Posted: December 22, 2010
Crucial questions for every business owner
How do you measure up?David Tolson
How do you compare against your industry peers? Are you more profitable or less profitable? Is your collection period faster than the industry average?
These are questions that every business owner should ask themselves. When applying for a bank loan, soliciting investment from a professional investor, or marketing your business, these third parties size you up against similar entities. While benchmarking key financial metrics against an industry peer group prior to selling your business is essential, our philosophy is that benchmarking, in general, is an underutilized strategic planning tool. Using benchmarks from your industry peer group can act as the foundational layer of your strategic plan and should be used regularly as a health check on your company.
Every industry has a set of key metrics that are most important to that industry. For example, some industries may place more relevance on the days inventory ratio than other industries. Industry players and bankers understand exactly what metrics are important to that particular industry. They also have expectations of where your ratios should be, based on these industry metrics. Right or wrong, the industry player has a preconceived notion about where certain metrics should be. Any deviation from industry norms can cause a buyer or an investor (including banks) to pause and ask questions.
This is true whether the metrics fall below industry averages or above. For example, a manufacturing firm may produce remarkable results. The firm's gross profit may typically be in the 70% range while operating profit is in the 30% range. Both of these metrics are superior to industry averages. While impressive, buyers and investors will question how this business is able to perform at such remarkable levels and if they are sustainable - even though there may be perfectly logical explanations for why these metrics are considerably higher than the industry average. Identifying these types of issues in advance, and having a detailed explanation at the ready, will set the buyer, banker, or investor's mind at ease.
One of the biggest challenges to benchmarking is that it is not a perfect science. Rarely does a business fit cleanly in to one particular industry code (benchmarks are typically sorted by SIC or NAICS code). Putting too much faith in benchmarking can lead to bad decisions, so this analysis must be taken with a grain of salt. To offset this risk, having professional advisors assist you with understanding what the financial metrics mean and how to use them will help. In addition, trending of these same metrics over time can prove to be valuable as well. In so doing, a benchmark is created from prior history and can be held against subsequent business performance.
For our clients, we typically benchmark 18 to 20 financial ratios against a company's prior history and an industry peer group. These metrics can be divided into four core categories:
• Liquidity/ Solvency Ratios
• Leverage Ratios
• Operating Efficiency
Where is industry peer group data found? Internet based services that track financial metrics by industry group is one option. Often times these are subscription-based services that can be expensive. One of the easiest (and sometimes the least expensive) resources can be industry associations. On occasion, the industry association will charge for the data or will make it available for free if you are a member and agree to contribute your financial data to their benchmarking studies.
Changing your financial metrics to make them more "attractive" can take time. Some changes can take years to fully implement while others are more immediate. By focusing on key financial metrics and benchmarking, you can establish goals for your company and integrate the goals into an overall strategic plan, including a more comprehensive budgeting process.
Benchmarking key financial metrics against an industry peer group and trending your financial metrics over time is critical. Not only does it provide you with a good assessment of the overall health of your business, but it also provides you with a baseline for a strategic plan. Moreover, understanding how similarly competitive companies operate can often help provide valuable insight as to how you're doing against your peers and leave you well positioned should you need capital or receive an unsolicited offer to sell.
David Tolson is Managing Director of CapitalValue Advisors, LLC. Since 1992 David has worked in small and middle market based businesses in operations, sales, and marketing, and has extensive experience in appraisals and mergers and acquisition. He is widely regarded as an expert in middle market private company valuation. He has conducted numerous seminars, taught senior level university courses in organizational management, and been featured as a special speaker at the graduate level on strategic planning and acquisition strategies at both Colorado State University and the University of Colorado. Additionally, he is the co-author, along with Chris Younger, of the book Harvest: The Definitive Guide To Selling Your Company.