Ratios & Analysis

8.1 Audits & Assurance Engagements—Discussion Guide

Performance Indicator: Explain the nature of audits and assurance engagements

THINK ABOUT IT

Have you ever had a classmate read a paper you wrote to make sure your grammar is correct?

• Maybe you’ve asked a peer to review your math homework to check that your calculations are right.

• These types of “checks” on your work are similar to the audits and assurance engagements used to verify the accuracy of business reports and increase confidence in business operations.

KEY CONCEPTS

Slide #1 What Are Assurance Engagements?

• Assurance engagements (AE) analyze an organization’s operations, reporting, and/or procedures so company stakeholders (shareholders, investors, board of directors, etc.) can make informed decisions.

• Assurance is how confident the practitioner, or auditor, is that they’ve identified material misstatements (mistakes.)

• An AE must include the following features:

  • Three-Party Relationship.

    • To preserve objectivity in the AE, there are three parties involved: the business (called the responsible party), the stakeholders of the organization seeking AE results (called intended users), and the practitioner conducting the AE.

  • Subject Matter.

    • The type of information the practitioner is reviewing (such as financial statements or internal control systems) should be clearly defined from the beginning.

  • Criteria.

    • Assurance engagements must measure a business against a standard of some kind.

  • Evidence.

    • The practitioner must support their report conclusions with ample evidence.

  • Report.

    • The practitioner needs to express an opinion (or assurance) of the company’s performance in response to predetermined objectives.

Slide #2 What Are Audits?

• Audits are a type of AE that verifies an organization’s accounts and records.

• While assurance aims to improve the quality of information in a company and aid in decision-making, an audit specifically ensures a company’s financial records are accurate, compliant, and fairly prepared.

• An attestation by the audit conductor means the financial numbers are accurate and reliable.

• Audits can be either internal or external.

  • Internal audits are conducted by company employees, who report their findings in any type of format to management.

  • External audits, on the other hand, are conducted by an independent audit firm, who must issue findings using specific formats to outside stakeholders such as investors and lenders.

• Because audits can have a substantial and long-term impact, it’s crucial that they are conducted in a professional, organized manner.

• Effective audits should be:

  • Scheduled.

    • Audits can require a great deal of time, effort, and paperwork.

    • They should be scheduled ahead of time so all involved parties can prepare appropriately.

  • Objective.

    • Audits should be conducted in an unbiased manner.

    • Auditors should make sure not to let their own personal needs and desires affect the audit’s conclusions.

  • Discreet.

    • Auditors deal with important, and often sensitive, information.

    • Remaining discreet during an audit preserves confidentiality and ensures information is handled with care.

Slide #3 Possible Limitations

• Assurance engagements are not foolproof.

• Because there are limitations to AEs, auditors report a level of assurance, which represents the extent to which they are confident (or assured) that their findings are sound and dependable.

• Positive assurance refers to what the auditor knows.

  • For example, this level of assurance is used to indicate that the auditor has confirmed something to be true or correct through extensive examination.

• Negative assurance, on the other hand, refers to what the auditor does not know.

  • This assurance means an auditor has determined something to be accurate simply because no evidence has been found that indicates wrongdoing.

• Reasonable assurance is a type of positive assurance that indicates the auditor has a high level of confidence in the accuracy of the materials but cannot guarantee the absence of material misstatements.

• Limited assurance is a type of negative assurance. The auditor has examined the material and found no evidence of wrongdoing but has not given it extensive examination.

Slide #4 The Role of Ethics

• Ethics play a crucial role in audits and assurance engagements.

• While a company might conduct an AE to gather information that helps in decision-making, audits are frequently conducted to check for wrongdoing: fraud, misrepresentation, misuse of funds, etc.

• Audits and AEs help preserve integrity in the reporting process.
  Additionally, auditors must conduct themselves in an ethical manner.

• This means maintaining professionalism at all times, demonstrating objectivity, confidentiality, compliance with regulations, and an appropriate level of due care.

