According to the most reliable news reports the economy, and retailers as well, are coming out of a deep slumber. Retailers had the best Christmas season in three years. But what of the intervening three years? Whether it was the bursting of the hi-tech bubble which dragged the entire stock market down, the war in Iraq, the 9/11 tragedy and resulting war on terrorism or poor government polices, it hardly matters. Regardless of the reason, businesses still had bills to pay. Vendors and employees had to be paid on time. Payment on bank notes and other forms of long term and installment debt had to be made on time. When the business cycle turns down many publicly owned businesses can promote additional volume by offering liberal extended payment on credit terms at little or zero interest to their customers. Because they have access to the open market for seemingly unlimited funds at the most favorable interest rates (which have been at a 40-year low due to the Fed trying to stimulate the economy) they can literally ‘buy’ volume. It is no coincidence their need for funds to promote more sales occurs precisely when the cost of borrowing those funds is at a low point.
Unlike publicly owned corporations, the independent retailer has only two sources of funds from which to keep the credit-grnting lines flowing. One avenue is for the business owner to inves additional personal funds in the business. This is usually not practical because in most cases the business owner has all of their liquid funds already invested in the business.
The other source is profit. Make no mistake, a business, to stay in business, must be profitable. There simply is no alternative. An unprofitable business will quickly have trouble getting factor-financed vendors to accept their orders. The more valuable the vendor, the quicker the vendor will refuse to ship.
How much profit SHOULD a business generate? By all rights, the profit should be relative to the risk. Small businesses are riskier than large dominant businesses which have patents or trademarks or a name so well recognized it is considered a franchise. Accordingly, small businesses should be more profitable from a percentage standpoint than large publicly traded corporations. The value of a publicly traded corporation is based on its earnings; the market value (or capitalization) is expressed as a multiple of its after-tax earnings. This is not practical for privately owned businesses. For privately owned businesses profit should be expressed as a percentage of its book value. The approach is exactly reversed. Also, the federal and state tax burden is disregarded for privately owned businesses – earnings are stated as pre-tax – since so many of them are individual proprietors, partnerships or Sub S corporations which do not directly pay taxes.
In my opinion, to justify the risk of owning and operating a small business, profit must be at least 15% of its net worth. And this is after fair compensation for the owner-operator, considering the functions he/she performs.
Let’s look at some retail math:
- Assume net worth of $250,000 (excluding any business owned real estate and excess funds)
- The pre-tax net profit should be a minimum of (15%): $37,500
- Liabilities (to vendors, banks, etc) should not exceed an equity to debt ratio of 2 to 1: $125,000
- Total assets then are ($250,000 + $125,000): $375,000
- This would support annual sales of $1,000,000 to $1,250,000, resulting in annual profit based on sales of only 3.75% to 3.00%
At what rate of return on invested funds is the owner/operator better off in their own business? My experience tells me the number is around 25% per annum.
This presents another ‘retail ratio’: the ratio of sales to owner’s equity. A healthy ratio of sales to equity is between four and five to one. For every dollar of equity, sales should be between four and five dollars. (Real estate such as a store-owned building and surplus funds invested in securities must be omitted). This indicates that the owner’s investment is being wisely used and further that the business is not over capitalized. I mention the latter because excess funds generally end up in excess inventory.
How much profit MUST a business generate? The answer is very simple. It must create enough profit (after the owner-operator’s compensation) to pay its bills on time and replace facilities (furniture, fixtures and equipment) as they wear out or must be mo modernized. That’s barely getting by. This level of profitability provides no return to the owner for invested capital. My experience tells me this business usually will not survive times like the last three years.
In Part II , we will discuss the positive and productive ways an independent can survive and prosper in the retail jungle.
Gerald H. Smith is a retired Retail Industry Consultant.
