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Chapter 6 Financial Strategy

Objectives and Goals

Financial Objectives
When assessing financial performance, most people focus on profits: what were the retailers profits or profit margin (profit as a percentage of sales) last year, and what will they be this year and into the future? Think of the decisions you might make when planning how to invest some money you might have. In making this investment, you want to determine the highest percentage return you can the highest interest rate or greatest percentage increase in stock price not absolute amount of the return. o A commonly used measure of the return on investment is return on assets, or the profit return on all the assets possessed by the firm.

Societal Objectives
Societal objectives are related to the broader issues about providing benefits to society making the world a better place to live. Other societal objectives might include offering people unique merchandise, such as environmentally sensitive products, providing an innovative service to improve personal health, such as weight reduction programs, or sponsoring community events. Performance with respect to societal objectives is more difficult to measure than financial objectives. But explicit societal goals can be set, such as the percentage of executives or store managers that are women or minorities or the percentage of profit s donated to worthy charities.

Personal Objectives
Many retailers, particularly owners of small, independent businesses, have important personal objectives, including self-gratification, status, and respect. By operating a popular store, a retailer might be recognized as a well-respected business leader in the community. Whereas societal and personal objectives are important to some retailers, financial objectives should be the primary focus of managers of publicly held retailers retailers whose stocks are listed on the bought through stock market. Investors in publicly held companies must have the same objectives as the investors. Therefore, the remaining sections of this chapter focus on financial objectives and the factors affecting a retailers ability to achieve financial goals.

Strategic Profit Model

The strategic profit model, is a method for summarizing the factors that affect a firms financial performance as measure by ROA. The model decomposes ROA into two components: o Net profit margin o Asset turn over The net profit margin is simply how much profit after tax a firm makes divided by its net sales. Thus, it reflects the profits generated from each dollar of sales. If a retailers net profit margin is 5 percent, it makes .05 for every dollar of merchandise or service it sells. Asset turnover is the retailers net sales divided by its assets. This financial measure assess the productivity of a firms investment in its assets and indicates how many sales dollar are generated by each dollar of assets. Net profit margin * Asset turnover = ROA Return on assets Net profit/Total Assets

Profit Margin Management Path

Information used to examine the profit margin management path comes from the retailers income statement, which summarizes a firms financial performance over a period of time. To capture all the sales and returns from the Christmas season, most retailers define their fiscal year as beginning on February 1 and ending January 31. Net Sales The term net sales refer s to the total revenue received by a retailer after all refunds have been paid to customers for returned merchandise. Sales are an important measure of performance because they indicate the activity level of the merchandising function. Net Sales = Gross amount of sales + promotional allowances customer return Customer returns represent the value of merchandise that customers return and for which they receive a refund of cash or a credit. Promotional allowances are payments made by vendors to retailers in exchange for the retailer promoting the vendors merchandise. Gross Profit The gross margin, also called gross profit, is net sales minus the cost of goods sold. It is important measure in retailing because it indicates how much profit the retailer is making on merchandise sales without considering the expenses associated with operating the store. Gross margin = Net Sales Cost of goods sold Gross margin, like other performance measures, is also expressed as a percentage of net sales so retailers can compare o The performances of various types of merchandise and o Their own performance with other retailers with higher or lower levels of sales Gross Margin/Net sales = Gross Margin% Operating Expenses Operating expenses are costs, other than the cost of merchandise, incurred in the normal course of doing business, such as salaries for sales associates and managers, advertising, utilities, office supplies, and rent. Operating expenses are expressed as a percentage of net sales to facilitate comparisons across items and departments within firms. Operating Expenses/Net Sales = Operating Expenses % Net Profit Net profit (after taxes) is the gross margin minus operating expenses and taxes: Net profit = Gross margin Expenses Taxes It is a measure of overall performance with respect to the profit margin management path and can also be expressed before taxes. Net profit margin, like gross margin, is often expressed as a percentage of net sales: Net Profit/Net Sales = Net Profit % A commonly used overall profit measure is the profit percentage before interest and taxes. This measure is used because operating managers have little control over interest and tax expenses, so these expenses do not reflect the performance of operating managers or the retailers operating effectiveness.

Asset Management Path

The information used to analyze a retailers asset management path primarily comes from the firms balance sheet. Whereas the income statement summarizes the financial performance over a period of time, the balance sheet summarizes a retailers financial position at a given point in time, typically at the end of its fiscal year. Assets are economic resources (such as inventory or store fixtures) owned or controlled by a firm. There are two types of assets, current and fixed. Current Assets By accounting definition, current assets that can normally be converted to cash within one year. In retailing assets are primarily cash, accounts receivable, and merchandise inventory. Accounts receivable are primarily monies owned to the retailer from selling merchandise on credit to customers. Current Assets = Cash + Accounts receivable + Merchandise Inventory + Other current Assets The principle benefit retailers offer customers is having the right merchandise inventory available at the right time and place. Inventory turnover, a ratio like gross margin, is used to evaluate how effectively retailers utilize