8.2 Analyze Cash-Flow Patterns—Discussion Guide

Performance Indicator: Analyze cash-flow patterns

THINK ABOUT IT

Businesses analyze cash-flow patterns to determine how efficiently and effectively they are generating funds, receiving payments, and covering expenses.

• Cash-flow analysis is crucial to tracking a business’s financial health and increasing its overall financial standing.

KEY CONCEPTS

Slide #1 Information in Cash-Flow Patterns

• The cash-flow statement shows cash outflows (how a business spends its money) and cash inflows (how a business receives its money).

  • The cash-flow statement divides funds into three categories: operating activities, investing activities, and financing activities.

• Businesses use either accrual accounting, used by most businesses in which revenue is marked as income when it is earned instead of when payment is received, or cash accounting, where revenue and expenses are recorded when payment is received and paid.

• To calculate operational cash flow, businesses can use either the direct or indirect cash-flow method.

  • Most businesses use the indirect cash-flow method, also referred to as the reconciliation method, in which businesses start with net income and add or deduct items that do not affect cash.

  • Both methods should yield the same results, but it is important select and utilize one method for continuity of results.

• Businesses look at the cash-flow statement to determine their financial standing.

  • After determining the business’s cash-flow patterns, management should compare operating cash-flow ratio, which measures the amount of cash that is generated for each dollar of sales, to the business’s past performance and its industry peers to gauge its financial standing.

Slide #2 Importance of Cash-Flow Analysis

• Cash-flow analysis is important because it helps businesses understand just how much cash is available and exactly where money is going.

  • Cash-flow analysis is key to understanding a business’s financial strength.

• Clarifying these patterns helps a business determine whether it is efficiently collecting payments from customers, whether it has substantial funding for a large equipment purchase, and similar critical information.

• Understanding where and how a business’s money is tied up reveals whether it can pay employees, purchase inventory, pay suppliers, and ultimately stay in business.

• Many small businesses fail because they cannot effectively manage their cash flow.

Slide #3 Procedures for Analyzing Cash-Flow Patterns

• Businesses should analyze their cash-flow patterns at least once a month and more often if the company is in an unpredictable industry or is experiencing issues with its cash flow.

• The first step involves creating a cash-flow statement, which is typically in a spreadsheet.

  • Enter the business’s total cash balance at the start of the time period. Then, enter the cash inflows (positive) and outflows (negative) in three categories: operating, investment, and financing activities.

    • Operating activities:

      • (+) Inflows: money from sales and paid receivables

      • (-) Outflows: employee payroll, money paid to suppliers, depreciation, taxes

    • Investment activities:

      • (+) Inflows: selling or renting equipment, real estate, or investment securities

      • (-) Outflows: purchasing equipment, real estate, or investment securities

    • Financing activities:

      • (+) Inflows: receiving a loan for the business

      • (-) Outflows: paying toward the loan

• After recording all transactions on the cash-flow statement, calculate the total closing balance.

  • If the closing balance is lower than the opening balance, the business has a negative cash flow.

  • If the closing balance is higher than the opening balance, the business has a positive cash flow.

Slide #4 Actions Businesses Can Take

• As a result of cash-flow analysis, businesses gain a better understanding of their detailed cash status.

  • If a business is running low on cash, management can determine ways to save money, investigate short-term financing, or plan to increase funds.

  • If a business has extra cash available, management can consider investing in needed equipment or save it for the future.

• Having an accurate idea of a business’s financial standing enables it to take full advantage of its opportunities.

• After analyzing their cash-flow patterns, businesses can determine when they run low on cash and then take actions to limit costs or increase their income.

  • This could involve raising prices, contacting late-paying customers, adjusting staffing, purchasing less inventory, modifying the vendor pay schedule, and creating an offer or discount to attract more customers.

  • If these internal actions are not successful, businesses can consider short-term financing like cash flow loans as another option.

  • These modifications enable struggling businesses to streamline their efforts and stay afloat financially.

