Financial Benchmarking for Success
|A comprehensive benchmarking study can provide your business with a healthy start to the new year. By comparing your business’s financial performance to competitors — or even itself over time — benchmarking can help identify trends, value drivers and potential risks. Here’s a look at the components of a comprehensive benchmarking study and how various factors affect risk.|
The size of a business is conventionally measured in terms of market share, annual revenue or total assets. In general, small private companies are riskier than large public ones. Large businesses tend to have stronger internal controls, more professional management, more reliable financial reporting and more resources to weather economic downturns.But bigger isn’t always better. Sometimes niche players earn higher profit margins because they specialize in one market segment. Businesses that deviate from their core market sometimes choose to divest noncore operations to improve performance. A recent example is General Electric’s decision to divest its share of Baker Hughes, an oil field services company. The move was designed to strengthen GE’s balance sheet and refocus on its traditional business operations.
Typically, growth is measured by the dollar and percentage change in revenue, profits or market share from year to year. Steady upward growth is ideal. But rapid growth can be just as perilous as a rapid decline. Companies that grow too fast have a voracious appetite for cash — and it’s all too common for high-growth operations to take on more debt than their cash flow streams can support.Like all benchmarks, historic growth is relevant only to the extent that it demonstrates future trends. Companies with strong growth expectations almost always carry less risk (and higher value) than those with poor outlooks.
Liquid companies have sufficient current assets to meet their current obligations. Cash is obviously the most liquid asset, followed by marketable securities, receivables and inventory. Working capital — the difference between current assets and current liabilities — is one way to measure liquidity. Others include working capital as a percentage of total assets and the current ratio. (See “3 Types of Benchmarking Reports” at right for more on ratios.) A more rigorous benchmark is the acid (or quick) test, which excludes inventory and prepaid assets from the equation.
Public companies focus on earnings per share, while private companies tend to look at profit margin and gross margin. Rather than focus on the top and bottom of the income statement (revenue and profits), it can be helpful to look at individual line items, such as: Material costs, Returns, Shipping, Utilities,Rent, Payroll, Owners’ compensation, Travel and entertainment, Interest, and Depreciation expense. Comparisons usually require adjustments for nonrecurring items, discretionary spending and related-party transactions. When comparing companies with different tax structures, leverage or depreciation methods, it may be helpful to turn to earnings before interest, taxes, depreciation and amortization (EBITDA).
Turnover ratios show how efficiently companies manage their assets. Total asset turnover (revenue divided by total assets) estimates how many dollars in revenue a company generates for every dollar invested in assets. In general, the more dollars earned, the less risky a business is. Turnover ratios also can be measured for each category of assets. Inventory and receivables turnover ratios are often calculated in terms of days. For example, the average collection period equals average receivables divided by annual revenue times 365 days. A collection period of 45 days indicates that the company takes an average of one and one-half months to collect invoices.
A company’s ratio of debt and equity also sheds light on risk. But leverage is a double-edged sword. Debt allows businesses to earn a return using other people’s money. But debt load can spiral out of control if a business is paying an exorbitant interest rate and can’t repay its obligations. As interest rates rise, companies with excessive amounts of variable-rate loans will incur higher interest expense than they did in previous periods. Another important metric is the interest coverage ratio — earnings before interest and taxes (EBIT) divided by interest expense. The latter ratio shows how many times EBIT will cover interest expense. Burden ratios are similar but incorporate principal repayment into the equation.
Valuable Management Tool
Market conditions have changed in recent years — and more changes are expected in the coming months. Business owners and managers can use a comprehensive benchmarking study as a strategic management tool to improve operating efficiency, build value and anticipate expected development in the marketplace. Contact your CPA to help you perform a benchmarking study on your 2023 financial statements.
3 Types of Benchmarking Reports
There are various strategies you can use to analyze your company’s financial performance. Here are three formats to consider:
1. Horizontal analysis. A good starting point is to put your company’s financial statements side by side and compare them. A comparison of two or more years of financial data is known as horizontal analysis. Often changes are shown as a dollar amount and percentage. For example, if accounts receivable increased from $1 million in 2021 to $1.2 million in 2022, the difference is $200,000, or 20%. Horizontal analysis helps identify trends.
2. Vertical analysis. You can highlight changes with vertical (or common-size) analysis, which shows line items as a percentage of revenue or total assets. For example, a common-size income statement — which shows each line item as a percentage of revenue — explains how each dollar of revenue is distributed between expenses and profits. Changes in such statements over time — a combination of horizontal and vertical analysis — can highlight trends and operating inefficiencies.
3. Ratio analysis. Ratios depict relationships between various items on a company’s financial statements. For example, profit margin equals net income divided by revenue. Ratios are typically used to benchmark a company against competitors (which may be bigger or smaller) or in comparison with industry averages. What’s good or bad for a particular ratio depends on the industry in which your company operates. Contact your CPA for sources of comparative data, such as industry trade associations and benchmarking publications.