Retail business performance relies on several factors that must be quantified and tracked to ensure efficient functioning. The financial health of businesses can be judged using specific calculations called financial ratios. These ratios form the basis of key performance indicators for retailing firms. They help business owners stay aware of how well their business functions despite the many variables involved. Factors like long-term goals, profitability, and short-term targets can all be tracked using specific financial ratios to inform business decisions.
To keep track of financial ratios, businesses will need to collect crucial information. Most commonly, this involves checking the firm’s balance sheets and income statements. Key points from these documents can be used to calculate relevant retail ratios that allow businesses to judge both current financial health and project potential performance values. In addition to these benefits, retailers can also judge business aspects such as pricing, inventory consumption, and the overall financial viability of their businesses with financial ratios.
What are Financial Ratios?
Financial ratios are key indicators calculated by taking numerical values from the financial statements of a company. The ratio can be used to calculate the performance of the retailing firm against competitors to decipher where the company stands. These ratios can also be used by external stakeholders and investors to understand the financial history and background of the firm before making any commitments. To calculate financial ratios, businesses often look to their income statements, balance sheets, and cash flow records.
Unlike what the name might suggest, a financial ratio goes beyond the limitations of mere calculations and instead is a core indicator of a highly specific aspect of a retailing firm. Businesses can make use of numerous financial ratios to help them analyze their performance; however, only some are relevant to retailing firms and their success. These ratios often correspond with a vast array of company parameters such as liquidity, growth, margins, leverage, profitability, average returns, and more. Retail firms must conduct regular calculations of these ratios and make them available to the managers so that any weaknesses can be promptly identified and corrected.
The Importance of Tracking Financial Ratios for Retailers
Keeping track of your retail business’ financial ratios can provide key insights and inform your decisions. Ratios help businesses identify issues in the nick of time. Below, we list the core reasons for businesses to calculate and track their financial ratios.
Ascertain the Operation’s Financial Health
Financial ratios, when calculated over defined periods, indicate emerging patterns and trends that can enable projections. These projections allow financial managers and experts to determine how a company will perform when it comes to cash flow, income, and other parameters. Simplified access to these ratios is a deciding factor for businesses that are serious about assessing risks while also identifying business strategies that have worked for their retail operation. A business that remains aware of these indicators is bound to act on operational red flags sooner, potentially saving the firm from financial losses and cutbacks.
Enhance Retail Performance
Ratios like gross profit margin, inventory turnover, and current ratio can help retailers assess their store’s performance. By referring to these indicators, business owners can take all the necessary steps to course correct or enhance their retail store management and operations. In case you detect concerning trends that emerge from these ratios, they can also guide you toward the sources of these issues. Upon identifying them, businesses can rethink their strategies and proceed with corrective measures. A re-assessment of the ratios following the corrective measures will allow business owners to examine the extent of improvement.
Better Inventory Management
The inventory forms the backbone of a retail business. Inefficient inventory management can lead to serious operational problems, or worse, even business closure. Tracking inventory turnover allows businesses to understand how their inventory is being managed. Businesses always look toward higher inventory turnover as it indicates higher sales rates. Low inventory turnover rates indicate slow sales and push businesses to market themselves better. Alternatively, an excessively high turnover rate can hint at your business not receiving procurement discounts from your suppliers. Therefore, tracking ratios like inventory turnover forms the cornerstone of managing inventory in retail.
Determine Pricing
Pricing will indicate how much profit your retail store can generate. To decide on an effective pricing strategy, business owners will need to calculate and track gross profit margins and return on asset ratios. Entrepreneurs can compare these values to existing industry benchmarks to determine whether or not their goods and services are priced at a sustainable level. Any deviations from existing standards will warrant a rethink on the part of the business to optimize pricing. Most retailing firms will need to undertake a dynamic pricing protocol that includes several ratios that informs their decisions.
Improve Profitability
Profitability is a core metric that determines business success across industries. For retailers, however, this can be tracked with financial ratios like gross profit margins, earnings before interest, and returns on assets. Financial professionals will undertake a multifaceted analysis that looks at several variables and calculate these ratios to judge your firm’s profitability. Following this, you can undertake the necessary steps to guide your business goals according to the relevant ratios and their findings.
Key Financial Ratios to Track in Your Retail Business
Though businesses need to track an array of ratios to stay competitive in the market, a few of them are of greater value when it comes to retail. Below, we describe and detail seven important financial ratios that must be tracked by a retail entrepreneur.
Return on Assets
Return on assets is a key measure of profitability for retailers and also informs pricing decisions. It is among the most important financial ratios for a retailing firm since it relies on inventory to generate profit. The ROA or return on assets ratio is calculated by dividing the company’s net income by the average value of assets. The ratio informs businesses about how profitable their retail business is. Comparing your business’ ROA with industry benchmarks can give you clear insights.
ROA Formula
ROA = Net Income / Average value of assets
Net Income: Net earnings in a defined period
The average value of assets: (Ending Assets – Starting Assets) / 2
Improving ROA
If the industry benchmark ROA is 8% and your business is averaging around 7%, the ROA indicates that your business is holding onto too much inventory or isn’t charging your customers enough. Improving your ROA would require you to improve inventory turnover rates or devise a better pricing strategy to make your business more profitable by bringing in higher margins of profit. Using assets efficiently leads to higher net income.