8.3 Total Revenue, Marginal Revenue, Output, and Profit—Discussion Guide

Performance Indicator: Determine relationships among total revenue, marginal revenue, output, and profit.

THINK ABOUT IT

Businesses every day need to consider how to improve the ways they adjust to the markets in which they operate.

• Their goal is to remain continuously profitable, and one way to accomplish this is to ramp up their production of goods and services, increasing sales one item at a time.

• Below you will read what happens when businesses start to consider these changes, and how different factors affect the relationship between total revenue, marginal revenue, output, and profit.

KEY CONCEPTS

Slide #1 It sounds simple, but revenue and costs are the essential ingredients to understanding a company’s profit, the income that is left after all expenses are paid.

• You solve for a company’s profit by subtracting total revenue from total costs.

• Specifically, a business’s total revenue is the total amount of money a company receives from the sale of its output.

• The output of a business is what a company makes, or the goods and services produced as the result of combining inputs.

• Inputs are the specific economic resources used in producing goods and services.

• Total revenue is simply quantity multiplied by price.

• The total costs of a business are the sum of the overhead and direct costs required to make a profit.

• It’s beneficial for a business to have total revenue higher than total cost, because that helps improve their profit.

Slide #2 Total revenue and total cost are useful markers for calculating profit, but businesses need to look at more specific details in order to plan for production and maximize their efficiency.

• One way to do that is to understand marginal revenue and marginal cost.

• Marginal revenue is the change in total revenue that occurs when one more unit of output is sold.

• The formula for calculating marginal revenue is as follows.

  • Marginal Revenue = Change in Total Revenue / Change in Quantity Sold

• Marginal revenue can help determine whether increased output is worth the additional revenue.

• Likewise, marginal cost is the change in total cost when there is a change in output. Solving for marginal cost is as follows.

  • Marginal Cost = Change in Total Cost / Change in Quantity Sold

• These concepts are used to assess how much of a product should be made without driving production cost over revenue, which prevents making profit.

Slide #3 Generally, a company wants to make as much profit as possible.

• The ideal situation for a business is to have marginal cost and marginal revenue be equal.

• Once marginal cost reaches the point that it exceeds marginal revenue, the business is operating at a loss, which becomes unsustainable.

• Consider the example of a business that makes car engines.

  • When marginal cost and marginal revenue are equal, it means that the ideal cost of making one more engine and selling one more engine have been reached.

  • Before that point, a business could have been making too few engines, making too many engines, or selling the engines at too low of a price or too high of a price.

• If a company is producing products in the short run, or the period of time when at least one factor is a fixed cost, it will factor those fixed costs into the total cost.

• Think back to the engine example.

  • Fixed costs can include the actual building where the engines are built and wages for employees.

• There are also variable costs, which can be brought up or down in a short amount of time.

  • A variable cost might be the cost of physical materials used to build an engine, because they might change from order to order from a supplier.

• Because of those fixed prices, though, there can be little flexibility in how much of a product is made in a day, and marginal revenue can only be affected by changing variable prices or output, or even both.

• There is also an economic theory called the Law of Diminishing Marginal Returns, which states that once a business has reached the ideal capacity for production, adding in more production capacity would begin to reduce the output of the business.

Slide #4 The type of market structure can affect the marginal and total revenue of a business.

• A market structure is the type of market that a business operates in.

• In a perfectly competitive market, there are many businesses that are selling similar or identical products.

  • In that situation, marginal revenue is constant, even as the output is increased.

  • Items are sold at market price, and that allows for total revenue to increase because there is demand for the product.

• In a monopoly, oligopoly, or a monopolistic competitive market, marginal revenue falls as the output of a business increases.

  • That is because businesses need to reduce their prices to sell more products as their output increases.

  • That also means that even if the business is selling more products in these markets, the total revenue will eventually fall.

8.4 Common Management Accounting Performance Measures—Discussion Guide

Performance Indicator: Describe common management accounting measures

THINK ABOUT IT

You might not be familiar with the term “performance measures,” but it’s something you’ve likely encountered frequently in your experience as a student.

