company has until the stock runs out. This KPI lets the company know if they have enough merchandise to cover all the inventory and if the company will have enough merchandise to replenish the inventory once it is sold out.

This is the current units of stock the company has. This metric increased from 2xx0 (1,475) to 2xx1 (2,250). The units on hand are increasing and may mean that the company needs to work better with the supplier to bring lead time down, know their customer so that the company is aware when they will be buying specific products, and place orders with the supplier once an order is placed.

Stock dollar EOM = Units on hand * Average ticket price

This is the amount of cash that the inventory is costing the company to hold at the end of the month. This is calculated at the line item or SKU level to accommodate pricing differences between products and then summed to a total.

The stock dollar increased $127,125 from 2xx0 ($199,125) to 2xx1 ($326,250). This is not a positive number; however, if the cost of goods price decreased, perhaps the ticket price could be reduced, and this metric would look better.

Fill rate = (Number of orders shipped) / (Total number of orders or Transactions)

Fill rate percent = Fill rate * 100

This is a forensic measure that is useful to help predict future orders. This measurement helps you understand how well the company is able to meet customers’ demands. It is the key to improving customer experience and to redefining a wholesale inventory management and fulfillment center. Fill rates should be as close to 100 percent as possible. For fill rate, the company needs to also assess the dead stock, loss and damaged products, and products that are obsolete now. Sometimes orders and transactions are interchanged. Transactions includes returns.

The percent went up slightly from 2xx0 (94 percent) to 2xx1 (97 percent). This indicated that the company seemed able to meet the customer demands for the products.

Stock / Sales = (Stock dollars EOM) / (Net sales)

This measures inventory on hand, which is based on the previous months of sales. This metric shows how much inventory was needed to achieve the sales in a month’s time. The lower the number, the more sales will have moved because the denominator is sales. This measure is very important to small and medium-sized companies because inventory is one of their largest expenses. It is important to maintain a good balance between a well-stocked inventory and selling enough merchandise to move your inventory into purchases from storage in order not to lose money. A good stock to sales is in the range of 0.16 to 0.25.

Stock to sales increased from 2xx0 (0.19) to 2xx1 (0.24). Although both are in the range, 2xx1 is getting close to the boundary, and it should be assessed to find out what is going on. Again, if the cost of goods decreased, this number may improve. Also, the company could have more presales and promotions to help cut the stock to sale number.

Weekly units sold = Units shipped/52 weeks in a year

The weekly units sold decreased from 2xx0 (164) to 2xx1 (159).

Weeks of supply = (On-hand inventory units)/ (weekly unit sales)

This measures how many weeks it takes for merchandise to sell and how long the inventory will last given the average current rate of sales. This measure is a forward-looking metric and helps the company forecast to assess what strategy to use to reduce the inventory by advertising this product with promotions or discounts.

Here, the numbers increased as well from 2xx0 (9) to 2xx1 (14) showing that there is more inventory than needed. This shows that the company is carrying too much supply and it should be reduced.

Beginning week on hand = (Starting inventory)/(Weekly units sold)

This metric is the average amount of time it takes a company to sell the inventory it has. For small and midsize companies, this metric is a snapshot of the company’s health because inventory is a big expense for the company. Investors may look at this criterion to see the health of the company. The lower the number the quicker the company is able to turn its investment into revenue. Too much or too little to sell should be watched carefully because the company does not want to run out or have too many products.

The beginning week on hand increased from 2xx0 (30) to 2xx1 (32). This means that the inventory is out for approximately a month for both years.

Sell through = (Units sold)/ (Units sold + Beginning of the weeks units on hand)*100

This metric is usually analyzed by retailers weekly and is a very similar metric to turnover. Regularly priced merchandise and reduced merchandise with regular prices are commonly analyzed together to compare sell-through velocity. This is a comparison measure of the amount of inventory a retailer receives from a manufacturer or supplier to what is actually sold. This amount indicates how much of the supplies the company has gone through and if the company needs to restock any of the items. A good sell-through rate is between 40 percent and 80 percent. The higher the percentage, the better.

Sell-through decreased from 2xx0 (85 percent) to 2xx1 (79 percent). The sell-through rate for this company is pretty good, which indicates the company is selling through its merchandise at a good pace.

Growth Metrics

The growth metrics focus on improving the operations of the online sales and payment to increase revenue. This section consists of two metrics: last year total sales and build. This metric aids in making sure that the company is on a positive trajectory.

Last year total sales = Net sales/build

Last year total sales increased from 2xx0 (893,750) to 2xx1 (1,072,545). This is a good sign.

Build or trend = (This month’s total sales)/(Previous month’s total sales)

This is a measure of the change from one month or week from the previous month or week. Typically, it is ideal if this time keeps increasing. The build increased from 2xx0 (1.20) to 2xx1 (1.25); that is a good sign.

Now that we know the definition of each KPI, what each metric does, and why it is important, the next step is to dive into the analysis of the retail metrics for the dress company. However, it does not show all five years, which is when the company was incepted, of financial statements the company. Only the past two years are shown, and it appears that the flow from the past two years is positive. This is a good sign indicating that the core of the business has enough money to invest in new equipment, profit, and grow. This is a positive sign of potential growth. It also shows that the company has enough money to pay for the previous debt and potential future loan agreements. The cash flow statement predicts the future health of a company’s ability to pay back loans. It lets the administration know that the company has enough money to pay its expenses.

What the company needs is for buyers to negotiate a decreased cost of goods with suppliers while expanding the inventory base. This will help enable the company to increase profitability. Once that is accomplished, the company’s task is to increase its sale prices and maintain its merchandise costs. This cost optimization process may help increase items per transaction and have a ripple effect with profit.

Summary

This chapter illuminates basic retail math, inventory or stock, and growth metrics with the aid of Appendix A. Through a fictitious retail company’s example, this chapter covered how to use retail metrics in a constructive and useful way to analyze and start telling a story of a retail company. The next chapter will demonstrate how to look at the financial ratios using the data from the same real-life company, and then it will explain how to sum up financial ratios information.