Benchmarking 103: Pitfalls to Avoid

While we think you really should be benchmarking (come on, how else will you know how you rate?), we also feel the obligation to tell you about some things to avoid when starting a benchmarking analysis. We’re nice like that.

  • Comparing Company A to Company B: Comparing your business to a peer group is helpful if the peer group is representative of the industry. However, if you begin to compare yourself to another, single company, there may be considerable differences that prevent true comparisons. Look critically at any benchmark analysis that restricts the sample size to only one other company.
  • Be careful with calculations and conclusions drawn from them: certain benchmarks (net profit margin, liquidity ratios, and turnover ratios) are common financial measurements, and their calculations are not generally refuted or changed. However, if you expand your benchmark analysis to include industry-specific key performance indicators (KPIs) (restaurant-sales per seat, for example), be sure to use the same calculation, period after period. If a subaccount is included for one period but then excluded for the next period, any trend analysis performed could be misleading.
    • Once definitions for the metrics are determined, be sure that all members of management and the finance team have this set of definitions. Also, be sure they understand what the metrics mean. There should only be one interpretation.
  • Assume that numbers and performance are always changing: Positions in a horse race are constantly shifting: first to third, fourth to last and so on. Comparing your business to its peers only once per year may not be optimal, given that the industry is always changing, even if your business isn’t. The more frequent the benchmark analysis is performed, the sooner the business can identify trends and react.
  • Recognize that the benchmark analysis doesn’t end with a variance report: Though it may seem that the work is complete once you have compiled a report showing variances between its financial metrics and its peer group benchmarks, the work is actually just beginning. And so are the opportunities! Each variance gives you a potential problem area to fix and the opportunity to improve the company’s overall performance. The variance report will show in which areas the business is really excelling. Take pride in these success, and see if the winning strategy can be implemented in other areas of the company.

Remember: the objective of benchmarking analysis isn’t to build a benchmark report. The objective is to illuminate successes and challenges for the company and give business owners actionable insights!

Benchmarking 102: Prioritizing Benchmarks

In a previous blog, we learned WHY benchmarking is so important. Here’s a brief refresh:

  • It helps you understand your situation.
  • It can be used continually. Benchmarking is not a use it once and pitch it solution.
  • It provides you with real-time data. That is, as long your data is accurate, timely and relevant.

So now that we’re all up to speed, let’s revisit benchmarking again. After securing the accurate, timely and relevant data source you’ll use, the challenge becomes choosing which benchmarks to analyze and use as a proxy for business success.

Different industries, even different companies within an industry, could have different measures of success. For example, a contractor may have large subcontractor expenditures. Are these expenses normal considering the contractor’s sales volume?

Rather than define all these industry-specific key performance indicators (KPIs), we’re going to focus on a few financial metrics that are the most universally important to business and, when analyzed together, provide a quick and high-level review of a company’s health. Get excited.

  • Net Profit Margin. Generally expressed as a net-profit before taxes in a given financial period divided by sales. Another way to look at it is how many cents of profit you extract from each dollar it earns in revenue. This may be a rudimentary financial metric, but it is also the most important!
  • Liquidity Ratios. Did you note the plural usage? Good because there are two that need to be analyzed jointly.
    • Current Ratio is expressed as current assets divided by current liabilities. This metric shows your general liquidity, however it has some limitations. By including inventory in the calculation, it may provide a distorted understanding of your very short cash flow.
    • Quick Ratio is typically expressed as cash accounts receivable divided by current liabilities. Again, this ratio may not be perfect for gauging liquidity, but it is a useful and popular comparison to pair with the Current Ratio.
  • Turnover Ratios. Plural again … because there are three this time to consider:
    • Accounts Receivable (AR) is expressed as accounts receivable divided by sales, multiplied by 365 days. It roughly measures the number of days your 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 on the books.
    • Accounts Payable (AP) is expressed as accounts payable divided by cost of goods sold, multiplied by 365 days. The accounts payable ratio indicates the number of days you take to pay its vendors. Here, higher numbers are better as it means you are able to hold onto cash longer.
    • 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. As a note, this ratio 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.

By using some of these financial metrics repeatedly, you can being to build a picture of where your business should be going, where it’s excelling and where you can change and improve.

Benchmarking 101: How Do You Rate?

By: Jim Ramstad, Business Consulting Manager

Sometimes, you just want to know how you stack up. Chalk it up to competitive drive or the need for constant improvement. Whatever the reason, utilizing benchmarking, especially in the business world, can be a powerful tool to assess performance and see how you compare to your peers. In fact, when used correctly, benchmarking can help you succeed and thrive as an organization.

Here are just a few reasons why benchmarking is so important:

It helps you understand your situation. Knowing how your company ranks relative to others empowers management to evaluate the company’s performance. Business owners can use peer group benchmarks to not only understand their current situation, but also identify new or future opportunities. To best do this, make sure that you’re using a peer group comparison rather than a one company comparison.

It can be used continually. Benchmarking is not a one-time solution. It can (and should) be used throughout the life cycle of the business. Assume the numbers and performance is always changing. The more frequently the benchmark analysis is performed, the sooner the business can identify trends and find solutions.

It provides you with real-time data. You’re only as good as your data. So make sure to look for benchmarking data that is:

  1. Accurate:  In order for a benchmark analysis to provide meaningful insights, the business owner has to trust the accuracy. Heed Ronald Reagan’s advice and “trust, but verify” the data prior to relying on it for decisions
  2. Timely: Ensure the benchmarks being used are the most recent benchmark’s available to account for seasonality, economic cycles and other externalities.
  3. Relevant: Make sure to take into account your industry, geography and organization size. Each of these has their own trends and externalities to incorporate. This ensures an “apples to apples” comparison.

It helps you gauge success. Each industry (and even different companies within an industry) could have different measures of success. While only you can determine what success looks like for your organization, there are a few metrics that, taken together, will provide a quick and high level review of your organization’s health:

  • Net Profit Margin=Net Profit Before Taxes divided by Sales
  • Liquidity Ratio-Current Ratio=Total Current Assets divided by Total Current Liabilities
  • Turnover Ratios, including accounts receivable days, accounts payable days and inventory days.

Benchmarking is a great way to gauge your current status and help implement changes that can grow your organization. By utilizing peer group comparisons you can work to find the solutions that make sense for your business.

Don’t really get how benchmarking can help? Or what benchmarking can do for you? NO WORRIES. We can help. Contact Jim at jramstad@eidebailly.com or call 701.239.8500.