Keeping up with the Jones’ – Comparing your business to your competitors’
In this blog, we discuss how CBV’s use industry benchmarks as a tool to analyze the subject business, as well as introduce two common financial ratios used.
(Originally Posted July 16, 2018)
Everyone does it. People will try to peer into their neighbors’ yards to see what they have and what they are doing. As valuators, we do that for your business. We look into your competitors’ financial health and compare it to your business’. Specifically, we look how your business’ financial ratios compare to industry benchmarks.
We look to industry benchmarks as an indication of what ratios an average business in your industry should be achieving. We often compare current ratio and debt to equity ratio to industry benchmarks.
Current ratio represents the business’ ability to pay debts that are due within one year. Current assets are assets that can be converted to cash within one fiscal year. Current liabilities are liabilities that must be paid within one fiscal year. For example, if a current ratio is 1.0, there is $1 of current asset available for every $1 of current liability. Current ratio is calculated by dividing current assets by current liabilities.
Current ratio = current assets/current liabilities
Assume a family run business – Smith and Co. – has a current ratio of 1.0. Most would assume this to be an ideal current ratio, and indicative that Smith and Co. is in good financial health since there are enough current assets to pay current liabilities within one year. However, if the average current ratio for similar business’ in the same industry performs at a current ratio of 1.5 we would consider Smith and Co. to be operating at a below average current ratio.
Debt to Equity
Debt to equity ratio is a reference to how much the business is leveraged and if there is capacity to be more leveraged. Debt includes current and long-term liabilities, such as accounts payable and long-term debt. Equity includes amount paid for the business’ shares and the business’ retained earnings. For example, if a debt to equity ratio is 2.0, there is $2 of debt for every $1 of shareholders’ equity.
Debt to equity ratio = total liabilities/total equity
A high debt to equity would suggest Smith and Co. has taken on large amounts of debt and therefore has a higher risk. A low debt to equity ratio would suggest Smith and Co. has taken on low levels of debt and therefore has a lower risk. It is difficult to determine what ratio constitutes as high or low for any given industry. Therefore, we would rely on industry benchmarks to compare Smith and Co. Assume Smith and Co. had a debt to equity ratio of 2.5. However, the average debt to equity for similar business’ in the same industry have an average of 2.0. We would consider Smith and Co. to be higher risk and more levered.
To align Smith and Co. to industry benchmarks, we may adjust the key balance sheet accounts affecting both current ratio and debt to equity. Using industry benchmarks allows us to compare your business to your competitors’.
If you want to know how your business fares compared to industry averages, give us call, we like keeping up with the Jones’.