• Once you think about it, the term is actually pretty self-explanatory: it’s a process of measuring performance toward reaching a given objective.

• In your experience, that measurement of performance probably came from school grades, or even athletic goals and standards.

• Performance measures aren’t something that will go away when you graduate, though—businesses use them all of the time, too!

• Read on to learn about the common performance measures used in management accounting.

KEY CONCEPTS

Slide #1 What Are Performance Measures?

• Performance measurement is the process of assessing how well an organization is reaching its objectives.

  • Think of performance measurement as a kind of “progress check.”

• Assessing the performance of a business as it operates helps management see where improvements might be needed in order to achieve established goals by the desired time.

  • This process is similar to midterm grades you might receive throughout high school and college—the grades represent your performance in the semester so far and give you an indication of whether you need to make adjustments to achieve your intended goal (perhaps an ‘A’ or a passing grade) by the end of the term.

• Without checking performance, students and businesses might not realize they’re not on track to hit their goals until it’s too late.

• If performance measurement is the process of checking progress, then performance measures are the different ways that a business can check that progress.

• These measures can be applied to any part of a business and can take many different forms.

• Typically, performance measurements are provided to management on a consistent basis, and any measure that doesn’t meet a predetermined standard will receive additional focus from leadership.

• For management accounting, the type of accounting that leadership uses internally to make important business decisions, there are three common types of performance measures:

  • Return on Investment

  • Balanced Scorecard

  • Customer Profitability Analysis

Slide #2 Return on Investment

• Return on investment (ROI) is one of the most commonly-used performance measures.

• Essentially, ROI measures the amount of return (money received) against the cost of an investment (money given), which helps determine whether a given activity is profitable and how it compares to other opportunities.

  • The higher the ROI, the better.

• Many organizations will use benchmarks to determine whether an activity’s ROI is high enough to justify moving forward with the investment.

• However, ROI doesn’t typically provide context or explanation surrounding a given decision, so its usage is often limited, especially in regards to long-term investments.

Slide #3 Balanced Scorecard

• The balanced scorecard is a management strategy tool developed by Drs. Kaplan and Norton in 1992 as a way to track both the financial and nonfinancial activities within an organization.

• As a performance measurement framework, the balanced scorecard helps management measure progress and then identify changes that might need to be made for improvement, especially with regard to four different categories: financial, customer, internal process, and learning and growth.

• Because the scorecard helps organizations align activities to business visions and strategies, it will look different from company to company.

• The scorecard provides information about a company’s priorities, objectives, measures and targets, and any supporting initiatives.

• The balanced scorecard relies heavily on accurate and timely reporting, so its use can be labor- and time-intensive, with opportunity for error if software tools and additional control measures are not implemented.

Slide #4 Customer Profitability Analysis

• Customer profitability analysis is a measurement method that focuses on an organization’s profit per customer, rather than profit per product.

• This method involves identifying and calculating the costs incurred when servicing specific customers (or segment of customers).

• With this knowledge, organizations can determine the most profitable customers, which then helps them attract and retain these customers while working to cut costs for those who are less profitable.

• Customer profitability analysis has been historically criticized for being “backward looking” and having limited time frames, although new data-tracking mechanisms help mitigate this limitation.

8.5 Calculating Financial Ratios—Discussion Guide

Performance Indicator: Calculate financial ratios

THINK ABOUT IT

Financial ratios provide information about a business’s wellbeing.

• By analyzing financial ratios that measure liquidity, profitability, debt, and activity, leadership can make informed decisions that will help improve, maintain, and/or secure the continued success of a business.

KEY CONCEPTS

Slide #1 The Importance of Financial Ratios

• Financial ratios are comparisons of numbers from a business’s financial statements.

• Analyzing financial ratios helps business managers see relationships between dollars, numbers, and percentages.

• Financial ratios are used to standardize financial data for comparison purposes.

