I feel sorry for business owners trying hard to learn financial reporting and the various measurements cited throughout financial statements.
The language can be confusing. One report or measurement can have different names. Similar terms may have other definitions. In short, the terminology can be dizzying for a student of financial statements.
For instance, an Income Statement is also called a P&L. What’s the difference between gross profit and gross margin? And then we have earnings, oh my! Let’s see, we have net income, net earnings, EBT, and several other terms. There is also the oft-mentioned ‘bottom line’ by bankers, financial analysts, and other readers of financial statements.
In this discussion, I want to focus on the bottom line. However, there’s more than one bottom line in retail.
What is The Bottom Line?
The very last line on the income statement is the bottom line. The author of True Profit suggests every reader should know the definition of the bottom line so that the reader will know what is included and what’s left out.
For this discussion, the bottom line includes ‘all’ revenues and ‘all’ expenses. What is left over is net income or the bottom line. Check out the video below to see where Walmart’s bottom line is presented in their 1975 annual report.
The Three Bottom Lines
I have worked with many retailers and eCommerce businesses. In those cases, we have three bottom lines:
- operating cash flow
- return on inventory
Most business owners and their managers are focused on the P&L, that’s all. As a former controller for a business acquired by Tractor Supply, the management team was laser-focused on sales, gross margins, and the bottom line, not the other two.
We need three bottom lines because earnings alone do not pay the bills or the banker. Operating cash flow depends on a sound business model about finding, getting, and keeping a customer.
The ultimate efficiency metric for retailers is the return on inventory. Earnings can be engineered. Cash flow can be manipulated. But return on inventory (called GMROI in the industry) does not lie. But be careful. A store can have a high return but low earnings and operating cash flow.
In short, we need all three, as shown in the brief video below.
What About Professional Services Firms?
For years, I sweated that I couldn’t find the third bottom line for professional services firms because there was no inventory. The deliverable is knowledge and expertise, not a tangible product.
When I started working with PTs nationwide, I noticed some made more money than others. In one coaching session with a seasoned PT owner, I compared their earnings (money they derived from running the practice) to $350,000, an arbitrary number I pulled out of thin air. “Are you okay with what you took home compared to my number?” That became my third bottom line. The other two were earnings and cash flow.
I compared their earnings to what they could make elsewhere for a larger organization, such as running a small PT practice with at least a dozen or more clinics. I pulled a page from an economist’s playbook by examining actual vs. economic profit.
Return on equity is an accounting construct, so I never use ROE as the third bottom line in professional services. Plus, most professional services firms do not need growth capital; most earnings are pulled from the business each year. That means ROE is a bogus measurement.
The Three Bottom Lines in Asset-Intensive Industries
The three bottom lines are not just for retailers and eCommerce businesses. The concept applies to asset-intensive organizations too:
- vehicle leasing
- energy firms
- real estate
In the cases above, I’d swap out the denominator with the gross investment in long-term capital assets.