Most Important Financial Performance Ratios- EssayTank.com
You are running a retail shop that sells merchandise such as clothes, alcoholic beverages, or fast-moving consumables at a grocery store and you would like to assess its financial health. Or you are working on a financial analysis project about the financial status of a listed retail company such as Walmart, Target, The Home Depot, or Kroger. What metrics do you rely on for your analysis?
Retailers are Different from Other Businesses
Retail business differs from service business because of the need to have a sufficient stock level. It however comes with complications and risks such as stock going bad, obsolescence, and even price fluctuations.
Other risks include overstocking, stock-out costs, and fraud from employees. It therefore requires keen control measures and proper auditing of financial records. In fact, banks are unlikely to give credit to retail business owners who cannot demonstrate a proper financial trail of their transactions.
What Are the Most Important Ratios for Retailers?
Here are some of the most critical metric to use when analyzing retailers books of accounts.
This ratio compares a company’s current assets with current liabilities. It is an indication of a company’s ability to meet short-term obligations to creditors.
Receiving merchandise on credit is quite the norm in the retail industry and it helps retail stores grow their turnover quickly. However, such creditors need to be paid quickly, often within weeks or months. If a company does not have enough current assets, it may find itself in trouble with suppliers.
According to Wells Fargo, the average current ratio in the retail industry is 1.47.
The quick ratio is a more refined form of the current ratio. It shows the ability of a company to pay short-term obligations from the liquid assets. In most cases, inventory is omitted from the summation of current assets.
For a retail company, a healthy quick-ratio is an indication that the company can pay-off creditors without having to liquidate too many assets.
Gross Profit Margin
The gross profit of any business is found by subtracting the cost of goods sold from total sales. The gross profit margin is the figure of gross profit divided by the sales figure.
The gross profit margin is important for a retailer because it is from that amount that other expenses such as rent and administrative expenses are paid. Retailers who stock thousands of goods (supermarkets) need to take a keen interest in this ratio because each item has a unique gross profit margin. It is imperative that they have the right mix of high margin and low margin products so as to keep customers happy and at the same time protect their profits.
Inventory management is the single most problematic issue for retailers. The inventory turnover ratio measures efficiency in this regard. It is found by dividing the net sales with average inventory level. A business should try and have as high an inventory turnover ratio as possible.
A higher ratio shows that the business is not keeping too much stock and that it is protecting itself from obsolescence costs. For instance, in the clothing industry, a turnover ratio of close to 4 times within a year is seen as healthy.
Return on Assets
Return on Assets is another important measure of efficiency in the retail industry. The calculation is done by dividing net earnings by total assets. It indicates how much the company is making using the assets owned. A higher ratio is desirable.
Interest Coverage Ratio
For a debt-leveraged company, this is a critical ratio. You calculate it by dividing the interest expense by the earnings before interest and tax figure (EBIT). It shows how many times the company can pay its interest expense. Besides debt financing, interest expense can arise from lease of property and equipment.
The Importance of Ratios for Retailers
Once these ratios have been calculated, the analyst can do comparisons with other years or quotas to come up with a trend analysis.It is also prudent to find industry data to identify areas of weaknesses in the financial or operations structure. Numerous financial analysis websites collect and curate reliable data for various industries. The beauty of ratios is that they can help compare businesses in the same industry even when they differ in balance sheet size.
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