• Managers use financial ratio analysis to:

  • Identify their company’s financial strengths and weaknesses

  • Evaluate the company’s operations and business performance

  • Identify trends across time

  • Compare the company’s performance against that of competitors

• Financial ratio analysis is used externally by many different organizations, including:

  • Investors deciding whether to buy, sell, or hold a company’s stock

  • Lenders measuring a company’s debt

  • Suppliers looking at the company’s ability to pay its bills

  • Governments reviewing the company’s taxable profits

Slide #2 Liquidity Ratios

• Liquidity is the ability to easily convert assets (e.g., investments) back into cash.

• Managers calculate liquidity ratios to measure the company’s ability to turn assets into cash, determine whether the company is able to pay its bills as they come due, compare current (liquid) assets with current debts, and identify any cash-flow problems.

  • Current Ratio measures the business’s ability to pay current debt (Current Liabilities) and how current assets compare to short-term debt.

    • Here is how it is calculated:

      • Current Ratio = Current Assets / Current Liabilities

  • Quick Ratio a.k.a. Acid-Test Ratio measures overall liquidity when inventory cannot be easily converted to cash and the value of current assets available to cover current liabilities.

    • Here is how it is calculated:

      • Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Slide #3 Profitability Ratios

• Profitability is the level of profit of a business or product.

• Managers calculate profitability ratios to measure the company’s ability to make a profit and determine how well the business is being operated.

• There are many types of profitability ratios:

  • Gross Profit Margin a.k.a. Gross Margin measures the business’s efficiency in producing its products, how much of each sales dollar is left after the business pays for its products, and how well management is controlling costs.

    • Here is how it is calculated:

      • Gross Profits = Sales – Cost of Goods Sold

      • Gross Profit Margin = Gross Profits / Sales

  • Operating Profit Margin measures how much of each sales dollar is left after the business deducts all costs and expenses except taxes and interest.

    • Here is how it is calculated:

      • Operating Profit Margin = Operating Profit / Sales

  • Net Profit Margin measures how much of each sales dollar is left after the business deducts all costs and expenses, including taxes and interest.

    • Here is how it is calculated:

      • Net Profit Margin = Net Earnings / Sales

  • Earnings per Share (EPS) measures the number of dollars earned on each share of common stock and overall corporate success.

    • Here is how it is calculated:

      • EPS = Net Earnings / Outstanding Shares of Common Stock

  • Return on Assets (ROA) a.k.a. Return on Total Assets or Return on Investment (ROI) measures the business’s earnings on each dollar of assets and management’s effectiveness in using assets to generate profit.

    • Here is how it is calculated:

      • ROA = Net Income / Total Assets

  • Return on Equity (ROE) a.k.a. Return on Common Equity measures management’s ability to make a profit with common shareholders’ investment.

    • Here is how it is calculated:

      • ROE = Net Income / Shareholders’ Equity

• Accurately interpreting each profitability ratio is important.

• Businesses should aim to have high profit margins, high earnings per share, high return on assets, and high return on equity.

Slide #4 Debt Ratios

• Debt ratios, also known as safety ratios or financial leverage ratios, are a class of financial ratios that compares what a company owns to what it owes.

• Managers calculate debt ratios to determine the extent to which the company uses money from creditors versus shareholders to finance operations and growth.

  • Debt Ratio measures how much of a company’s assets are owned by creditors and what percentage of assets is financed by debt.

    • A high debt ratio means that the business is very dependent on borrowed money to finance its activities.

    • Here is how it is calculated:

      • Debt Ratio = Total Liabilities / Total Assets

  • Times Interest Earned Ratio measures how well a business can pay interest on its debt.

    • A high ratio is good, because it means that the business is in a good position to pay interest to creditors.

    • Here is how it is calculated:

      • Times Interest Earned = (Earnings Before Interest and Taxes) / Interest

Slide #5 Activity Ratios

• Activity ratios, also known as asset management ratios or efficiency ratios, are a class of financial ratios that measures how quickly a company can convert accounts into cash or sales.

