Annual Performance
On the surface, the chain of stores did very well in year 8, posting healthy gains in net sales while holding the line on merchandise costs and general and administrative expenses (G & A). As well, Company D did very well on investment income. Consequently, bottom-line performance at the home center chain improved on year 7 to a satisfying degree.
Table 1
Net sales rose over the prior year at an 8.8% clip. At the same time, the cost of merchandise sold climbed just 7.5%, possibly by dint of strong supplier relations. Equally likely is that the chain was able to mark up at will inventory obtained earlier in the year at more advantageous prices. In any case, the outcome was operating income that outpaced the prior year by a satisfying 12.1%.
Operating expenses – chiefly selling and store operations – grew rather faster than net sales did. This suggests loosening the reins on advertising and sales promotions that reaped dividends in terms of dollar turnover.
On the other hand, controlling G & A expense (so that outlays merely kept pace with the comparatively low run-up in merchandise costs) contributed significantly to realizing a healthy bottom line.
For the rest, store opening costs slowed and Company D offset the negligible rise in interest expense with admirable returns on investments.
Balance Sheet
On the other hand, the balance sheet reveals grounds for concern, chiefly around mushrooming inventories and having to fund these out of retained earnings, as well as the debt of both short- and long-term tenors.
Cash and near-cash shrank in the face of an inventory build-up (up 32% in dollar terms) that the chain largely failed to move out its doors. At the same time, the asset mix became less liquid (and by definition, riskier) since investments in land, buildings and furnishings rose by a collective 14% even as store turnover expanded just 8.8%.
Even when cash reserves dwindled, the chain opted for more current liabilities (up 24.6%) while shifting only a minuscule portion of the inventory overhang to long-term liabilities (up 11.7%). Consequently, there were no dividends to speak of.
Table 2
Analysis of Financial Ratios
The current ratio worsened slightly from 1.8 in year 7 to 1.7 the following year. Such a performance is also below-average for the industry, suggesting that Company D is comparatively illiquid, notwithstanding the fact that it theoretically has $1.80 in current assets to pay off every dollar of current liabilities.
The quick or “acid test” ratio deteriorated even more sharply, from 0.6 in year 7 to 0.2 in year 8 and puts the store chain in the bottom quartile of the industry. By excluding inventory and other current assets which are more difficult to turn into cash, we realize that the conservative measure casts Company D in a poor light. Looking cash-strapped is reinforced by the finding that the quick ratio is significantly lower than the current ratio above.
The average days the chain takes to collect receivables has lengthened slightly from 6.7 in year 7 to 7.4 days in year 8. Nevertheless, the week’s credit and collection cycle that Company D enforces with its customers are actually excellent, given that even the top quartile of competitors average about a month (27.2 days) to collect receivables.
Average days to sell inventory have worsened markedly, from 65.6 the prior year to 80.7 days in year 8. This puts the chain lower than even the third quartile of rival stores that average 72.6 days.
At Company D, the asset turnover ratio stands at 2. This means that management managed to produce $2 of net sales for every dollar of assets in use or deployed. This does not bespeak remarkable efficiency, given that the chain has to invest in branches as well as product inventory. Such inefficiency puts Company D just below the third quartile of competitors (2.4 times average asset turnover); on the other hand, the industry is not especially well-known for high multiples of asset turnover, since the top quartile of rivals typically boasts an asset turnover of just 3.8.
Table 3
A debt-to-equity ratio of 0.4 is fairly low and holds steady from year 7. This is, from the viewpoint of conservative management, a positive factor. This means that Company D is using less leverage and has a stronger equity position. Put another way, the company’s stockholders have about two-and-half times more money than creditors in the company tills. Such a debt-equity ratio puts the chain in the top quartile of the industry.
Consistent with other findings on healthy margins, Company D ROE based on EBIT improved tangibly from 27.2% to 29.5%. This means that management has done even better at controlling operating expenses and debt load. As a result, the chain is solidly within the top tier of home furnishing chains.
As a percentage of revenue dollars, the gross margin ratio improved marginally from 30.2% the prior year to 31.1% in year 8. Such a performance outclassed the industry median (27.3%), demonstrating that Company D counted in the upper half of competitors in its ability to turn a profit before factoring in tax and debt obligations. This bespeaks efficiency in using labor, inventory and distribution-related fixed assets to generate profits. On the other hand, the gross margin ratio is not quite the reliable performance metric in retail that it is for manufacturing operations.
Finally, the pre-tax profit margin ratio completes the story of increasingly healthy returns at Company D. Returns before accounting for tax liabilities rose from 9.2% to 10.1%, distinctly better than the equivalent metric of 3.4% that is the median for all its competitors. The chain undoubtedly stamps its class on the industry, at least where earning superior returns is concerned.