Chapter 8 Managing a Retailer’s Finances

Learning Objectives Describe the importance of a merchandise budget and know how to prepare a six-month merchandise plan. Explain the differences among and the uses of these three accounting statements: income statement, balance sheet, and statement of cash flow. Explain how the retailer is able to value inventory.

The Merchandise Budget Merchandising - Planning and control of the buying and selling of goods and services to help the retailer realize its objectives. Merchandise budget - Plan of projected sales for an upcoming season, when and how much merchandise is to be purchased, and what markups and reductions will likely occur. LO 1

The Merchandise Budget In developing the merchandise budget, the retailer must answer five major merchandising questions: What are the anticipated sales for the department, division, or store? How much stock on hand is needed to achieve this sales plan, given the level of inventory turnover expected? LO 1

The Merchandise Budget What reductions, if any, from the original retail price are likely to be needed in order to dispose of all merchandise brought into the store? What additional purchases must be made during the season? What gross margin (the difference between net sales and cost of goods sold) is the department, division, or store likely to contribute to the overall profitability of the company, given this merchandising plan? LO 1

The Merchandise Budget Four rules in preparing the merchandise budget: It should always be prepared in advance of the selling season. The language of the budget must be easy to understand. It must be planned for a relatively short period of time. The budget should be flexible enough to permit changes. LO 1

Exhibit 8.3 - Formulas for the Six-Month Budget LO 1

Exhibit 8.3 - Formulas for the Six-Month Budget LO 1

The Merchandise Budget Forecasting is most important for service retailers because their services are perishable. It is important to use recent trends when forecasting sales. LO 1

The Merchandise Budget Determining planned BOM and EOM inventories Stock-to-sales ratio - Depicts the amount of stock to have at the beginning of each month to support the forecasted sales for that month. Planned average beginning-of-the-month (BOM) stock-to-sales ratios are either based on industry averages or are calculated directly from a retailer’s planned turnover goals. Generally, stock-to-sales ratios will fluctuate month to month because sales tend to fluctuate monthly. LO 1

The Merchandise Budget Determining planned BOM and EOM inventories Stock-to-sales ratios always express inventory levels at retail, not cost. The BOM inventory for one month is equal to the end-of-the month (EOM) inventory for the previous month. LO 1

The Merchandise Budget Determining planned retail reductions Planned retail reductions fall into three types: markdowns, employee discounts, and stock shortages. They are included to reflect the additional purchases needed for sufficient inventory to begin the next month and to point out that taking a reduction is not a bad thing. Reductions are one of the major items in the merchandise budget subject to constant change. LO 1

Retail Accounting Statements Income statement Balance sheet Statement of cash flow LO 2

Income Statement It is a financial statement that provides a summary of the sales and expenses for a given time period, usually a month, quarter, season, or year. Comparison of current results with prior results allows the retailer to notice trends or changes in sales, expenses, and profits. LO 2

Exhibit 8.5A - Retailers’ Basic Income Statement Format LO 2

Income Statement Gross sales Retailer’s total sales including sales for cash or for credit. Returns and allowances Refunds of the purchase price or downward adjustments in selling prices due to customers returning purchases, or adjustments made in the selling price due to customer dissatisfaction with product or service performance. Net sales Gross sales less returns and allowances. Cost of goods sold Cost of merchandise that has been sold during the period. Gross margin Difference between net sales and cost of goods sold. LO 2

Income Statement Operating expenses Expenses that a retailer incurs in running the business other than the cost of the merchandise. Operating profit Gross margin less operating expenses. Other income or expenses Includes income or expense items that the firm incurs which are not in the course of its normal retail operations. Net profit Operating profit plus or minus other income or expenses. LO 2

Income Statement Retailers must consider the Generally Accepted Accounting Principles (GAAP) regulations and the Internal Revenue Service (IRS) rulings when presenting their income statement. The IRS provided a tax break for retailers by ruling that they may estimate inventory shrinkage. GAAP allows for variations in how retailers report certain expenses. LO 2

