By Brian Hamilton, Developer, Profitcents.com
“Benchmarks” are of interest to many types of financial professionals. The topic has been covered substantially lately because, if they are gathered and used properly, they can be helpful to the financial analysis process.
As used here, “benchmarks” are financial metrics/ratios/results which show the average ranges of financial performance by companies in a given industry. There are many different types of financial benchmarks. When we use benchmarks, the main question we are trying to answer is: what is the average level of performance for a given ratio/metric in a specific industry? In a way, a benchmark is a scorecard, against which we can assess the relative strength of a company.
Understanding the average financial performance of specific industries is important to both accountants and bankers who want to understand industry conditions and how the companies they are evaluating compare to other companies in a given industry. For example, credit analysts at banks use industry benchmark data as a way to assess the relative health of a given company. Valuation analysts use benchmark data to assess the future earning potential of a company. Accountants use benchmark data as a way to identify any weak areas that need to be improved by their clients.
Getting access to good quality industry benchmark data has been a major challenge in the United States. There are many reasons for this. First, historically, companies that have sold benchmark data are selling data gathered largely from companies’ tax return filings. Data from tax returns tends to give conservative and unrealistically low numbers for operating profits. Second, in the United States, private companies are not compelled to publish their financial results. Consequently access to private company data is quite limited. There are several companies that gather industry data, but these sources tend to be relatively unreliable. However, Sageworks has attempted to overcome some of the limitations of currently available industry benchmark data. It gathers real-time benchmark data that is compiled by accountants and bankers, which is based upon real operating data. Thus, the industry data is quite strong.
When evaluating any industry data, here are the following items which should be assessed:
1) The sample size of the industry that is reported on. This is very important. If there are not enough companies in the industry that is being reviewed, the results/conclusions will be faulty; the financial results can be skewed and incorrect. Keep in mind as well, that in looking at industry data, and at a particular company in a given sales range you have to make sure that there are enough sample companies in that particular sales range; i.e. even within the same industry selection there can be a different number of companies represented in each sales range. Although there are no perfect rules, it is generally good to see at least five companies represented in each sales range.
2) Where the data has been derived from. As noted previously, tax returns are generally not a good source of private company benchmark data.
3) How the data provider calculates the key metrics that it reports on. Typically, many financial formulas can vary, so it’s important to know how the numbers are calculated. Specifically, any metrics about profitability should be carefully scrutinized because net profit formulas vary dramatically, depending on what expense and/or revenue items are included, e.g. net profit before taxes, net profit before taxes amortization and depreciation, operating profit, and net income after taxes.
4) How often the data provider updates its benchmark data. Older data is sometimes of very little value to users, so it’s important to know the age of the data is that is being used.
Here are the most important financial metrics that should be focused on when looking at industry benchmark data:
1) Net profit Before Taxes Margin. The net profit margin is typically expressed as net profit before taxes during a given operating period, divided by sales. A good way to look at net margin is to think of it as determining how many cents of profit a business extracts from each dollar it sells. There are many financial metrics that might be analyzed, but none is as important as the net profit margin.
2) The Liquidity Ratios. There are two major liquidity ratios. The first one is the Current Ratio, which is expressed as current assets divided by current liabilities. Generally, this ratio indicates what the overall liquidity position of a company is. There are many limitations to the current ratio, but it is always good to know the relative strength of a company compared to its peers. The Quick Ratio is another liquidity ratio. The Quick Ratio is typically expressed as cash plus accounts receivables divided by current liabilities. Many financial professionals put more weight on the Quick Ratio because it is a better measure of a company’s very short term cash position. Again, the Quick Ratio is not a perfect indicator of liquidity, but it is helpful in determining where a company compares relative to peers.
3) Turnover Ratios. There are 3 major turnover ratios that should be reviewed. The first one is the Accounts Receivable Turnover, in days, which is calculated as accounts receivable divided by sales times 365 days. It roughly indicates the number of days it takes a company to convert accounts receivable to cash. The lower the number, the better. The second one is Accounts Payable Days, which is calculated as accounts payable divided by cost of goods sold times 365 days. The Accounts Payable Days ratio measures the number of days it takes to pay vendors. The third turnover ratio is Inventory Days ratio which is calculated by inventory divided by sales times 365 days. The Inventory Days ratio measures the average number of days it takes to sell inventory. The lower the number, the better. It’s always interesting to me to look at these turnover ratios and analyze them carefully. I don’t believe they perfectly reflect what they try to reflect, but they are good indicators, generally. Essentially it’s especially helpful to know how a company compares to its peer group, because that will give a general idea of how the company is managing the resources available to it.
Benchmarking will become more and more important in the United States as financial professionals have access to better data and use it more effectively in making decisions.
About the author:
Brian Hamilton is the developer of ProfitCents. Based in Research Triangle Park, North Carolina, ProfitCents produces narrative text about what financial statement numbers and metrics mean in plain language. Hamilton can be reached at [email protected]