United States: Ratio Analysis And Industry Benchmarking Reveal Hidden Messages In Your Financial Statements

By themselves, financial statements provide limited insight into a manufacturer's performance. To get a clearer picture of what is really occurring, there must be a relevant basis of comparison. Financial ratios and industry benchmarks provide management with the tools to identify strengths and weaknesses. This article examines several ratios that can uncover new insights to your business.

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 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. A high ratio results from increased levels of debt. This ratio will likely be taken into consideration by a financial institution when you apply for a business loan. A ratio of 1 to 2, or 50%, will communicate that you are a reliable applicant with manageable debt. By keeping this ratio low, you will be provided greater financial flexibility.

The return on assets (ROA) ratio provides insight into how much profit you are generating for each dollar you have invested in total assets. This ratio is calculated by dividing net income by total assets. A higher ROA is associated with increased efficiency. This efficiency means you are able to earn more money on less of an investment.

Below are some additional ratios that provide helpful insight into operations:

  • Current Ratio (current assets divided by current liabilities) — This ratio measures your ability to pay short-term obligations. It will let users of your financial statements know your ability to turn products into cash.  As the ratio increases, so does your capability to cover your obligations. A ratio of 2 to 1 is generally preferred.
  • Quick Ratio (current assets minus inventory, then divided by current liabilities) — By excluding inventory from current assets, this ratio gives insight to your liquidity. The higher the quick ratio, the better your liquidity position. A ratio of 1 to 1 is usually satisfactory. This means that you have $1 in liquid assets to pay $1 in short-term obligations.
  • Sales to Inventory Ratio (annual sales divided by inventory) — This ratio can also be called inventory turnover and communicates how many times your inventory was sold and replaced over a period. A low turnover implies poor sales which results in excess inventory. You should compare your ratio against industry averages.
  • Times Interest Earned Ratio (net earnings before interest and tax divided by interest expense) — This ratio reflects your company's ability to meet interest expense obligations from earnings from operations. It is typically a warning sign if this ratio drops below 2.5.

How Do You Measure Up?

In addition to measuring the progress of your business over a certain period and unearthing trends and problems, benchmarking is useful. It presents a clearer view of where your manufacturing company stands in relation to your competitors.

Trade associations, such as the National Association of Manufacturers, provide up-to-date financial figures that can be used for benchmarking. These figures include 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 will 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.

What is 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 has 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. It is important to catch undesired trends in the beginning stages. Early detection of these trends will allow you to make the necessary changes to your operations before it becomes unmanageable.

How Can You Avoid Potential Pitfalls?

However, calculating and evaluating these ratios can be time consuming. Also, inaccuracy in financial information can provide misleading statistics and these incorrect figures may lead to knee-jerk responses. Before reacting to undesirable ratios, be sure to spend time evaluating the information used in the calculation.

Finding the Right Fit

Every manufacturing operation is unique. The generalized benchmarks discussed here are for a typical manufacturer. A financial advisor who specializes in manufacturing and distribution can provide customized guidelines that will fit your manufacturing 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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