By Brad Schaefer, Analyst, Sageworks
Businesses often want to see how their company's financial performance stacks up against the competition, but it's difficult for accountants to find quality data on comparable, private companies. The ability to benchmark effectively is a skill that can help you transition from quarterly CPA to trusted business advisor, but in order to provide this service, it's important to seek out data with the following characteristics:
- Accuracy: In order for a benchmark analysis to provide meaningful insights to a business owner, the data used as benchmarks must be accurate, and the business owner must trust its accuracy. This can be difficult given that every data set has its eccentricities: sources of data, bounds used to determine outliers, sample size, or even classifications.
- Timeliness: In some cases, old data can't be avoided, but business is run in real time, and industries shift financially over the course of a year. Consequently, if a company uses benchmarks from a previous year, the resulting analysis may be ineffective or altogether misleading.
- Relevancy: Different industries, geographies, and business sizes have their own trends and circumstances that can affect benchmark data. In order to maximize data effectiveness, business owners, whenever possible, should seek out data that's granularly defined and closely corresponds to the business being analyzed.
After securing an accurate, timely, and relevant data source, the challenge becomes choosing which benchmarks to analyze and use as a proxy for business success.
Different industries, even different companies within an industry, can have different measures of success. While industry-specific performance indicators can provide invaluable and highly specialized information, the following financial metrics are almost universally important to businesses. When analyzed together, they allow you to provide the client with a high-level, quick review of a company's health.
Net profit margin
Net profit margin is a rudimentary financial metric, but it's also the most important. It can help your customers understand better how many cents of profit the business gets to keep from each dollar it generates in revenue.
If it's available, check raw financial data or the formula used by the data source to validate that it's consistent with the company's calculations. Verification is especially important for this measure of profitability, as other firms might make adjustments to assist in their own analyses. For example, at Sageworks, net profit margin is adjusted to exclude taxes and include owner compensation in excess of their market-rate salaries – adjustments commonly made to private company financials to provide a more accurate picture of a company's operational performance.
There are two fundamental liquidity ratios that should be analyzed jointly to help your client assess a company's health. Current ratio (current assets divided by current liabilities) shows a company's general liquidity, but by including inventory in the calculation, it may provide a distorted understanding of a company's very short-term cash flow. The second liquidity ratio to examine with clients is the quick ratio (cash plus accounts receivables divided by current liabilities), which provides that shorter-term view of the cash situation.
There are three fundamental turnover ratios to calculate:
- Accounts receivable (AR) days (accounts receivable divided by sales, multiplied by 365 days) can help your client see roughly the number of days a company takes to turn accounts receivable into cash. Help your client understand that lower numbers are more desirable, since it's better to have cash in the bank than extra receivables on the books.
- Accounts payable (AP) days (accounts payable divided by cost of goods sold, multiplied by 365 days) helps clients assess how quickly they're paying their own vendors. Here, higher numbers are better because it means the company is able to hold onto cash longer.
- Inventory days (inventory divided by cost of goods sold, multiplied by 365 days) measures the number of days it takes to sell off inventory, but it's very specific to the industry. Imagine how long wine is stored at a winery compared to how long eggs are on grocery store shelves. The key takeaway for clients is that generally, lower numbers are better.
Pitfalls of Benchmarking
With these metrics in mind, here are a few additional tips for conducting a benchmarking analysis.
Comparing company A to company B is a common mistake. Comparing one business to a peer group is helpful if the peer group is representative of the industry. However, if your analysis begins to compare your client to another single company, there may be considerable differences that prevent a useful comparison.
The benchmarks previously discussed – net profit margin, liquidity ratios, and turnover ratios – are common in financial analysis, and their calculations aren't generally refuted or changed. However, if you expand your benchmark analysis to include industry-specific key performance indicators, such as sales per seat, be sure to use the same calculation, period after period.
Finally, know that benchmark analysis doesn't end with a variance report. Though it may seem that your work is complete once you've compiled a report showing variances between your client's financial metrics and their peer group benchmarks, the work is actually just beginning. But so are the opportunities. Each variance can show the client a potential problem area to fix and the opportunity to improve the company's overall performance.
Likewise, the variance report will show in which areas your client is really excelling. Point these out to your clients and urge them to take pride in these areas. Work with them to see if the winning strategy can be implemented in other areas of the company.
Raleigh, North Carolina–based Sageworks is a financial information company. Sageworks' data and applications are used by thousands of financial professionals across North America to analyze privately held companies. Sageworks is now offering its database of industry statistics on privately held companies available for free to all US accounting firms. To sign up for access to the free industry benchmarking data, visit the industry data home page.