Reading financial statements is about as exciting as watching Grandma knit a sweater! And I suspect that this same feeling is experienced by retailers who must read their corporate P & L statements and balance sheets.
Some retail chores are a lot more exciting than studying one’s balance sheet and P&L statement. The gratifying part of retailing is picking a product line and then selling it successfully. Moreover, aren’t the financial statements just something that the accountants read?
Financial statements are crucial to your business survival. The P&L statement is a measure of your profitability or losses for a defined period. The balance sheet is a measure of the health of your business in terms of your assets versus your liabilities. To the extent that you either don’t produce these documents, don’t read them, or don’t understand them… then you are courting potential financial disaster.
Let’s simplify these two documents such that you will be comfortable in reading them and understanding what the numbers are telling you. Let’s start with the profit and loss statement.
The formula for calculating profit is sales, minus cost of goods sold (COGS), minus all fixed expenses, minus all variable expenses equals net profit before taxes. The P&L statement simply lists all these revenue or cost components by groups and completes the profit or loss calculations.
From the P&L statement other calculations can be made which present profits or losses in an alternative perspective. For example, profit can be reviewed as a percent of sales. If your profit is 10% of sales, that’s good. On the other hand, if it is only 2% of sales that’s bad.
Profit should also be viewed relative to the investment in inventory and/or the equity of the investors. For example, if you invested a million dollars to earn $12,000, that’s a poor return.
The balance sheet consists of three groups of elements: company assets, the company’s liabilities, and owners’ equity.
There are many metrics that businesses and accounts use to measure the financial viability of a company. These metrics come from three information pools: assets, liabilities, and profits.
Many of these ratios require the use of the income statement in conjunction with the balance sheet. The balance sheet groups all items as either assets, liabilities, or owner’s equity.
Current Ratio (CR): current assets divided by current liabilities. The CR measures the degree of liquidity for the company. A current ratio of 1.5 to 1 is considered healthy in that current assets exceeds current liabilities,
The Quick Ratio or Acid Ratio is an even better of liquidity for it compares cash plus marketable securities and accounts receivable relative to current liabilities. Any acid ratio greater than one (1) is good.
Return On Equity (ROE): is a measure of how much profit is generated from investor equity investment relative to profits delivered and is calculated by dividing the income for the period by investor equity (paid in capital plus retained earnings). A return of 2% is lousy while a return of 10% is good.
Inventory Turnover: Cost of goods sold (COGS) divided by average inventory for the period expressed in cost dollars. The COGS is calculated as follows: beginning inventory, plus purchases, minus ending inventory equals cost of goods sold. As a rule, the turnover number should be north of 2.5 and closer to 3 or 4. A turn rate of 2 means you are stocking a 6 months’ supply of inventory.
Gross Margin Return On Inventory (GMROI): Gross margin dollars (sales minus cost of goods sold) divided by average inventory at cost. GMROI tells you how much gross margin (not net profit) is generated per dollar invested in inventory. If your resultant number is something like 1.25, it means you have earned a 1.25 for every dollar invested in inventory. That 1.25 has to support all fixed and variable expenses plus profit. A number like to or 2.75 is much healthier.
In summary, if you are the owner or manager of a store, then you need to get these financial statements regularly, read and understand what the numbers mean and lastly act upon the data if the numbers are saying “we have a problem here.”
Mastering financial statements can be the difference between surviving versus getting rich! Make it so!