• Managers calculate activity ratios to measure how efficiently the business is managing its assets (including inventory, accounts receivable, and fixed assets) and its current liability (accounts payable).

  • Inventory Turnover Ratio a.k.a. Stock Turnover Ratio measures how quickly the business sells its inventory and the number of times a company turns over inventory during the year.

    • A low inventory turnover ratio may be a sign that the business’s inventory is dated or obsolete.

    • It might also indicate that the managers need to find out why the inventory isn’t selling quickly.

    • Here is how it is calculated:

      • Inventory Turnover = Cost of Goods Sold / Inventory

  • Average Collection Period a.k.a. Average Age of Accounts Receivable measures how many days it takes to collect money owed by customers (the company’s accounts receivable) and the effectiveness of credit and collection policies.

    • A low ratio is generally preferred because it means that the business is doing a good job of collecting payment from customers in a timely manner.

    • Here is how it is calculated:

      • Average Daily Sales = Annual Sales / 365

      • Average Collection Period = Accounts Receivable / Average Daily Sales

  • Average Payment Period Ratio measures a business’s ability to repay suppliers and the average number of days it takes the company to pay its suppliers.

    • A low ratio is generally preferred because it means that the business is doing a good job of making payments to suppliers in a timely manner.

    • Here is how it is calculated:

      • Average Daily Purchases = Annual Purchases / 365

      • Average Payment Period = Accounts Payable / Average Daily Purchases

  • Total Assets Turnover Ratio measures how efficiently assets are being used to generate sales and how many dollars of sales are generated per dollar of assets.

    • A high total assets turnover ratio is preferred.

    • Here is how it is calculated:

      • Total Assets Turnover Ratio = Sales / Total Assets

8.6 Calculating Return on Investment—Discussion Guide

Performance Indicator: Calculate return on investment (ROI)

THINK ABOUT IT

Slide #1 (Farhan’s Dilemma) Last summer, Farhan decided to pursue two investment opportunities.

• He invested $1,000 in a new pizza business called Cheesy Slice and sold his shares one year later for $1,200.

• He also invested $2,000 in his sister’s landscape company called Bloom with Us and sold his shares one year later for $2,800.

• This year, Farhan wants to reinvest his earned money into a single business.

• But, since he made money through both investments last year, he’s not sure which company to choose.

  • How does he decide which company is the best investment opportunity?

• To make an informed decision, he needs to calculate return on investment—an important investment tool used by individuals and businesses big and small.

KEY CONCEPTS

Slide #2 What Is Return on Investment?

• Return on investment (ROI) is a financial ratio that measures the amount of return against the cost of the investment.

  • Consider the name: we are comparing the return (money back) on an investment (money given).

• When people invest money, they hope to earn a profit.

• Return on investment helps us determine whether an investment is profitable and how it compares to other investment opportunities.

• This useful ratio can be applied to a number of scenarios, such as real estate transactions, stock investments, and even Farhan’s investment dilemma outlined above.

Slide #3 How To Calculate Return on Investment

• Return on investment is calculated by dividing net profit by investment.

• To determine net profit, subtract the cost of the investment (how much was invested) from the current value of the investment (how much the investment is worth now).

• Here is the formula for calculating ROI:

  • ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment

Slide #4 Let’s Help Farhan

• Let’s use ROI to help Farhan decide how to invest his money.

• CHEESY SLICE:

  • His original investment in Cheesy Slice was $1,000, which represents the cost of his investment.

  • He then sold his shares for $1,200, which is the current value of his investment.

  • Here’s what that looks like in equation form:

• ROI = ($1,200 – $1,000) / $1,000 🡪 ROI = ($200) / $1,000 🡪 ROI = .2 (or 20%)

• So, the ROI of Farhan’s investment in Cheesy Slice was 20%.

• BLOOM WITH US:

  • Let’s compare this percentage to his investment in Bloom with Us.

  • He originally invested $2,000 and sold his shares for $2,800.

