Having an understanding of how your company “measures up” to others in its peer group is an excellent tool to manage operations. Getting a handle on which financial metrics to analyze and where to get the information will allow you to reach greater levels of financial success. Who doesn’t want that?!
First, a lot can be told from analyzing GROSS PROFIT MARGINS regardless of industry. Comparing margins with the peer group will give management a flavor for how well they are purchasing materials or raising prices in relation to material costs. For example, the financial success of a gas station is heavily reliant upon gas margins. Consumers may pay little attention to the gas price now that it is hovering just over $2 per gallon. But when gas prices approached $4 per gallon, consumers kept a close eye on every price fluctuation. Diligently overseeing prices is crucial to the success of this type of business. Buying low and selling high is the name of the game, but that can be extremely challenging when gas prices have an increasing trend line. It is also much more difficult when hyper-competitive pressures exist, as in the retail gas business.
One metric is to review specific OPERATING EXPENSES as a percentage of revenues. By comparing these to the peer group, or prior operating periods, management is given an indication if they are on the right track for optimal profitability. A few key indicators include compensation, advertising, rent, and insurance expense. It is not uncommon for two similar businesses to have different expenses in terms of revenues but if there is no explanation for the variance, additional analysis may be warranted. A lower percentage is not always the best answer. For instance, if advertising is too low, it might indicate a missed opportunity in sales.
WORKING CAPITAL components include inventory, accounts receivable and accounts payable. If your company is carrying a significantly greater inventory level than industry peers, an investigation should ensue. Perhaps your company has obsolete inventory that should be cleaned up and sold at a discounted price. With excessive inventory levels, the company is unnecessarily financing the asset with expensive equity or bank financing. On the other hand, if inventory is too low your customers may experience shipping delays, or worse yet, they may shop elsewhere. High accounts receivable could indicate bad debts or that the subject company is being too “easy” with customers. Conversely, low accounts payable can mean you are paying your debts too quickly. While it is imperative to pay bills on time, stretching them out until the due date offers you free financing. Take advantage of it!
Finally, comparing your CAPITAL STRUCTURE (debt and equity mix) with industry peers will allow you to analyze whether your company is carrying too much interest-bearing debt or possibly, not enough. We know we can purchase assets with either debt or equity. Banks obtain guarantees and security so they are essentially assured they will get their money back; as such, they can loan money at a very lost cost at say 4%. However, equity investors are taking the risk of failure and can lose even more money than they have invested. These investors want a very high return, maybe 20-50% per year depending on the circumstance. Simply put, equity is expensive. Therefore, the business with debt versus equity can oftentimes enhance the equity owner’s return. On the other hand, too much debt can lead to excessive risk taking and failure.
Are you interested in understanding how your company ranks amongst your peers? If you are part of a franchise, your franchisor will likely have the data. If not, we have access to databases to help you with such analysis. Please call us! We are happy to help!