McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6 Financial Strategy

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. This chapter examines: 1) how the financial analysis can be used to assess the retailer's performance, 2) assess the reasons its performance is above or below expectations and 3) provide insights into appropriate actions that can be taken if performance falls short.

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Objectives and Goals First step in the strategic planning process involves articulating the retailer’s objectives and the scope of activities it plans to undertake. These objectives guide the development of the retailer’s Strategy. Three types of objectives retailer might have are: 1)Financial objectives 2)Societal objectives 3)Personal Objectives

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Objectives Most people focus on profit to assess the financial performance and this is not RIGHT!!! It is not profits it is RETURN ON INVESTMENT (ROI) Aiming for profitAmount of money Invested ROIPerformance $100,000$500,00020%Excellent $100,000$2,000,0005%Poor A common used measure of ROI is RETURN On ASSESTS (ROA)

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Societal Objectives Societal objectives are related to broader issues about providing benefits to society-Making the world better place to live. Examples: retailers might be concerned about providing employment opportunities etc. Performance with respective to societal objectives is more difficult to measure than financial objectives. We rely on percentages for example percentage of women Employed in the retailer Business.

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Personal Objectives Many retailers especially owners of small business have personal objectives such as self-gratification, status, and respect Examples: retailers might be concerned about providing employment opportunities etc. Performance with respective to societal objectives is more difficult to measure than financial objectives. We rely on percentages for example percentage of women Employed in the retailer Business.

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Strategic Profit Model The strategic profit model is a method for summarizing the Factors that affect a firm’s financial performance by ROA. The model decomposes ROA into two components: 1)Net profit margin and 2)Asset turnover The net profit margin is simply how much profit (after tax) a firm Makes divided by its net sales. It reflects the profits generated from each dollars of sales. If a retailer’s net profit margin is 5%, it makes $.05 for every dollar Of sale

McGraw-Hill/Irwin Retailing Management, 6/e Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Strategic Profit Model Asset turnover is the retailer’s net sales divided by its assets. This financial measure assesses the productivity of a firm’s Investment in its assets and indicates how many sales dollars are generated by each dollar of assets.

6-9 The Strategic Profit Model: An Overview Profit Margin xAsset turnover = Return on assets Net profitxNet sales (crossed out) = Net profit Net sales (crossed out) Total assets Total assets Net profit margin x Asset turnover = Return on Assets 10%10 times1%La Madeline Bakery 10%1 time10%Kalame Jewelry La Madeline Bakery has a net profit margin of only 1 percent And asset turnover of 10 resulting in ROA of 10%. Its profit margin is low due to highly competitive nature of its business.

6-10 The Strategic Profit Model: An Overview Profit Margin xAsset turnover = Return on assets Net profitxNet sales (crossed out) = Net profit Net sales (crossed out) Total assets Total assets Net profit margin x Asset turnover = Return on Assets 10%10 times1%La Madeline Bakery 10%1 time10%Kalame Jewelry its assets is high because the firm has a very low Level of inventory assets. It has very little inventory because it sells everything the same day it is baked.

6-11 The Strategic Profit Model: An Overview Profit Margin xAsset turnover = Return on assets Net profitxNet sales (crossed out) = Net profit Net sales (crossed out) Total assets Total assets Net profit margin x Asset turnover = Return on Assets 10%10 times1%La Madeline Bakery 10%1 time10%Kalame Jewelry Kalame Jewelry store has a net profit of 10%. The jewelry store Has the same ROA because it has a very low asset turnover.

6-12 Components of the Strategic Profit Model

6-13 The Strategic Profit Model: Profit Management Net Profit Margin Sales Net Profit Gross Margin Total Expenses Sales Cost of Goods Sold 15%

6-14 La Madeline Bakery & Kalame Jewelry La Madeline Bakery is achieving 10 % ROA by having high asset turnover: This is called Asset Management Path Kalame Jewelry store is achieving its same ROA with high profit margin: The profit margin management Path

6-15 Federated Department Store and COSTCO Store Federated offers a wide variety of fashionable apparel and home furnishings and high customer service provided by its sale associates and an attractive shopping environment. Costco’s warehouse stores offer a limited assortment of food and general merchandise in a self service, warehouse environment.

6-16 Profit Margin Management Path Source of information comes from Retailer’s Income Statement. Income Statement summarize a firm’s financial performance over a period of time. Income statement in retailers annual report provides a summary of the retailer’s performance during the pervious fiscal year. Most retailers define their fiscal year as beginning on Feb. 1 and ending Jan. 31.

6-17 Income Statements for Federated Department Stores and Costco

6-18 Income Statement Net Sales: refers to the total revenue received by a retailer after all refunds have been paid to customers for a returned merchandise. Sales are an important measure of performance because they indicate the activity level of the merchandising function. Costco’s net sales are more than three times greater than Federated.

6-19 Income Statement Net sales= Gross amount of sales+Promotional allowance–Customer return Promotional allowances are payments made by vendors for the retailer promoting the vendor’s merchandise. Slotting Fees: consumer packaged good manufacturers will frequently ask pay supermarkets chains to stock a new product. Gross Margin or Gross profit is net sales minus the cost of goods sold. Gross Margin is an important measure because it indicates how much profit the retailer is making on merchandise sales without considering the expenses associated with operating the store.

