Introduction to Financial Plans

What you’ll learn to do: Use strategic profit modeling to create a financial plan

In the coming sections, we will consider how best to assess the financial performance of a company, comparing it to past performance or others within the competitive environment. We’ll focus on tools retailers use to measure, summarize, and assess their finances.  Ultimately, these are planning tools, which not only describe how well an organization is functioning, but can be diagnostic, helping to improve performance going forward. The goal is to improve the business’ ability to turn assets and investments into profit for shareholders or owners.

Financial Goals

Although it may seem obvious, the first financial goal of a business is to make money, but that really isn’t specific enough. The goal is to make enough money to cover all expenses and grow the business as well. This means that revenue must cover the cost of goods sold, operating expenses, and taxes, while also having some portion left over to support investment back in the business to fund new or special initiatives.

This requires that retailers understand profits as a percentage of sales (profit margin = profit / sales revenue), looking to increase it in future periods through efficient management of the business.

As we continue our learning, we will see how to use financial calculations and ratios to judge performance. In this way, they can be used a management tools to assess operations and identify areas for improvement. Some important ones to consider are operating profit margin, asset turnover, and return on assets.

Operating Profit Margin

Operating profit margin, also called operating margin, is sometimes referred to as earnings before interest, taxes, and depreciation. It is the measure of the profitability from business operations, and a good indicator of future profitability. This information can be gathered from the company’s profit and loss statement and is calculated as operating margin = operating earnings / revenue, where operating earnings = revenue – cost of goods sold (COGS), labor, and general and administrative expenses.

For example, let’s consider a grocery store, FreshEatz, and their financials:

• Revenue-                $15,000,000.00
• COGS-                    -12,000,000.00
• Labor-                       -1,800,000.00
• General & Admin-        -900,000.00
• Profitb                         $300,000.00

In this example, COGS, labor, and general and admin combine as operating expenses ($14,700,000), which are subtracted from the revenue ($15,000,000 – $14,700,000 = $300,000).

Thus, the operating margin is $300,000 / $15,000,000 or 2%.

Asset Turn-over

Asset turnover, or turnover rate, is a ratio of how many times during a selling season assets are turned over, or used.

In other words, it calculates how many sales dollars are generated for each dollar invested in assets. The formula is revenue / net assets. Again, let’s return to the example of FreshEatz, whose asset turnover is 1.5 ($15,0000,000 / $10,000,000).

This means that FreshEatz turns-over their assets 1 ½ during the selling season or period we’re reviewing. This alone isn’t telling. But, it potentially shares a great deal when compared to historical data or to competitors.

For example, if Goodness Great Tastes, a rival grocer in-market, has comparable revenue at $15,000,000 and assets of $15,000,000, their asset turn-over would be 1.0 ($15.000,000 / $15,000,000). This would indicate that Goodness Great Tastes doesn’t deploy its assets to generate revenue as efficiently as FreshEatz.

Return on Assets

One way a firm can reflect its efficiency is return on assets (ROA), which is how much income is produced by its use of assets. Again, for a retail business, assets are inventory available for sale and the dollars generated by sales. Again, consider FreshEatz and Goodness Great Tastes, for an example. Let’s assume each has profits of $300,000, Thus, it might appear that they are performing equally well.

But we know from earlier that they have different levels of assets. Thus, if we look closer, we see:

• FreshEatz- $10,000,000 in assets
• Goodness Great Tastes- $15,000,000 in assets.

In this scenario, FreshEatz would be considered more profitable, since they were able to generate more profit on a smaller value of assets ($300,000 / $10,000,000 = 3% for FreshEatz vs. $300,000 / $15,000,000 = 2% for Goodness Great Tastes). This means that every dollar in assets returns an extra $.03 for FreshEatz and only $.02 for Goodness Great Tastes. While that difference may appear modest, it reflects how well FreshEatz is deploying their assets to generate profit, compared to Goodness Great Tastes.

The retailer’s ROA can also be calculated by multiplying the operating profit margin by asset turnover. Let’s check to see whether this would work for FreshEatz, given our previous work.

• Operating Profit Margin- 2.0%
• Asset Turn-over- 1.5

Thus, 2.0% x 1.5 = 3.0%, which matches the previous calculation. Simply, you should know that there are different approaches to determining the ROA for a firm.

