Using Financial Ratios to Benchmark Company Performance

If you’ve ever worked in an investing, auditing, business valuation or credit risk analysis role, or perhaps in the procurement process, you’ve had to put on your analysis goggles and critically evaluate a business’s financial information. Financial statements can be stuffed full of figures, making it difficult to get to the bottom of a company's performance.

To get the most out of a financial analysis, you need capable tools on your side. You might turn to a SWOT or PESTLE analysis to assess a business and its environment. These are handy tools to have inside your toolkit, but a financial analysis is never complete without financial ratios. Financial ratios act as a decluttering tool and enable you to extract the most valuable and relevant information.

Financial ratios are also a useful tool to benchmark a business against other companies, or even against its broader industry. They’re an important instrument in the analysis process and help guide major business decisions and strategies. Let’s unpack what financial ratios are, and how they can help you.

What are financial ratios?

Financial ratios take key financial information from a business’s financial statement, such as income statements and balance sheets, and express them as percentages to create a more meaningful figure for your analysis. These percentages create an even playing field for you to benchmark a business against its peers. 

The standardized nature of financial ratios makes them an invaluable tool during your financial analysis, whether you work in accounting, procurement, business valuation, consulting, or almost any field in the business world. They help professionals in these roles identify red flags in a business’s financial statements and diagnose the financial wellbeing of a company. These revelations help influence important business decisions, shape crucial strategies, and determine risk assessments and credit analyses.

The most important financial ratios

There are many types of financial ratios, and each is useful in a range of circumstances. The four most common financial ratio categories are:

• Liquidity
• Profitability
• Leverage
• Efficiency

Liquidity ratios

Liquidity ratios shed light on how quickly a business can access cash to meet its short-term needs. This shows how prepared a business would be if it suddenly needed to pay its debts. If it has high liquidity, it can easily deal with an unexpected financial problem. However, if a company has low liquidity, it would be forced to sell assets at unfavorable prices to raise money.

Low liquidity sets off some alarm bells during a financial analysis, as it limits potential strategic flexibility, and can indicate more worrying factors like cash flow issues.

Liquidity ratios include:

• Current ratio: indicates whether a company can service its current debt, if needed
• Quick ratio: a more conservative measure of liquidity than the current ratio
• Inventory turnover: measures the number of times inventory is turned over during the year

Profitability ratios

Profitability ratios, also called operating ratios, highlight a company’s performance compared to competitors and reveal how well a company can make money when you consider all its costs. That means the higher a company’s profitability ratio, the better it is performing relative to its competitors.

Some profitability ratios to consider include:

• Return on equity (ROE): measures how capable a company is at generating profit
• Return on assets (ROA): indicates a company's profitability relative to its total assets
• Profit margin: The percentage of sales left over after all expenses are paid

Leverage ratios

Leverage ratios look deeper into the long-term health of a company by considering how much of their money comes from borrowing. Leverage ratios are important when you’re sizing up the financial health of a company because companies rely on a mixture of their own equity and debt to keep things running.

Leverage ratios to consider:

• Fixed assets/ net worth: measures the extent to which owner's equity (capital) has been invested in plant and equipment (fixed assets)
• Debt/ net worth: express the relationship between capital contributed by creditors and that contributed by owners

Efficiency ratios

Efficiency ratios reflect a company’s ability to effectively use its assets and resources to manage its liabilities and debts. While there are several efficiency ratios, they are all similar because they measure how quickly a company can turn its assets into cash. 

Some efficiency ratios to consider include:

• Asset turnover: measures the value of a company's revenue in relation to the value of its assets
• Account receivables turnover: measures the number of times account receivables turns over during the year (also known as sales/receivables)
• Days’ sales turnover: measures the average numbers of days a company takes to turn its inventory into sales

How to apply financial ratios

Now that we’ve broken down what financial ratios ARE, let’s look deeper into how you can add them to your financial analysis toolkit. The best way to understand how to use them is to see them in action. We know financial ratios are used in many different roles, but for this example let's say that you're a procurement professional.

A successful procurement department depends on a robust supply chain. As a procurement professional, you can’t control the supply chain, but you can use your skills to manage the risks of the external environments to make sure you’re choosing the most reliable suppliers.