6-20 Income Statements for Federated Department Stores and Costco COSTCOFederated Dep. Income Statement ($ million) $48,107$15,630Net Sales 42,0939,297 Less: Cost of goods sold 6,0146,333Gross Margin COSTCO has more than three times the sales of Federated and both have the same gross margin. Gross Margin / Net sales = Gross Margin % Federated 6,333/15,630=40.5% (high price & making use of loyalty bec. Customers are not price senstive) COSTCO 6,014/48,107=12.5% (they sell in low prices)

6-21 Income Statements for Federated Department Stores and Costco Operating Expenses are costs, other than the cost of merchandise, incurred in the normal course of doing business such as salaries, advertising, utilities, office supplies and rent. Another major expenses category, interest includes the cost of borrowing money to finance everything from inventory to purchase of a new store location. COSTCOFederated Dep. Income Statement ($ million) 4,6294,933Less operating expenses Less: interest expenses/income 4,6145,217Total expenses

6-22 Income Statements for Federated Department Stores and Costco Operating expenses / Net sales=operating expenses % Federated 4,933/15,630=31,6% Costco 4,629/48,107=9.6% (lower selling expenses) COSTCOFederated Dep. Income Statement ($ million) 4,6294,933Less operating expenses Less: interest expenses/income 4,6145,217Total expenses

6-23 Income Statements for Federated Department Stores and Costco Net profit (after tax) is the gross margin minus operating expenses and taxes. Federated 689/15,630 = 4.4% Costco $882/$48,107 = 1.8% COSTCOFederated Dep. Income Statement ($ million) $882$689Net profit The strategic Profit model suggests that Federated is performing better than Costco, but the asset Management path tells a different story

6-24 Profit Management Path for Federated and Costco

6-25 The Strategic Profit Model: Asset Management Asset Turnover Total Assets Sales Current Assets Fixed Assets Inventory Accounts Receivable Other Current Assets 1

6-26 The Strategic Profit Model: Return on Assets Net Profit Margin Sales Net Profit Gross Mar Total Exp. Sales Cost Goods Sold 15% Asset Turnover Total Assets Sales Current Assets Fixed Assets Inventory A/R Other Cur Assets 1 Return on Assets 37.5% Times Net Profit Net Profit Net Sales Total Assets = Net Sales x Total Assets Net Sales Total Assets ( ) Net Profit Net Sales ( ) Net Profit Total Assets ( ) ÷ ÷

6-27 Financial Implications of Strategies Used By a Bakery and Jewelry Store Net Profit X Asset = Return on Assets Margin Turnover La Madeline Bakery 1% X 10 times = 10% Kalame Jewelry 10% X 1 time = 10%

6-28 Income Statements for Federated Department Stores and Costco

6-29 Net Sales Gross Margin Gross Sales Less Returns Less customer allowances COGS Components of Gross Margin

6-30 Gross Margin for Federated and Costco Gross Margin = Gross Margin % Net Sales Federated:$ 6,333= 40.5% $15,630 Costco:$ 6,014= 12.5% $48,107 Gross Margin = Gross Margin % Net Sales Federated:$ 6,333= 40.5% $15,630 Costco:$ 6,014= 12.5% $48,107 Why does Federated have higher margins than Costco? Does the higher margins mean the Federated’s is more profitable?

6-31 Operating Expenses Operating Expenses = Operating Expenses % Net sales Federated: $4,933 = 31.6% $15,630 Costco: $4,629 = 9.6% $48,107

6-32 Types of Retail Operating Expenses Selling expenses = Sales staff salaries + Commissions + Benefits General expenses = Rent + Utilities + Miscellaneous expenses Administrative expenses = Salaries of all employees other than salespeople + Operations of buying offices + Other administrative expenses

6-33 Net Profit Net Profit = Net Profit % Net sales Federated: $689 = 4.4% $15,630 Costco: $882 = 1.8% $48,107

6-34 Asset Information from Federated’s and Costco’s Balance Sheet

6-35 Asset Management Path for Federated and Costco

6-36 Inventory Turnover Cost of Goods = Inventory Turnover Average inventory Federated: $9,297 = 3.0 $3,120 Costco: $42,093 = 11.6 $ 3,644

6-37 Inventory Turnover

6-38 Asset Turnover Net Sales = Asset Turnover Total Assets Federated: $15,630 = 1.1 $14,885 Costco: $48,107 = 3.2 $15,093

6-39 Return on Assets Net Profit Margin x Asset Turnover = Return on Assets Federated: 4.41 x 1.05 = 4.63% Costco: 1.83 x 3.29 = 5.84%

6-40 Strategic Profit Model Ratios for Selected Retailers

6-41 Income Statement for Gifts to Go

6-42 Gross Margin Percent Gross Margin = Gross Margin Percent Net Sales Stores: $350,000 = 50% $700,000 GiftstoGo.com $220,000 = 50% $440,000

