Retail Dogma

Retail Balance Sheet Explained

The retail balance sheet is one of the retail financial statements that shows the assets of the business (what the business owns), the liabilities (what the business owes) and the shareholders’ equity (Assets -Liability).

So let’s find out more about the balance sheet of a retail business, and how it is linked to the P&L.

Why is it called balance sheet?

Short Answer: Because it has to balance!

The balance sheet lists the assets of the business vs its liabilities + shareholders’ equity (or net worth). Both sides have to balance.

Assets = Liabilities + Equity

The simplest way to understand this is through drafting your personal balance sheet.

Let’s have a look at how my, or your, balance sheet might look like

You have the following scenario:

  • 5000$ cash in the bank
  • 10,000$ invested in stocks
  • A home worth 350,000$
  • You paid 50,000$ down on the home and have a mortgage of 300,000$
  • You have credit card loan of 1000$

The question now is: What is your net worth (Equity)?

Equity = Assets – Liabilities

Equity = 5000$ + 10,000$ + 350,000$ – 300,000$ – 1000 $ = 64,000$

Personal Balance Sheet

As you can see here, your net worth or equity is 64,000 $. That’s because you have total assets of 365,000 $ but also total liabilities of 301,000$.

So your balance sheet has to balance the assets on one side, and the liabilities and your equity on the other side.

Retailer’s Balance Sheet Components

Now that we’ve understood the concept through the personal statement, let’s see how a retailer’s balance sheet looks like.

This is a balance sheet example for a retail business and you can download it for free from the button below.

Retail Balance Sheet

Assets

Assets are segregated into current assets and long term assets

Current assets include

  • Cash
  • Short term investments
  • Merchandise inventory

The reason merchandise inventory is considered a current asset is because typically merchandise can be liquidated quickly if offered at low prices.

Note: Current assets also include Accounts Receivable, which is any payment that is due to the business for goods delivered to customers but still not paid for. Since we are talking about retail & ecommerce businesses, and these businesses typically get paid before the customer receives the goods, we didn’t include it in the template. If you are selling on installments and will only get paid later, this is where you will insert this amount.

Long term assets are

  • Property
  • Equipment

The value of these assets will be net of the total depreciation amount that has been deducted every year from the P&L; i.e their real current value if they were to be sold in the market.

Liabilities

Liabilities are also segregated into current and long term liabilities

Current liabilities include

  • Accounts Payable, e.g payments due to suppliers
  • Taxes that are already due.

Long term liabilities include any long term debt

Equity

Equity will include any share capital (Equity Capital) that the owners paid in the business and any retained earnings that the business has accumulated and didn’t pay them in the form of dividends.

Which takes us to the next point..

What’s the link between the P&L and the balance sheet?

The P&L will generate the net profit for the year and this profit/loss will be added to the balance sheet in the form of “Retained Earnings” under equity or net worth. Retained earnings are the cumulative amount of profits and losses the business has generated in the previous years and decided to “retain” inside the business.

Learn More: P&L Management

Now because the balance sheet has to balance, and because Equity = Assets – Liabilities, any reduction in retained earnings throughout the years, means reduction in equity or net worth in the form of reduced assets or increased liabilities.

For example, if you make losses year after year, your inventory level (asset) might be reduced without replacement of new merchandise OR you will have to borrow money (liability) to buy merchandise and keep the business going.

If you make profits it can be used to increase your assets in the form of buying more merchandise, equipments or keeping cash in the bank. It can also be used to reduce your liabilities by paying down your debt.

So looking at the balance sheet will give you a better understanding of how the business has been performing over the years, instead of the short snapshot that the P&L gives for a certain period of time only.

Retailer’s Balance Sheet Red Flags

Now that we’ve explained the different parts of the balance sheet of retail businesses and why, as a business owner and as a retail manager, you should be managing the business from the balance sheet and not only the P&L, let’s have a look at some things you should look out for in a balance sheet.

You will often hear the term “clean balance sheet” when it comes to evaluating a business for investment purposes. How to make sure your business has a clean balance sheet?

Look out for the below 3 red flags

1. Debt Distress

Gearing Ratio = (long term debt + short term debt) ÷ Equity

Calculate the ratio of interest bearing debt on the balance sheet to the shareholders’ equity to measure the level of leverage of the company. Leverage is the use of borrowed money to increase revenue of the company.

Normally 25% to 50% gearing ratio is acceptable and expected for established companies. Higher levels represent a red flag because they increase the financial risk of the company through the risk of defaulting and bankruptcy.

2.Working Capital Crisis

Working capital measures the liquidity of the company and its ability to generate cash quickly if needed.

If your working capital falls or becomes negative for an extended period of time you need to look deeper into this issue and fix it.

To calculate working capital you can use this formula:

Working Capital = Current Assets – Current Liabilities

Read More: What is Working Capital?

Also check next point.

3. Inventory Build Up

You might find that your working capital is actually too high, and the reason is that your inventory is building up too quickly.

You should already be having a process for calculating OTB to buy your inventory, so that you avoid overstocking or under-stocking, which are both bad situations.

However; even if you do it right, you might end up in an overstock situation because your sales didn’t come through for some reasons. In this situation you have to be actively liquidating the excess stocks to free cash for new buying and fresh merchandise.

This is also why I recommend re-visiting your OTB in the season and adjusting your actual buying (that has not been ordered) based on your current sales trend.

Read more on Inventory Management

Bottom Line

Retail managers and retail business owners should be managing their business through both, the income statement and the balance sheet. The P&L is often a focus point and an important KPI for any retail manager, but it only tells a part of the story and it doesn’t take into account the future health of the business.

“It’s the balance sheet that actually matters!”

Read more on Retail Financials