Balance Sheet A financial statement that identifies and quantifies all the firm’s assets and liabilities. It shows the financial condition of a retailer’s business at a particular point in time. The basic equation for a balance sheet: Assets = Liabilities + Net worth Comparing a current balance sheet with one from a previous time period enables a retail analyst to observe changes in the firm’s financial condition. LO 2

Exhibit 8.6A - Retailers’ Basic Balance Sheet Format LO 2

Balance Sheet Asset Anything of value that is owned by the retail firm. Current assets Assets that can be easily converted into cash within a relatively short period of time (usually a year or less). Accounts and/or notes receivable Amounts that customers owe the retailer for goods and services. Prepaid expenses Items for which the retailer has already paid, but the service has not been completed. Retail inventories Merchandise that the retailer has in the store or in storage and is available for sale. LO 2

Balance Sheet Noncurrent assets Assets that cannot be converted to cash in a short period of time (usually 12 months) in the normal course of business. Goodwill An intangible asset, usually based on customer loyalty, that a retailer pays for when buying an existing business. Total assets Equal current assets plus noncurrent assets plus goodwill. Liability Any legitimate financial claim against the retailer’s assets. Current liabilities Short-term debts that are payable within a year. LO 2

Balance Sheet Accounts payable Amounts owed to vendors for goods and services. Long-term liabilities Debts that are due in a year or longer. Total liabilities Current liabilities plus long-term liabilities. Net worth (owner’s equity) Total assets less total liabilities. LO 2

Statement of Cash Flow Lists in detail the sources and types of all cash revenue and cash expenditures for a given time period. When cash inflows exceed cash outflows, the retailer is said to have a positive cash flow. When cash outflows exceed cash inflows, the retailer is said to be experiencing a negative cash flow. It enables the retailer to project the cash needs of the firm. LO 2

Exhibit 8.7A - Sample Cash Flow Statement

Exhibit 8.7B - Typical Cash Inflow and Outflow Categories

Retail Accounting Statements Differences: A balance sheet shows the financial condition of a retailer’s business at a particular point in time, as opposed to the income statement, which reports on the activities over a period of time. In a statement of cash flow, the retailer is concerned only with the movement of cash into or out of the firm. An income statement reflects the profitability of the retailer after all revenue and expenses are considered. LO 2

Inventory Valuation Accounting inventory system Inventory pricing systems LO 3

Accounting Inventory System Cost method - Provides a book valuation of inventory based solely on the retailer’s cost of merchandise including freight. Limitations: It is difficult to do daily inventories or even monthly inventories. It is difficult to cost out each sale. It is difficult to allocate freight charges to each item’s cost of goods sold. Used by retailers with big-ticket items and a limited number of sales per day. LO 3

Accounting Inventory System Retail method - Values merchandise at current retail prices, which is then converted to cost based on a formula. The basic steps: Calculation of the cost complement. Calculation of reductions from retail value. Conversion of the adjusted retail book inventory to cost. LO 3

Accounting Inventory System Advantages of the retail method over the cost method of inventory valuation Accounting statements can be drawn up at any time. Inventories need not be taken for preparation of these statements. Physical inventories using retail prices are less subject to error and can be completed in a shorter amount of time. The retail method provides an automatic, conservative valuation of ending inventory as well as inventory levels throughout the season. LO 3

Accounting Inventory System Disadvantages of the retail method It is a ‘‘method of averages.’’ It places a heavy burden on bookkeeping activities. LO 3

Inventory Pricing Systems FIFO (first in, first out) - Values inventory based on the assumption that the oldest merchandise is sold before the more recently purchased merchandise. LIFO (last in, first out) - Values inventory based on the assumption that the most recently purchased merchandise is sold first and the oldest merchandise is sold last. LO 3

Inventory Pricing Systems In times of rapid inflation, most retailers use the LIFO method, resulting in lower profits on the income statement and lower income taxes. Most retailers also prefer to use LIFO for planning purposes since it accurately reflects replacement costs. LO 3