Ultimately, it’s the use of ratios and calculations like the ones described above that can serve as helpful management tools for a firm, identifying areas that can help improve long-term profitability. Financial planning like this is the foundation of retail management, an important component of the retail strategic plan. Based on past performance, balanced by industry benchmarks and current trends, financial planning has an eye toward improved performance.

Profit and Loss Statements

The income statement is an accounting tool that reports a company’s financial performance over a specific period, providing a summary of the business’s revenues and expenses from operations and non-operational activity. Below, you’ll find a sample income statement for XYZ Retailers. We will use this statement to analyze and understand the importance of financial statements for retailers.

As you can see, XYZ has net sales revenue of $250,000, given that there are no discounts or allowances to apply to reduce their sales. But, it may be more difficult to understand how to determine COGS (cost of goods sold). In truth, we have to understand how the XYZ operates and what the accounting entries mean.

In this case, XYZ had $40,000 in inventory on-hand, when the accounting period opened on 7/1/17. That simply means they had product in their inventory, such as boxes and cans sitting on their shelves and in their backroom. During the period, they made $100,000 in additional purchases to bring in more inventory. To this they add freight and customs expenses of $10,000. So, for the period, their total accumulated inventory would have been $150,000 ($40,000 + $100,000 + $10,000).

But, at the end of the period, they have only $60,000 of inventory on-hand. What happened to the rest? Easy. It was sold. So, we now know the COGS is $90,000 ($150,000 accumulated inventory – $60,000 ending inventory). Thus, we can see that sales net of COGS is $160,000 ($250,000 in revenue – $90,000 in COGS). Further, we see that XYZ has some non-traditional revenue streams: rent ($3,000) and commissions ($2,000). We add these to get a total net revenue of $165,000.

However, as we learned earlier, businesses incur other operating expenses. For XYZ, these are related to selling and distribution, general and administrative, and financial. In total, they sum to $105,000 ($14,500 in selling and distribution + $89,000 in general and administrative + $1,500 in financial) and are deducted from the total net revenue to show $60,000 in net profit (EBIT or earnings before interest and taxes).

While the numbers are straight forward, it’s the meaning behind them that’s most important and telling for a decision-maker, looking to improve the financial performance of the organization. That is, they reflect what is happening in the business’ operations for better or for worse. For example, the closing inventory is $20,000 greater than the opening inventory. Does this reflect a slow down in sales or a ramp-up in inventory on-hand to accommodate seasonality? If we compared these results against past periods, what we would learn about changes selling and distribution expenses? Wages? Are these costs increasing or decreasing? And, at what rate are they increasing/decreasing relative to revenue and profit?

As you can see, the income statement provides important information about the financial performance of the firm, helping decision-makers understand where to focus to improve going forward. The following video, which uses Walmart as an example, may be a helpful tutorial to broaden your understanding of income statements.

You can view the transcript for “How to analyze an income statement – Walmart example (case study)” here (opens in new window).

Performance Objectives and Measurements

A performance metric measures an organization’s behavior, activities, and performance. It should support a range of stakeholder needs from customers to shareholders to employees. While traditionally many metrics are finance based, inwardly focusing on the performance of the organization, metrics may also focus on the performance against customer requirements and value. In project management, performance metrics are used to assess the health of the project and consist of the measuring of seven criteria: safety, time, cost, resources, scope, quality, and actions.

A criticism of performance metrics is that when the value of information is computed using mathematical methods, it shows that even performance metrics professionals choose measures that have little value. This is referred to as the “measurement inversion”. For example, metrics seem to emphasize what organizations find immediately measurable—even if those are low value—and tend to ignore high value measurements simply because they seem harder to measure (whether they are or not).

To correct for the measurement inversion other methods, like applied information economics, introduce the “value of information analysis” step in the process so that metrics focus on high-value measures. Organizations where this has been applied find that they define completely different metrics than they otherwise would have and, often, fewer metrics. For projects, the effort to collect a metric has to be weighed against its value as projects are temporary endeavors performed with finite resources.

There are a variety of ways in which organizations may react to results. This may be to trigger specific activity relating to performance, such as an improvement plan, or to use the data merely for statistical information. Often closely tied in with outputs, performance metrics should usually encourage improvement, effectiveness, and appropriate levels of control.