May 16, 2011 12:37
Benchmarking the financial performance of your business against that of your peers is an important aspect of running and growing your business. Comparing yourself to your competitors can help highlight trouble areas and can serve as red flags for you. As Chad Parker, a Partner at Sink, Gillmore & Gordon LLP accounting firm puts it, “Industry comparisons are a valuable part of understanding and improving business performance as they can point out areas that businesses need to take a look at and see why they are performing below the rest of the industry.”
But, before you find true value from these comparisons, you will need to decide which financial metrics are important to you and understand what they actually mean. After you complete these two steps, finding quality industry data to benchmark yourself against is the third important step in getting true value from industry comparisons.
Below are generally the most important financial metrics to focus on when looking at industry benchmark data and a short explanation of what they actually mean.
1. Net profit Before Taxes Margin
Net profit margin is generally expressed as net profit before taxes in a given financial period divided by sales. Another helpful interpretation is how many cents of profit a business extracts from each dollar it earns in revenue. This is a basic financial metric, but it is the most important.
2. Liquidity Ratios
There are two fundamental liquidity ratios that should be analyzed jointly. Current Ratio is expressed as current assets divided by current liabilities. This metric shows the company’s general liquidity, but it has some limitations. For example, by including inventory in the calculation, it may provide a distorted understanding of the company’s very short-term cash flow. The second liquidity ratio is the Quick Ratio, which is typically expressed as cash plus accounts receivables divided by current liabilities. Again, the Quick Ratio may not be perfect for gauging liquidity, but it is a useful and popular comparison to pair with the Current Ratio.
3. Turnover Ratios
There are three fundamental turnover ratios that you should calculate. Accounts Receivable Turnover, in days, is expressed as accounts receivable divided by sales multiplied by 365 days. It roughly measures the number of days a company takes to turn accounts receivable into cash. Lower numbers are more desirable. The second ratio, Accounts Payable Days, is expressed as accounts payable divided by cost of goods sold multiplied by 365 days. The Accounts Payable Days ratio indicates the number of days a company takes to pay its vendors. Here, higher numbers are better. The third turnover ratio, Inventory Days ratio, is expressed as inventory divided by COGS multiplied by 365 days. The Inventory Days ratio measures the number of days it takes to sell inventory, but it is very specific to your industry. Generally, lower numbers are better.
Download the full whitepaper to access private-company stats for these metrics and read more about where to find quality benchmarks: Benchmarking Best Practices.