The 4 R's Of Investing In Retail

By Will Ashworth AAA

In retail, successfully managing return on investment (ROI) and other financial indicators is the key to a healthy business. Expansion is an important part of retail growth but only when generating positive cash flow from those capital expenditures. Without a positive return on investment, retailers are wasting good money after bad. It's critical for retail managers to quantify as much as possible so that they may better understand the profitability and financial health of their business. When combined with other financial metrics like same-store sales, the four R's of retail should paint a financial picture that's vibrant and constantly getting stronger:

1. Return on Revenues

Return on revenues (ROR) is the first R and the cornerstone of any retail operation. It tells you how much net income is made from those top-line revenues. Nearly as important is gross margin return on investment, which is the gross margin profit on the cost of your inventory. The more you make per unit sold, the easier it is to produce bottom-line net profits.

ROR has two basic building blocks: 
Balance Sheet
Every retail store maintains inventory. Considered an asset on the balance sheet, when combined with the P&L statement, it can tell you a lot about how the product is selling. Dividing inventory into the trailing-12-months' revenue, you arrive at the number of inventory turns in those 12 months (the higher number, the better). Grocery stores traditionally have lower margins, and thus need to turn inventory many more times than luxury retailers who make far more per transaction but far less in overall unit sales. Ultimately, the two retailers may deliver the same net income, but from much different volumes.

Cash Flow Statement
Did you know it's possible to be profitable and yet generate negative cash flow? Well, it's true and the converse happens as well. This is when a business losing money generates positive cash flow. Often it can be as simple as the payment terms you have with your suppliers. For instance, the profitable retailer might get 30 days to pay its bills while the money loser gets 60. Although this catches up with the money-losing retailer eventually, it can carry on for some time. Look for companies that make money and generate positive cash flow. Even better are those that generate free cash flow, which is the cash from operations after taking into account capital expenditures.

2. Return on Invested Capital
Moving from the big picture company-wide to the front line individual store operations for a moment, the second R in retail makes its appearance. Return on invested capital, sometimes referred to as "four-wall cash contribution," is the amount of profit generated per store. The speed at which each store can return the invested capital required to open it, the faster the retailer can grow its overall profits. For example, if a new store in a home improvement chain averages $2 million in annual sales in the first year open and its four-wall contribution is $200,000, a $300,000 investment to build and open the store is repaid in 18 months. Its return on invested capital is 67%. Successful retailers look for store revenues and four-wall contribution to increase in years two and three. If not, there's a problem.3. 

3. Return on Total Assets
Back to the big picture, return on total assets tells a company how much operating profit it's making from its assets. Here again, bigger is better. In the retail industry, this number will vary depending on the business. Specialty retailers require less retail space, fixtures, inventory, etc. Home improvement stores on the other hand operate in much larger retail footprints and thus require greater assets. Having to use more doesn't necessarily make these stores inferior. It's simply the cost of doing business in that particular industry. What's important is how a retailer's return on total assets compares with the competition. If it's generating a return on total assets of 10% and its competitor across the street does 20%, it's an indication that the competitor is operating more efficiently.

4. Return on Capital Employed
This tells us how efficiently retailers use their capital. It is defined as earnings before interest and taxes (EBIT) divided by capital employed, which generally is represented by total assets less current liabilities. However, a more appropriate definition of capital employed would be shareholders' equity plus net debt. After all, ROCE is a pretax look at its return on debt & equity, which is different from ROIC, which is an after-tax (dividends paid) look at its profitability. While ROCE is a more telling number than return on equity, it too has its limits. For instance, if a retailer in the auto parts business repurchased $1 billion of its own stock in a given year and as a result, its book value turned negative, both the ROE and ROCE are affected adversely, despite the fact it made close to $1 billion in net profit. Financial metrics can only take you so far.

Conclusion
Although customer service is an important component of successful retail, it's just one of the many things that must be executed flawlessly in order to continue growing. At the top of the list should be financial discipline. If a retail business doesn't possess this trait, it likely won't be around very long. The strongest retailers understand that every store should be profitable. Otherwise, there is no justification for tying up the capital required to open them. The faster a store is able to recover the initial investment, the faster it's able to please the four R's of retail. (For related reading, take a look at Analyzing Retail Stocks.)
 

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