Hidden Messages in Your Financial Statements: Ratio Analysis and Industry Benchmarking Provide Added Insight
By themselves, financial statements provide limited insight into a manufacturer’s performance. To get a clearer picture of what’s really happening requires a relevant basis of comparison. Financial ratios and industry benchmarks provide management with the tools to identify strengths and weaknesses.
Which ratios should you focus on?
Financial ratios are calculated by comparing two or more items on your balance sheet or income statement. While this can be done in a variety of ways, manufacturers distributors tend to use certain ratios more often than others.
For example, the debt to assets ratio is calculated by dividing your total debt by total assets. More debt results in a higher ratio. Because banks will likely take this ratio into consideration when you apply for a business loan, strive for a ratio of 1 to 2, or 50%, to be considered a reliable applicant with manageable debt.
The return on assets (ROA) ratio shows how much profit you’re generating for each dollar invested in total assets. This is calculated by dividing net income by total assets. A higher ROA generally means greater efficiency, because you’re earning more money on less investment. Additional ratios include the:
- Current ratio (current assets divided by current liabilities) — a current ratio of 2 to 1 is generally preferable,
- Quick ratio (current assets minus inventory, then divided by current liabilities) — a quick ratio of 1 to 1 or better is usually satisfactory, and
- Sales to inventory ratio (annual sales divided by inventory) — try to target for about 6 to 1, meaning you’ll need to order new inventory about six times a year.
Another useful ratio, the times interest earned ratio, is calculated by dividing net earnings before interest and tax by your interest expense. This reflects your company’s ability to meet interest expenses from operations.
How do you measure up?
In addition to measuring the progress of your business over a certain period and unearthing trends and problems, benchmarking presents a clearer view of where your manufacturing and distribution company stands in relation to your competitors.
Trade associations such as the National Association of Manufacturers provide up-to-date financial figures, including industry averages for rent, utilities, materials costs and employee compensation. Trade journals, as well as the U.S. Department of Labor, can also be helpful sources for relevant financial statistics.
To find the applicable industry statistics, you’ll need to know your specific industry segment’s North American Industry Classification System (NAICS) code. Find your NAICS code by visiting the U.S. Census Bureau website at http://www.census.gov/eos/www/naics.
What’s the upside of benchmarking?
Benchmarking offers several benefits. First, it gauges your financial strength by comparing it to past company performance and industry averages. This allows your management team to gain insight into which goals the company has achieved and where it’s fallen short, providing tangible ratios for your reference.
Benchmarking also puts your financial operations under the magnifying glass. A close-up view brings to light small problems that could affect your company’s overall financial well-being.
How can you avoid potential pitfalls?
On the flip side, calculating and evaluating these ratios can be time consuming. Also, if a number is recorded incorrectly, a ratio is miscalculated, or a statistic is out of date, the process can yield misleading information — possibly leading to knee-jerk responses. If something seems out of whack, research it further before taking corrective measures.
Finding the right fit
Every manufacturing and distribution operation is unique. The generalized benchmarks discussed here are for a typical manufacturer. A financial advisor who specializes in manufacturing and distribution and distribution can provide customized guidelines that will fit your manufacturing and distribution specialty and company’s size.
If you work with your financial advisor to analyze your company’s financial ratios on a regular basis, your benchmarking efforts are more likely to be meaningful and reliable.