3 Crucial Areas of Focus for Benchmarking
Maybe it’s an inherent competitiveness or just the pursuit of improvement, but it is commonplace for people to seek out benchmarks that they can use to assess their relative position or performance. It interests people to know how they compare to their peers. Benchmarks have a place in business, too, and can be an invaluable instrument to help business owners succeed.
Equipped with an intimate knowledge of their clients’ finances, accountants are uniquely positioned to help their business clients think strategically to achieve success. With assistance from accurate and relevant data, accountants can help their business clients by comparing their financial performance to the performance of their peers. This ability to effectively benchmark is one way to transition from a quarterly tax specialist to a trusted business adviser.
Assuming that accountants are able to get their hands on reliable industry data, it becomes necessary to isolate a few specific metrics that will be especially useful across industries. While different industries and companies measure success in their own unique ways, a few metrics are almost universally indicative of a company’s financial health.
One area to focus on with your clients is their Net Profit Margin, generally expressed as net profit before taxes in a given financial period, divided by sales. In other words, Net Profit Margin represents how many cents of profit a company takes away from every dollar earned. It may seem like a pedestrian metric, but it’s one of the most crucial ways to gauge a company’s financial health.
If it is available, check raw financial data or the formula used by the data source to validate that it is consistent with your client’s business calculations. Verification is especially important for this measure of profitability, as other firms might use after-tax profits or make adjustments for owner’s compensation. Private-company financials are sometimes adjusted to include compensation that exceeds market rates.
There can be tremendous variability from industry-to-industry with the Net Profit Margin. If your client owns a restaurant, they shouldn’t expect the same margins as a dentist’s office. But what restaurants might lack in profitability, they might make up for in volume. This is why relevancy is so important for meaningful benchmarks, and it’s good to remind your clients of this.
Another key metric to focus on with your business clients is liquidity. When measuring liquidity, one should jointly measure the Current Ratio and Quick Ratio. Current Ratio is expressed as current assets divided by current liabilities, showing the company’s general liquidity. However, 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.
Consider also benchmarking your client’s turnover ratios against similar companies. Accounts Receivable 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 since it is better to have cash in the bank than extra receivable accounts on the books.
Another 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 because it means the company is able to hold onto cash longer.
The third turnover ratio, Inventory Days, is expressed as inventory divided by cost of goods sold, multiplied by 365 days. Inventory Days measures the number of days it takes to sell off inventory, but it is very specific to the industry. Imagine how long wine is stored at a winery compared to how long eggs are on grocery stores shelves. Generally, lower numbers are better.
Only the Start
Explain to your clients that benchmark analysis doesn’t end with a variance report. Though it may seem like the work is complete once a company has compiled a report showing variances between its financial metrics and its peer group benchmarks, the work is actually just beginning. But so are the opportunities. Each variance gives the business owner a potential problem area to fix and the opportunity to improve the company’s overall performance. You, as the business owner’s accountant, are better positioned than anyone to help the company tackle these problem areas.
Likewise, the variance report will show in which areas the business is really excelling. Encourage your clients to take pride in these successes; work with them to see if their strengths can be implemented in other areas of the company. By offering yourself as a resource in this way, you will have taken an important step in the direction of becoming a trusted business adviser.
Brad Schaefer, Analyst, Sageworks. Brad has led the development and ongoing enhancement of Sageworks’ credit risk management solution for financial institutions. He received his degree from the Poole College of Management at North Carolina State University where he graduated summa cum laude.
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