Current Ratio
The current ratio gives companies a precise outlook on their short-term financial commitments. Retail establishments frequently see seasonal variations that can become quickly problematic if finances are not assessed and tracked properly. The current ratio indicates liquidity and cash flow prospects in the short term for businesses that might be eager to pay off debt or other operational obligations. The current ratio essentially dictates how well-disposed your company is to meet its commitments in the immediate future.
Current Ratio Formula
Current Ratio = Current Assets / Current Liabilities
Improving Current Ratio
Having a current ratio of more than 1 indicates that your retail business is capable of paying off short-term liabilities. A higher current ratio is always advisable as it indicates that you can keep your business operating without any major concerns while also fulfilling your commitments. Delaying any cash payments or purchases, selling non-performing assets, reducing personal draw from the business, and restructuring debt can improve your business’s current ratio.
Inventory Turnover
This ratio is the key indicator of inventory management and its rate of efficiency. All retail companies rely on the utilization of inventory to achieve profitability and growth. The ratio calculates how many times a business sold out its inventory in a defined accounting period. Higher inventory turnover ratios indicate a successful business that generates high net income due to higher sales. Inventory turnover is calculated by dividing the cost of goods sold by the average inventory cost.
Inventory Turnover Formula
Inventory Turnover = Cost of Goods Sold / Average Cost of Inventory
Average Cost of Inventory = (Starting Inventory – Ending Inventory) / 2
Improving Inventory Turnover
Inventory turnover can be improved by a variety of methods like smart reordering, prioritizing existing inventory, and intuitive demand forecasting to project sales. You might also want to consider a better marketing and advertising campaign to boost visibility and sales so that they positively impact inventory turnover. A positive inventory turnover is key to efficient retail store management.
Quick Ratio
The quick ratio is a highly accurate indicator of a retailing firm’s immediate liquidity. It tends to be more reliable than the current ratio, despite being similar. The quick ratio is also called the acid test ratio as it uses only accounts receivable, cash, securities, and liquid current assets. The quick ratio does not consider assets like illiquid holdings and inventory that might be difficult to turn into liquid money. It is calculated by dividing the most liquid assets of the company by current liabilities.
Quick Ratio Formula
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
Improving Quick Ratio
A higher quick ratio is always desirable as it indicates the ability to address the business’s liabilities. Improving sales and inventory turnover can help bring in liquidity and enhance the operation’s quick ratio. Withdrawing credit lines from customers and collecting invoices is also another simple method of extending the quick ratio. Lastly, swift repayment of liabilities will also promote a higher quick ratio for your retail business.
Gross Margin
The gross margin or the gross profit margin is an important profitability ratio. This metric is especially valuable as it is also considered by potential investors and debtors. It calculates the percentage of income left after deducting the cost of goods sold. It is important to note that the cost of goods sold does not include overheads like operating expenses, taxes, and other expenses. The gross margins relate specifically to the profitability of the products and items in the inventory.
Gross Margin Formula
Gross Margin = [(Total Revenue – Cost of Goods Sold) / Revenue] x 100
Improving Gross Margin
Improving the gross margin can improve the overall profitability of your retail operation. Negotiating with your suppliers to offer better deals and discounts will help you extend your business’ gross margins. Moreover, cutting operating expenses will also extend the ratio. In addition to these simple methods, adopting upselling strategies and better marketing can also improve gross margins.
Working Capital
This is another ratio that is indicative of a retailer’s short-term financial health. It primarily accounts for the company’s assets and its short-term liabilities. High working capital ratios indicate that a company holds enough liquid assets to pay away its short-term obligations, whereas the opposite indicates the inability to do so. The working capital ratio also has implications for the company’s cash flow, which often remains the cornerstone of liquidity.
Working Capital Formula
Working Capital = Current Assets / Current Liabilities
Improving Working Capital
Since working capital is essential to address day-to-day needs, having a high working capital ratio indicates that your business is capable of meeting its daily commitments. Businesses can sell non-performing assets, collect unpaid invoices, request extensions on some payments, and improve inventory turnover to improve their working capital ratio.
Debt-to-Equity Ratio
This ratio determines how the company maintains cash flow and finances. The debt-to-equity ratio indicates if the company uses more debt or equity to finance its operations. It is a key solvency indicator that helps retailers know if shareholder equity is capable of addressing liabilities and debts. The ratio is calculated by dividing total liabilities by total equity.
Debt-to-Equity Formula
Debt-to-Equity Ratio = Total Debt / Total Liabilities
Improving Debt-to-Equity
A high debt-to-equity ratio indicates that a business might be incapable of covering its debts via its equity holdings. Industry standards often dictate that a ratio above 2 is not advisable. Paying off smaller debts, restructuring debts, and improving inventory turnover can help businesses bring down their debt-to-equity ratio in case it is above the optimal level.
Sum Up
The above ratios are relevant to retailing businesses and can aid entrepreneurs in keeping track of their firm’s financial performance. Regular calculation of these ratios is possible by referring to simple values mentioned in the balance sheets. Consult qualified financial advisors in case you’re concerned about further enhancing any of these parameters in your business.