their investment in inventory and reflects the cost of goods sold from the income statement divided by the average inventory level from the balance sheet. Cost of Goods/Average inventory = Inventory Turnover Inventory turnover is a measure of the productivity of inventory. It shows how many times, on average, inventory cycles through the store during a specific period of time (usually a year). Fixed Assets Fixed assets are those assets that require more than a year to convert to cash. o In retailing, the principle fixed assets are buildings (if store property is owned rather than leased), fixtures (such as display racks), equipment (such as computers or delivery trucks), and other long-term investments such as stock in other supplier firms. Fixed assets are more difficult to manage than current assets such as inventory. Net Sales/Fixed Assets = Fixed Asset Turnover Asset Turnover Asset turnover is a overall performance measure from the asset management component in the strategic profit model. Net Sales/Total Assets = Asset Turnover

Return on Assets
Net Profit Margin * Asset Turnover = Return on Assets 1. Retailers and investors need to consider both net profit margin and asset turnover when evaluating their financial performance. Firms can achieve high performance (high ROA) by effectively managing both net profit margins and asset turnover. 2. Retailers need to consider the implications of strategic decisions on both components of the strategic profit model.

Using the Strategic Profit Model to Analyze Other Decisions

The strategic Profit Model is useful to retailers because it combines two decision-making areas: profit margin management and asset turnover management. Manger can use the model to examine interrelationships between the components.

Setting and Measuring Performance Objectives

Performance objectives should include 1. A numerical index of the performance desired against which progress may be measured, 2. A time frame within which the objective is to be achieved, 3. The resources needed to achieve the objective.

Top Down versus Bottom-Up Process

Top-down planning means that goals are set at the top of the organization and passed down to the lower operating levels. o The overall strategy determines the merchandise variety, assortment, and product availability, plus the store size, location, and level of customer service. Bottom-up planning involves lower levels in the company developing performance objectives that are aggregated up to develop overall company objectives. o Buyers and store managers estimate what they can achieve, and their estimates are transmitted up the organization to the corporate executives. Frequently there are disagreements between the goals that have trickled down from the top and those set by lower-level employees of the organization. o These differences between bottom-up and top-down plans are resolved through a negotiation process involving corporate executives and operating managers.

At each level of the retail organization, the business unit and its manager should be held accountable only for the revenues, expenses, and contribution to ROA that they can control. Thus, expenses that affect several levels of the organization (such as the labor and capital expenses associated with operating a corporate headquarters) shouldnt be arbitrarily assigned to lower levels. Performance objectives and measure are used to pinpoint problem areas. Reasons performance may be above or below planned levels must be examined. Actual performance may be different than the plan predicts due to circumstances beyond the managers control.

Performance Objectives and Measures

Many factors contribute to a retailers overall performance, which makes it hard to find a single measure to evaluate performance. The measure used to evaluate retail operations vary depending on o The level of the organization at which the decision is made and o The resources the manager controls.

Types of Measures
Input measures asses the amount of resources or money used by the retailer to achieve output such as sales. Output measures assess the results of a retailers investment decisions. A productivity measure (the ratio of an output to an input) determines how defectively retailers use their resource what return they get on their investments. In general, since productivity measures are a ratio of outputs to inputs, they are very useful for comparing the performance of different business units. Corporate Performance At a corporate level, retail executive have three critical resources (inputs) merchandise inventory, store space, and employees that they can manage to generate sales and profits (output). Thus, effective productivity measures of the utilization of these assets are asset and inventory turnover, sales per square foot of selling space, and sales per employee. ROA is an overall productivity measure combining the profit margin percentage and asset turnover management. o Another commonly used measure of overall performance is same store sales growth, or the growth in stores that have been open for over one year. Merchandise Management Measures The critical resource (input) controlled by merchandise mangers is merchandise inventory. Merchandise managers also have authority to set initial prices and lower prices when merchandise is not selling (take a markdown). Finally, they negotiate with vendors on the price paid for merchandise. Inventory turnover is a productivity measure of the management of inventory; higher turnover means greater inventory management productivity. Gross margin percentage indicates the performance of merchandise managers in negotiating with vendors and buying merchandise that can generate a profit. Store Operations Measures The critical assets controlled by store managers are the use of the store space and the management of the stores employees. Thus, measures of store operations productivity include sales per square foot and sales per employee. Store management is also responsible for controlling theft by employees and customers, store maintenance, and energy costs.

Assessing Performance: The Role of Benchmark

Financial measures used to asses performance reflect the retailers market strategy. o The performance of the retailer over time o The performance of the retailer compared with that of its competitors

Performance over Time One useful approach for assessing a retailers performance is to compare its recent performance with its performance in preceding months, quarters, or years. Performance Compared to Competitors A second approach for assessing a retailers performance is to compare it with its competitors.