6-43 Operating Expense Percent Operating Expenses = Operating Expenses % Net Sales Stores: $250,000 = 35.7% $700,000 GiftstoGo.com: $150, % $440,000

6-44 Net Profit Percentage Net Profit = Net Profit Percentage Net Sales Stores: $ 59,800 = 8.5% $700,000 GiftstoGo.com: $ 45,500 = 10.3% $440,000

6-45 Balance Sheet Information for Gifts to Go and Proposed Internet Channel

6-46 Inventory Turnover Cost of Goods = Inventory Turnover Average Inventory Stores: $350,000 = 2.0 $175,000 GiftstoGo.com: $220,000 = 3.1 $ 70,000

6-47 Asset Turnover Net Sales = Asset Turnover Total Assets Stores: $700,000 = 1.84 $380,000 GiftstoGo.com: $440,000 = 2.09 $211,000

6-48 Return on Assets Net Profit Margin x Asset Turnover = Return on Assets Stores: 8.54 x 1.84 = 15.7% Giststgo.com 10.3 x 2.09 = 21.3%

6-49 Profit Management Asset Management The Strategic Profit Model Net Sales Cost of goods sold Variable expenses Fixed expenses Gross margin Total expenses Net profit Net Sales Net profit margin Asset turnover Return on assets Inventory Accounts receivable Other current assets Total current assets Fixed assets Net sales Total assets x

6-50 Productivity Measures Input Measures – assess the amount of resources or money used by the retailer to achieve outputs such as sales Output measures – asses the results of a retailer’s investment decisions Productivity measure – determines how effectively retailers use their resource – what return they get on their investments

6-51 Setting and Measuring Performance Objectives Retailers will be better able to gauge performance if it has specific objectives in mind to compare performance. Should include: numerical index of performance desired time frame for performance necessary resources to achieve objectives

6-52 Setting Objectives in Large Retail Organizations Top Down Planning Corporate Developmental Strategy Category, Departments and sales associates implement strategy

6-53 Setting Objectives in Large Retail Organizations Bottom Up Planning Buyers and Store managers estimate what they can achieve Corporate Operation managers must be involved in objective setting process

6-54 Financial Performance of Retailers Outputs - Performance Sales Profits Cash flow Growth in sales, profits – Same store sales growth Inputs Used by Retailers Inventory ($) Real Estate (sq. ft.) Employees (#) Overhead (Corporate Staff and Expenses) Advertising Energy Costs MIS expenses

6-55 Productivity - Outputs/Input Corporate Level –ROA = Profits/Assets (ROE = Profit/Equity) –Overhead/Sales Buyers (Inventory, Pricing, Advertising) –Gross Margin % = Gross Margin/Sales –Inv Turnover = COGS/ Avg. Inventory (cost) GMROI – Gross Margin/Average Inventory –Advertising/sales Stores (Real Estate, Employees) –Sales/Square Feet inv. Shrinkage/sales –Sales/Employee

6-56 Performance Objectives and Measures Used by Retailers

6-57 Examples of Performance Measures Used by Retailers Level ofOutputInputProductivity Organization(Output/Input) CorporateNet salesSquare feet ofReturn on assets (measures ofstore space entire corporation) Net profitsNumber ofAsset turnover employees Growth in sales,InventorySales per employee profits AdvertisingSales per square expendituresfoot

6-58 Examples of Performance Measures Used by Retailers Level ofOutputInputProductivity Organization(Output/Input) MerchandiseNet salesInventory levelGross Margin managementReturn on (measures for aInvestment (GMROI) merchandise category)Gross marginMarkdownsInventory turnover Growth in salesAdvertisingAdvertising as a expensespercentage of sales * Cost of Markdown as a merchandisepercentage of sales* * These productivity measures are commonly expressed as an input/output.

6-59 Examples of Performance Measures Used by Retailers Level ofOutputInputProductivity Organization(Output/Input) Store operationsNet salesSquare feet ofNet sales per (measures for aselling areassquare foot store or departmentGross marginExpenses forNet sales per within a store)utilitiessales associate or per selling hour Growth in salesNumber of salesUtility expenses as associatesa percentage of sales * * These productivity measures are commonly expressed as an input/output.

6-60 Illustrative Productivity Measures Used by Retailing Organizations Level ofOutputInputProductivity Organization(Output/Input) CorporateNet profitOwners’ equityNet profit / (chief executiveowners’ equity = officer) return on owners’ equity MerchandisingGross marginInventory*Gross margin / (merchandiseinventory* = manager andGMROI buyer) Store operationsNet salesSquare footNet sales / (director of stores,square foot store manager) *Inventory = Average inventory at cost

6-61 Benchmarks Performance of retailer over time – retailer can compare its recent performance to its performance in the preceding months, quarters or years. Performance of a retailer compared to its competitors

6-62 Sources of Information Balance Sheet (Snap Shot at One Time) –Asset Management Income Statement (Summary Over Time) –Margin Management Annual Reports/ SEC Filings – anysearch.htmlhttp:// anysearch.html