This is where financial ratios become a handy tool to have, because assessing the financial health of a current or potential supplier can make or break your supply chain. Procurement professionals use a range of financial ratios in their analysis process — let’s take a look at which ones you can use and how to use them.

Examples of ratios in action

Let’s say you are a procurement professional in the process of reassessing your Hand Tool & Cutlery Manufacturer. The companies you are considering include Proctor & Gamble Co (P&G) and Stanley Black & Decker, Inc. (SB&D). You want to choose the most reliable supplier to ensure a strong value chain for your business.

Current ratio

The current ratio, which is part of the liquidity ratio group, is an indicator of how well a company can cover its short-term debts using its current assets. Think of it as the cash-readiness of a business.

Current ratio parameters:

• Less than 1: suggests a company may not have the capital on hand to meet its short-term obligations if they were all due at once
• More than 1: suggests a company has the financial resources to remain solvent in the short term

To calculate a business’s current ratio, you need to divide current assets by current liabilities.

Current ratio = current assets ÷ current liabilities

Current assets are those that can be turned into cash in less than a year, such as accounts receivable, inventory and any other liquid assets. Current liabilities include wages, taxes payable and accounts.

For our example, this is what the current ratio looks like (as of December 2021):

Current Assets

• P&G: $25,545,000
• SB&D: $6,036,000

Current liabilities

• P&G: $38,027,000
• SB&D: $4,558,300

Current Ratio:

• P&G: 0.7
• SB&D: 1.3

Based on these metrics, SB&D looks like the more reliable supplier because it has a greater ability to meet its short-term obligations. That’s not the end of the story, because the current ratio only provides a snapshot of a supplier’s liquidity; it doesn’t give us the full picture.

To get to the bottom of the story, you have to look a bit deeper. You have to use your skills to determine the type of current assets a company has and how quickly they can be converted into cash if it really needs to. This could involve asking questions like ‘how quickly can a company collect its accounts receivables?’.

Days' receivables

The days’ receivable ratio tells you how many days on average it takes for customers to pay a business. If the days’ receivable ratio is high, the company takes a long time to collect money, which could point to late payments or problems with customers paying up.

Days’ Receivables = 365 ÷ (sales/receivables)

Net sales

• P&G: $76,118,000
• SB&D: $13,057,700

Trade receivables

• P&G: $5,241,000
• SB&D: $1,164,500

Sales/receivables

• P&G: 15.0
• SB&D: 11.4

Days’ receivables

• P&G: 24.3
• SB&D: 32.0

P&G took 24.3 days on average to get paid for their sales, while SB&D took longer at an average of 32 days. Now that we know how Proctor & Gamble and Stanley Black & Decker compare to each other, how do they stack up to other businesses in their industry?

Benchmarking company performance

You can benchmark the companies you're looking at against the industry average to give better context to their financial health and performance and get a sense of how they measure up to their peers. For example, both P&G and SB&D’s days’ receivable ratios are lower than the industry average of 53.5.

Current Ratios

• P&G: 0.7
• SB&D: 1.3
• Hand Tool & Cutlery Manufacturing industry average: 1.6

Days’ Receivable

• P&G: 24.3
• SB&D: 32.0
• Hand Tool & Cutlery Manufacturing industry average: 53.5

When looking at both the days’ receivable and current ratio, it's not clear which company will be the most reliable supplier, so you have to keep digging before you can settle on one or the other. Next, you should investigate the companies’ ability to handle their debts, their net worth, and fixed assets to net worth ratios.

To wrap up our example, while P&G has a good days’ receivable ratio, its current ratio is below the industry average. On the other hand, although SB&D's days’ receivable is higher than P&G's, it is still lower than the industry average. It also has a current ratio above P&G's (but lower than the industry average), which may make it more appealing as a supplier. To make a smart business call, you would need to examine these differences and consider other financial ratios.

Whether you’re investing, lending, contracting or procuring, without reviewing all available information and boiling it down to standard comparisons, you could be missing key indicators about the financial health of a company and its industry. Using financial ratios to benchmark companies against the industry average is a tool that professionals in any role need in their financial analysis toolkit.