INVENTORY: A CLUE TO CH. 11
Byline: Vicki M. Young
NEW YORK — Want to know what stores are likely to go bankrupt? Cherchez la inventory. “Inventory manipulation is a more accurate telltale sign of a retailer at risk than focusing on a company’s bottom line because there can be more than one game being played with the inventory reports,” said Thomas Yake, managing partner of Yake & Associates Inc., a management firm specializing in loss control in the retail industry.
He added that number-crunchers — those who focus on the bottom line — do get a financial snapshot of the company, but it’s “hopelessly outdated” by the time they get to see it.
Yake made those observations at a presentation last month on “Why Retailers Go Bankrupt and How to Tell in Advance” before the New York Society of Security Analysts Inc.
Other so-called “soft” indicators, although circumstantial, can substantiate the likelihood of corporate mismanagement, Yake said. He pointed to other potential red flags: closely held boards, affiliated transactions between company divisions and management, and questionable real estate transactions.
But the concept of shrinkage — and its opposite, swellage — is the easiest for companies to fudge, Yake emphasized.
The real problem, he pointed out, is the retail inventory method. In this method, retailers value their inventory based on the items’ presumed selling price. Making it even tougher is including all the markups and markdowns that occur.
Yake suggested that retailers need to move to the cost accounting method, which values the inventory at cost.
Shrinkage is generally thought of as inventory that’s lost or stolen.
“That’s a myth,” Yake said, “because it’s impossible to determine how much merchandise is stolen through employee theft and shoplifting. Shrinkage can be a convenient black hole for hiding buying errors, mismanagement and fraud.”
For example, Yake said his firm identified 108 causes for shrinkage in the retail industry in a report to the U.S. Tax Court, and only three were theft-related.
In an interview after the presentation, Yake noted that his first experience with abusive business practices occurred at Zayre Department Store, where he worked for 10 years starting in the mid-Sixties. Zayre was acquired by Ames Department Stores in 1988 and eventually closed.
“Acquiring a flawed retail operation,” he observed, “pushed Ames into bankruptcy.”
“I began as a stockboy, and in one early assignment, I was told by the store manager to destroy the bicycles left over after Christmas,” he said.
Zayre regularly destroyed merchandise to cover up buying and other operating mistakes, he disclosed. The company’s deceptive practices included inflated markups at the store level and unrecorded markdowns in the buying division, according to Yake. One common event was the chargeback.
“Vendors were asked to take hits for damaged or defective merchandise, but the items were actually overstocks that were later destroyed,” he said.
And “advise of error” forms were used to falsely notify distribution facilities of shipping errors, usually shortages, Yake pointed out. Shorting the distribution center and falsely crediting the store inflates the inventory level and pads shrinkage.
Both practices manipulate the inventory level, artificially making its value higher, which can influence the stock price.
Another inventory red flag is when merchandise inventories rise faster than sales. That’s what happened at now-defunct Merry-Go-Round, for which Yake served as a consultant.
“The retailer had inventories on Jan. 30, 1993 of $82.2 million, up 37 percent from $60 million the previous year,” Yake said. “Sales only grew approximately 15 percent to $877.5 million from $761.2 million. That’s a hint that a sharp increase in shrinkage could soon result. A good rule of thumb is: The more promotional a retailer becomes, the worse the shrinkage will be.”