Using Retail Financial Ratios
The financial ratios of companies in the retail industry assist management with their selling operations. Investors analyze these financial ratios to determine the long-term security, short-term efficiency, and overall profitability of a retail company. Financial ratios also help to reveal how successfully a retail company is selling inventory, pricing its goods, and operating its business as a whole. Here are the key ratios for the retail sector.
The current ratio is measured by dividing a company's current assets by its current liabilities. This financial metric measures the ability of a company to pay off its short-term obligations. A current ratio greater than one indicates that a company can cover its short-term debt with its most liquid assets. To an investor, the current ratio gauges the liquidity and short-term cash flow stability of an organization during the potential seasonal fluctuations common to retail or any unplanned transient short-term events that require immediate cash disbursements.
The quick ratio is calculated by dividing a company's cash and accounts receivable by its current liabilities. This ratio is similar to the current ratio, but the quick ratio limits the type of assets that cover the liabilities. For this reason, the quick ratio is a more accurate measurement of the immediate liquidity of a company. If a company is forced to liquidate its assets to pay its bills, companies with a higher quick ratio are forced to sell fewer assets. From an investor's standpoint, the quick ratio provides insight into the stability of the immediate liquidity position of a company.
Gross Profit Margin
The gross profit margin is a profitability ratio that is calculated in two steps. First, the gross profit is calculated by subtracting a company's cost of goods sold (COGS) from its net revenue and then dividing the gross profit by net sales. This metric is insightful to management as well as investors concerning the markup earned on products. From an investor's standpoint, higher gross profit margins are preferable since a piece of inventory generates more revenue when it is sold for a higher gross profit. Because all items in a retail company are inventory items, the gross profit margin relates to every item in a retail store.
ROA is particularly important for retail companies because they rely on inventory to generate sales.
Calculated by dividing cost of goods sold for a period by the average inventory balance for the same period, inventory turnover is a measurement of the efficiency of inventory management. Retail companies have inventory on hand to secure and protect. Additionally, older inventory may become obsolete. For this reason, higher inventory turnover is favorable for management as well as investors. A low inventory turnover indicates a company is inefficiently holding too much inventory or not achieving sufficient sales. Alternatively, an inventory turnover ratio can be too high. For example, a large ratio may indicate a company is efficiently ordering inventory but not receiving ordering discounts.
Return on Assets
Return on assets (ROA) is a profitability measurement that gauges how well a company is using its assets to generate revenue. This measure is especially important for a retail company, which relies on its inventory to generate sales. The financial ratio is calculated by dividing a company's total earnings by its total assets. An investor can compare a retail company's ROA to industry averages to understand how effectively the company is pricing its goods and turning over its inventory. For example, according to CSIMarket.com, the retail apparel industry reported an average ROA of 7.54% in the third quarter of 2019. If a company in this industry calculated a metric of 7%, it may be carrying too much inventory or not charging high enough prices compared to its competitors.
Interest Coverage Ratio
The interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by the average interest expense. A retail company may be charged an interest expense for the rent or lease of goods, equipment, buildings, or other items necessary for operations. The interest coverage ratio determines how well a company can cover the interest it owes for a period. An investor can use this ratio to determine the stability of a company as well as how well it can cover its interest charges.
The EBIT margin measures the ratio of EBIT to the net revenue earned for a period. A company can use this financial ratio to determine the profitability of goods sold without having to factor in expenses that do not directly affect the product. Although the EBIT margin accounts for administrative and sales expenses, it removes a few expenditures that may skew the perception of the profitability of a good. From an investor's standpoint, the EBIT margin gives an indication of a company’s ability to earn revenue.
- Investors analyze financial ratios to determine the overall profitability of a company.
- Financial ratios are based on accounting information disclosed by public companies.
- Key ratios for the retail sector are the current ratio, the quick ratio, gross profit margin, inventory turnover, ROA, interest coverage ratio, and the EBIT margin.