A Tale of Two Stores

September 30, 2008  by in UnCategorized   

By Home Furnishings Business in on October 2008 The vernacular used in financial reporting, balance sheets and financial statements often seems Mandarin to folks other than chief financial officers, accountants or holders of MBAs. Here’s a look at how to cut through the dense lexicon and get to the bottom line.

One of the biggest hurdles a store owner has to jump is figuring out how store finances reflect store operations. Even the simplest financial statements can be confusing.

First of all, there are two primary financial statements, the income statement and the balance sheet. Of course, there are many other, very effective ways of judging your store’s performance, but the basics are the best place to start.

We’ve set up the income statements of two stores, A and B (see accompanying table). Line by line, the components of their income statements are remarkably similar, not surprising since we crafted them this way.

Store A is a larger store, with gross sales of nearly $25 million. Store B’s gross sales are just under $16.3 million. Gross sales are the total sales of the store, before any adjustments. A store owner can pull this number from their sales receipts. That’s the total amount of sales for the year.

The difference between gross sales and net sales is “returns and allowances,” the term owners and vendors use for the amount of money the vendor “allows” the store to take off from their invoice to cover product that arrived at the store from the vendor in such poor condition that it couldn’t be repaired to be sold to the consumer and had to be either returned to the vendor or scrapped. The amount a store uses as “returns and allowances” is usually determined by their vendor contract, either as a percentage of products shipped or a flat fee.

Net sales are simply that—the amount of goods the store sold, including their markup. Net sales are frequently referred to just as sales.

Cost of goods sold (COGS) is the price the store owner paid the vendor for the products she sold to consumers. It includes the cost of warehousing those products prior to consumer sales and also shipping costs from the vendor, if those items are part of the selling contract with the vendor.

Gross margin is the difference between net sales and COGS.

Selling, General and Administrative (SG&A) expenses are the back-office expenses of the store. Included are expenses for advertising, insurance, property taxes, salaries and benefits.

Operating income is net sales minus COGS and SG&A.

After operating income on the income statement are other income and other expenses. These could include investment income, income from selling store income or interest expense.

Income before taxes is one of the most important numbers on the income statement, one that is commonly used to determine how financial secure a store is compared with other stores of similar size.

Income taxes, obviously, are important. But don’t forget that a store just like yours, located in a different city or state, will probably pay a different tax rate.

Net income, also known as the “bottom line,” is the actually amount the store made after all expenses are subtracted from net sales.

PUTTING THE NUMBERS TOGETHER Any store owner can most likely put together an income statement for their business without computer programs or accountants. But it’s what that income statement tells you that is important.

The first important financial equation is Return on Sales (ROS), also known as the net income margin. ROS is calculated by dividing net income by net sales. What this tells you is how much of every sales dollar is profit of the store. Store A has ROS of 3.3 percent, pretty average for stores in a normal economy. Store B’s 6.3 percent is high, so high that it is probably worthwhile to go back and check to make sure all the store’s expenses were listed on the income statement.

Gross Margin Percentage measures how much of the store’s net sales are absorbed by the cost of what the store sells. It’s calculated by dividing gross margin by net sales. Store A’s 43.2 percent indicates that after paying for the product it sells, Store A has 43.2 percent of each sales dollar left to pay other expenses. Once again, Store B’s gross margin percentage of 51.6 percent is high and probably indicates a miscalculation along the way or the store is undergoing special circumstances.

Operating Margin Percentage is calculated by dividing the operating margin by net sales. This calculation tells you how much of your sales dollar is absorbed by the cost of the products you’re selling and the cost of selling those products. Store A’s 4.9 percent is a little low, but if the store is keeping other costs down, the store can make a profit for the year. Once again, Store B’s 8.0 percent maybe high and is another flag to the watchful store owner.

ASSETS VS. LIABILITIES While the income statement reflects a specific time period, usually a year or quarter of a year, the balance sheet is a “snapshot” of store operations at one specific moment in time, usually the last day of the time period. There are two sides to the balance sheet, one showing all the assets of the store, the other showing the liabilities and net worth of the store.

Assets are the positives of the store. Fixed assets are assets that exist from one time period to another, such as displays, computers, the store building, etc. Current assets include cash on hand, marketable securities, etc. One of the biggest components on the store’s balance sheet is inventories, the goods held for sale by the store and not yet sold to a customer.

Liabilities, also commonly known as debts, are what the store owes. These can include accounts payable to vendors, long and short term loans, accrued taxes not yet paid, etc.

The difference between assets and liabilities is Net Worth or Equity. Simply put, if the store went out of business on the day the balance sheet was prepared, when all the assets are sold and all the liabilities are paid, the amount left over for the owners is the net worth of the business.

One of the most commonly used equations to value a business is Return On Assets (ROA). This is calculated by dividing net income from the income statement by the total assets of the store. This compares income to assets, showing the profit derived from the store’s assets. The higher the number, the better the store is doing. Store A’s 5.4 percent is good; Store B’s is rather high and, once again, bears looking into.

SO WHAT? The purpose of financial statements and ratios is to measure a store’s performance. The best comparison to use to establish your company’s health is prior year statements and ratios. Of less value is the performance of other stores because each company is a unique entity. Your store may be in a city or state with higher income taxes or property taxes, throwing off comparisons or salaries may be higher because getting good employees costs more.

If you don’t have prior year results to use as comparatives and have to use generic results, those that use pretax income as the basis are more valuable for your comparison.

If your store is large enough to break down product categories, consider applying the income statement ratios to each product line. Calculate sofa ROS and compare it with bedding ROS and all other major category results. Obviously, full-line store simply cannot discontinue an important product category simply because it trails other products in producing income for the store, but perhaps it’s time to minimize the number of SKUs of that product on your floor.

Also take a look at the amount of allowances and returns by product category. Is one category more problematic than another? Do you have more returns from a certain vendor? Whether or not the vendor is giving you a generous allowance for damaged items is secondary, if it takes too much of your staff’s time in dealing with these returns.

Is COGS really high for one vendor’s line? Don’t blindly drop the line, check into it and see if that line is producing a significant number of sales, particularly add-on sales. If that beautiful sofa that you think is maybe too expensive is driving sales of tables, chairs and/or lamps, discontinuing it is probably too costly.

One of the first things a company looks to when trying to hold the line on expenses is SG&A. In spite of the human cost of laying off employees, there’s a substantial business cost. Keep in mind that, in addition to paying severance costs, you’ll also have to find a way to get their jobs done, either by yourself or others. Can you afford to let them go if their job is essential to the business?

Be aware of special charges. Just as furloughing employees can result in extra costs, discontinuing product lines can be expensive, too, if you end up holding clearance sales. Keep track of these special charges and make sure they’re on your income statement because they do reflect the cost of doing business.

The simplest comparison an owner can use is the percentage change of line items on both the income statement and balance sheet from one period to the next. Did sales dip? If so, do you need to reduce expenses to maintain income? Are sales up? Is it costing you a lot more in SG&A to support those sales?

The most important thing to keep in mind is that each store owner knows his or her store best. Don’t be afraid to use your gut instinct. Keep track of your numbers and let them tell you the story of your business. If they’re changing, make sure you know why.

As for Store B? The company is going out of business and sales are up from the prior year, but they’re not ordering additional product, so their COGS is low. They didn’t hire more staff to sell product, but they’re working more hours, so SG&A is up. Their situation is impacting every line on their income statement, so they’re not a typical business.