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How You Can Understand a Retail Business – Part 2

shopping

Retail businesses  belong to an industry that is likely to be one of the most easily accessible for an individual investor to follow.

Examples of retail businesses you can find here in Singapore include Dairy Farm International (SGX: D01), Courts Asia (SGX: RE2), Challenger (SGX: 573), Sheng Siong Group (SGX: OV8), The Hour Glass (SGX: E5P), Aspial (SGX: A30), Osim (SGX: O23) and FJ Benjamin (SGX: F10).

While it’s important to have a rough idea of how popular a retail operation is, that’s not enough. The health of a retail business matters too, and that’s what we’re going to dig into here.

Gross Margin

As retailers tend to sell similar products year after year, their gross margins on the products should generally be stable. Therefore, if you spot the gross margins of a retailer decreasing over a number of years, it might be an indicator of potential trouble within the company.

Declining gross margins could be due to a company being unable to pass on an increase in costs to customers, or it could be because the company has started a price war with a competitor.

It is important to investigate whether problems related to gross margins are a short- or long-term issue for a retailer.

Inventory Turnover

Inventory turnover days, defined as the number of days needed for a company to sell off its entire inventory, is a good gauge for investors to understand the current strength of a retail business.

Normally, a retailer should have steady inventory turnover. However, if it finds itself burdened with merchandise that it’s unable to sell, inventory turnover days would start increasing. When this happens, a retailer might have to sell its products at deep discount or completely write off the unsold inventory.

Neither action is beneficial for a retailer as its profitability would suffer.

Stores Expansion            

Retailers need to add stores to grow. Tracking a company’s expansion plan can be a good indication of its growth prospects. If a company is adding many stores but revenue can’t grow, then there might be issues with the performance of existing stores.

This is a warning light that should prod us to explore deeper.

Foolish Bottom Line

The famous investor Peter Lynch once said Know what you own, and know why you own it.” I believe this is extremely true for retail businesses as they are operating in a fast changing and highly competitive industry. You never know when the tide might be changing, so it is important to constantly scrutinize the current health of any retailer you are invested in.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.