    • ROI = ($2,800 – $2,000) / $2,000 🡪 ROI = ($800) / $2,000 🡪 ROI = .4 (or 40%)

  • The ROI of Farhan’s investment in Bloom with Us is 40% – double his ROI from Cheesy Slice!

• With this information, Farhan can now make an informed investment decision: his sister’s company.

Benchmarks in Ratio Analysis—Discussion Guide

Performance Indicator: Discuss the use of benchmarks when analyzing ratios

THINK ABOUT IT

Benchmarks are important to business success.

• Businesses calculate financial ratios, then compare their performance to industry standards or benchmarks.

• By evaluating their findings, businesses can improve processes, increase efficiency, and enhance overall competitiveness.

KEY CONCEPTS

Slide #1 What Are Benchmarks?

• A benchmark is a standard or point of reference against which performance is measured or compared.

  • Benchmarking allows businesses to compare their data with industry averages to assess overall financial health.

• The process of benchmarking involves measuring a business’s performance, then comparing those metrics against the industry’s “best in class.”

  • Businesses use benchmarks to pinpoint opportunities for improvement in processes, operations, and/or products.

• Benchmarking data sources can be organized into the following categories: internal (comparing components of the same company), external (comparing competitors in the same industry), and functional (comparing non-competitors in different industries).

  • Both qualitative and quantitative data for industries and specific sectors are available through public and private institutions.

  • There are numerous sources of benchmarking data, including, but not limited to, the following: surveys, databases, indicator analyses, internal and external publications, observation and analysis of processes, benchmarking associations, expert opinions, chambers of commerce, professional associations, specialized publications, consulting companies, and scientific conference materials.

Slide #2 Benchmarks and Ratios

• Businesses calculate financial ratios to express how well or how poorly the company is doing financially.

  • These ratios typically come from the company’s financial statements, including the balance sheet and the income statement.

  • Financial information is converted into ratios or percentages, which allows companies to compare themselves to their competitors and the industry.

  • Businesses use these ratios to flag areas of concern, adjust forecasts, evaluate risk, and strategize.

  • Most financial ratios fall into four categories: profitability, leverage, efficiency, and liquidity.

• Businesses calculate different financial ratios, then compare them to benchmarks.

  • These benchmarks serve as guidelines for specific business sectors or the industry and enable businesses to compare performance on specific indicators or at various times.

Slide #3 Benefits of Using Benchmarks

• By calculating financial ratios on a regular basis, businesses can measure progress, detect issues, and direct management’s attention to the most important areas.

  • These objective measures enhance a company’s decision-making abilities.

• Benchmarks allow businesses to compare performance across companies within the same industry.

  • By comparing internal benchmarks, businesses can also compare the effectiveness of specific organizational and process changes over time.

• Using benchmarks can provide numerous benefits, including improved efficiency and work quality, increased customer satisfaction, and better competitive performance.

  • By comparing a business’s financial ratios with the industry standards, that business can identify areas of improvement and enhance performance.

  • It is important to remember that benchmarks simply provide data.

    • The numbers need to be analyzed further to take full advantage of the benefits stated above.

• Benchmarking using ratio analysis is useful both inside and outside the business.

  • For management, benchmarking enables managers to compare their performance to peers using quantitative data.

  • For investors, benchmarking allows them to compare a company to its peers when weighing different investing options.

Slide #4 Limitations of Using Benchmarks

• One limitation of benchmarking is that it only highlights the areas that need improvement; it does not give solutions.

  • Benchmarking compares numbers, but it does not provide the detailed factors that help explain those numbers.

• Sometimes companies can rely too heavily on external comparisons among competitors, which can be creatively limiting and increase their dependence on other companies’ strategies.

• When using benchmarks to analyze financial ratios, it is important not to mistakenly cross industries.

  • Ensuring companies operate within the same industry is key to benchmark validity.

• Occasionally entire industries can be incorrectly valued (which can occur during a stock market bubble), resulting in ratio analysis that is not useful.