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 The Secret to Understanding and Using Benchmark Information By Brian Hamilton, MBA, Sageworks Of interest to many types of financial professionals, benchmarks can be extremely valuable to the financial analysis process. However, benchmarking is a tool that is only effective when data is gathered correctly, and the benchmark information is utilized properly. “Benchmarks” are financial metrics/ratios/results, which show average ranges of financial performance by companies in a given industry. There are many different types of financial benchmarks. When using benchmarks, a primary question should be addressed: what is the average level of performance for a given ratio/metric in a specific industry? In a way, a benchmark is a scorecard against which the relative strength of a company can be assessed. Understanding the average financial performance of specific industries is important to both accountants and bankers, who want to understand industry conditions and how the companies they are evaluating compare to other companies in a given industry. For example, credit analysts at banks use industry benchmark data as a way to assess the relative health of a given company. Valuation analysts use benchmark data to assess the future earning potential of a company. Accountants use benchmark data as a way to identify any weak areas that need to be improved by their clients. For numerous reasons, it has been a major challenge in the U.S. to access good quality industry benchmark data. Historically, companies that have sold benchmark data were selling data gathered largely from tax return filings. Data from tax returns tends to give conservative and unrealistically low numbers for operating profits. Further, private companies in the U.S. are not compelled to publish their financial results. Consequently, access to private company data is very limited, and sources of industry data may be unreliable. When evaluating any industry data, the following items should be assessed: The sample size. If the sample size of the industry being reviewed is too small, conclusions may be faulty and financial results can be skewed and incorrect. When reviewing industry data and looking at a particular company in a given sales range, also make sure there are enough sample companies in a particular sales range, i.e. even within the same industry selection there can be a different number of companies represented in each sales range. Although there are no specific “rules,” a good rule of thumb is to have at least five companies represented in each sales range. The source of the data. As noted previously, tax returns are generally not a good source of private company benchmark data. Real-time operating data is valuable. The calculation of metrics. Data providers may use different financial formulas, so it’s important to know how the numbers are calculated. For example, metrics about profitability should be carefully scrutinized because net profit formulas vary dramatically, depending on the expense and/or revenue items included, i.e. net profit before taxes, net profit before taxes amortization and depreciation, operating profit, and net income after taxes. The age of the benchmark data. The frequency with which a data provider updates benchmark data is critical. Older data is sometimes of very little value; therefore, know the age of the data is being used. What are the most important financial metrics when reviewing benchmark data? These three should be at the top of the list:
Benchmarking will grow in importance as financial professionals gain access
to better data and use it more effectively in making decisions. |
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