Math for Retail Nerds

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Back-to-school time means most retailers will be full of parents and students looking for the latest fashions, must-have school supplies, and electronic gadgets.

Fool's School is always in session (it's the first part of our motto), so I thought it would be fitting to go over some things I look for when sizing up a retailer.

Ding-ding-ding! There's the bell for first period.

The metrics
I like simple things. Retailers have one of the simplest business models around: Buy stuff and sell it to other people.

But in fact, retailing can be a very difficult business to operate and can have lots of ups and downs. So to take advantage of the ups and avoid the downs in the stock market, let's go over some important metrics to help us size up retailers as potential investments.

Inventory
Grow, grow, grow. Investors love to focus on sales and profit growth.

While growth does have its place in the analysis, I think it's more appropriate to start on the balance sheet. Retailers use lots of capital, and what we want to measure is how well they use that capital. After all, we as shareholders supply it for them.

The goods that retailers buy go into inventory on the balance sheet. And the faster they can turn inventory into sales, the better. Fortunately, we have a metric to measure just that.

Inventory turns = cost of goods sold/average inventory

Inventory turns measure the number of times a company sells, or turns over, its inventory per year. If a company has inventory turns of two, that means it sells its inventory twice during the year.

Another way to measure how well a company manages its inventory is in days of inventory. It's the same equation flipped a little and multiplied by 365 days; i.e., days of inventory = average inventory/cost of goods sold * 365. The lower the days of inventory outstanding, the faster the company is turning it over.

There is no magic inventory turn line separating good and bad retailers. Like most things in investing, it depends on the context. People don't buy jewelry every day the way they do groceries. So we shouldn't expect a jewelry store like Tiffany (NYSE:TIF) to turn over its inventory as fast as a grocer like Kroger (NYSE:KR). In fact, Tiffany has inventory turns of one versus 10.5 for Kroger. So typically it's better to see turns increasing (days going down) than the opposite.

Accounts payable
The amount of money a company owes suppliers for those goods shows up as a liability called accounts payable on the balance sheet. We measure accounts payable in days as well.

Days payable outstanding = average accounts payable/ cost of goods sold * 365 days

Strong retailers can demand better credit terms and will see higher days payable. And the trend in days payable can offer clues about whether a retailer's business is getting weaker or stronger.

Last year, I invested in Cabela's (NYSE:CAB), the outdoor sporting goods retailer. Bass Pro Shops, a private, big-box retailer, and GanderMountain (NASDAQ:GMTN) are two major competitors in this space. Gander Mountain, whose stores are considerably smaller than the average Bass Pro Shop or Cabela's shop, has been struggling. One place we see evidence of its woes is in its days payable outstanding.

Data from Capital IQ, a division of Standard and Poor's

The falling days payable numbers indicate that suppliers are demanding faster payments from Gander Mountain. The question is, why would a supplier demand faster payment? Most likely, it's if the supplier were worried about not getting paid. Falling days payable can be one sign that there's a problem with the business.

Gross margins
Sales growth is important. But what's more important is the impact those sales have. That's why it's important to keep an eye on traffic numbers, the number of transactions, and average transaction size. Toss gross margin percentage into the mix and we get a good idea of how productive those sales are.

Gross margin = 1 - cost of goods sold/sales

Different retailers have different levels of gross margins, so it's not always helpful to compare the levels unless the companies sell similar things. Again, higher is usually better, but stable margins are usually good, too. That's because retailers have lots of operating leverage.

Selling, general, and administrative expenses act more like a fixed cost that depends on the size of the operation. So if gross margins are bouncing around, the bottom line can fluctuate even faster and may cause motion sickness.

What would cause this to happen? Poor merchandising or buying. If they don't stock the things customers want to buy, companies have to resort to heavy discounting to move the old merchandise out of inventory to make room for new items, leading to lower sales figures. Want an example? Look at the difference between New York & Co. (NYSE:NWY) and Guess? (NYSE:GES) below. New York & Co. has been having a tough time lately.

Data provided by Capital IQ

Same-store sales
You may be wondering why I haven't said much about same-store sales. Just because it's the first metric reported by the financial press does not mean it's the first I look at. And I suggest you read Alyce Lomax's great piece on the subject, which includes Sears Holdings (NASDAQ:SHLD) Chairman Eddie Lampert's view on the matter. They'll say it much better than I can.

Strategy
I have learned over the years that a company's competitive advantage depends on its position and the right supporting capabilities. The same applies for retailers.

Wal-Mart (NYSE:WMT) has decided to stake a claim on everyone in the world. In making goods available to all those people, it has made massive investments in developing its operating infrastructure and the people who run its operations. Everything works toward a single goal: getting customers to buy more and more things from Wal-Mart by offering the best deals.

I would contrast this against a company like Dollar General (NYSE:DG). It too would like to sell things to as many people as possible. But it caps the prices of its goods and tries to make its profits by buying things very cheap. To me, that's not an enviable position no matter how good its operations are, because expenses can only be cut so far.

The final bell
Remember, retailing is about buying stuff and selling it to customers. High inventory turns mean the retailer is selling stuff quickly. High days payable outstanding tends to indicate suppliers believe in the retailer's creditworthiness. Stable (and hopefully high) gross margins indicate the company is making enough profit to cover its product costs. And I think it all starts with strategy: Which market is the company targeting and what is it doing to fortify its position?

This is by no means an exhaustive list of things to look for when analyzing a retailer. But I think these can put you on the right track to making Foolish investment decisions about them.

The Fool has a newsletter for almost every type of investor. New York & Co. is a Motley Fool Hidden Gems recommendation and Wal-Mart is an Inside Value selection. See how these newsletters are beating the market with a free trial.

David Meier is the retail sector head at The Motley Fool and a member of the Inside Value newsletter team. He loves to share his knowledge and thoughts, owns shares of Cabela's, but does not own shares in any of the other companies mentioned. The Motley Fool has a disclosure policy.