Part 3 - Comparing Ratios to the Industry

In Part 1, we calculated The Widget Manufacturing Company's 200Y ratios. This provided us with some information regarding the company's performance.  In Part 2, we gained a greater insight into the performance of the Widget Manufacturing Company by comparing their 200X ratios to their 200Y ratios. At the end of Part 2, we concluded the company's performance had improved during 200Y.

Here in Part 3, we will gain further insight into the company's performance as we compare their ratios to ratios of other businesses within the same industry. Furthermore, in Part 3 we will compare the Widget Manufacturing Company's ratios to what are known as the Industry Average Ratios. Industry Average simply means "the average business within the industry". You may (and should) obtain a copy of industry averages for your particular industry from your state/provincial business service center, Small Business Administration, US Department of Commerce, Office of Business Analysis, and in some cases, the Chamber of Commerce. If these organizations are NOT able to provide you with industry averages for your particular industry, then search through the various trade journals and publications. If you are still unsuccessful, contact your local bank and ask the commercial loans manager where you can receive a copy of industry averages for your particular business. The bank may even provide you with the industry averages you need. (The resource used by most bankers is entitled, "Annual Statement Studies" by Robert Morris Associates).

Why are Industry Averages so Important?

Industry averages are important to both existing businesses and aspiring entrepreneurs planning to establish a business. Existing businesses, in most cases, require additional financing from time to time (for renovation, for purchasing new equipment, for financing operations during slow periods, etc). At any rate, when an existing business applies for a loan, a bank will require the business supply them with prior year's balance sheets and income statements. The bank will create ratios from the company's financial statements and compare their ratios to ratios of other businesses within the industry. This process generally determines whether the enterprise will have the ability to pay the loan back.

An aspiring entrepreneur, not in business, may wonder how industry averages and ratios, for that matter, apply to them. Well, if you're like most businesses starting out, you'll require financing; either from a bank, private investor or some other entity. Banks and educated investors will want to see a business plan, equipped with forecasted financial statements and ratios for a three year period. From a financial point of view, these individuals will read the forecasted balance sheets and forecasted income statement and compare the forecasted ratios to ratios of existing businesses within the industry. This process will confirm whether nor not the potential entrepreneur has under or overestimated their forecasts. An under or overestimation in financial statements may show an investor that the entrepreneur is not in touch with the business or the industry he or she is planning to enter. Therefore, by obtaining a copy of industry averages, an aspiring entrepreneur can determine whether or not their three year forecasts are in par with other businesses within the industry. In addition, it gives you a "MAJOR" advantage when seeking financing for your proposed business. One final note for all those aspiring entrepreneurs seeking financing;

If you are unable to obtain a copy of industry averages, don't worry. Have confidence in your business plan and forecasted financial statements. If you calculate your ratios for the three year forecasted period and you explain how each ratio has changed from year to year, then a banker or other investor  should be very impressed. Moreover, if your forecasts are objective, than your ratios should be competitive with other businesses within the industry.

Let's now begin our comparison of the Widget Manufacturing Company's ratios to the average ratios of other businesses within the industry (IE Industry Averages). Below provides the company's 200Y balance sheet and income statement as well as the balance sheet and income statement for the average business within the industry. Our task is to use the 200Y financial statements to calculate ratios for Widget Manufacturing Company and for the average business within the industry; and  finally compare the two. This will tell us how the Widget Manufacturing Company is performing relative to other businesses with the industry.

Below calculates and compares ratios of The Widget Manufacturing Company to ratios of the average business within the industry. The first ratio to be addressed is the Current Ratio.

Current Ratio

The current ratio measures whether a company has the ability to use its current assets to pay its short-term creditors (current liabilities). Recall Financial analysts deem a 2 to 1 ratio as an acceptable current ratio. The Widget Manufacturing Company's current ratio and the Industry Average current ratio for 200Y are calculated below.

In 200Y, The Widget Manufacturing Company's current assets exceed its current liabilities by 2.28 times. As indicated under the industry average column, other businesses with in the industry have current assets exceeding their current liabilities by 2.59 times. A higher current ratio indicates a stronger company. As a result, the following comparison can be made between the Widget Manufacturing Company and an average business within the same industry.

Other businesses within the same industry, on average, have a greater ability to use their current assets to pay short term debt.

Although the Widget Manufacturing Company's current ratio is below the industry average, it's still deemed acceptable by investors (current ratios 2 to 1 and higher are acceptable).

Quick Ratio

The quick ratio measures whether a company has the ability to use its current assets (without selling inventory) to pay its short-term creditors. Recall, investors like to see a high quick ratio, since it shows the company is more "liquid" and does not have to rely heavily on selling its inventory in order to pay its short-term debt. The Widget Manufacturing Company's quick ratio and the Industry Average quick ratio for 200Y are calculated below.

In 200Y, the Widget Manufacturing Company's current assets (excluding inventory) are equal to 102% of its current liabilities. That is, for every $1.00 the company owes, it has $1.02 in current assets (exceeding inventory). The average business within the industry, however, has $1.42 for every one dollar ($1.00) of current assets. As a result, the following comparison can be made between the Widget Manufacturing Company and the average business within the same industry.

Other businesses within the same industry, on average, have a greater ability to use their current assets (excluding inventory) to pay or meet their short-term debt.

Although the Widget Manufacturing Company's quick ratio is below the industry average, it's no indication that the company is struggling. In fact, the Widget Manufacturing Company's quick ratio of 1.02 indicates the company does not have to heavily rely on its inventory in order to pay its short-term creditors. PLEASE NOTE: a quick ratio of 1:1 or 100% to 100% is generally deemed acceptable.

Average Collection Period

The average collection period ratio determines the number of days it takes for a company to receive payment from customers who buy products on credit. Recall, financial analysts deem the average collection period should not extend beyond the company's credit granting policy (30, 60, 90, or 120 days). The Widget Manufacturing Company's average collection period ratio and the Industry Average's average collection period ratio for 200Y are calculated below.

As you can see, the 200Y average collection period for the Widget Manufacturing Company is 54 days. This means, the company's customers, on average, will wait 54 days before paying for products purchased on credit. The average customer within the industry, on the other hand, waits only 41 days (on average) to pay for products placed on credit. Furthermore, the Widget Manufacturing Company waits thirteen (13) days longer to collect from its customers than the average business within the industry. As a result, the Widget Manufacturing Company is financing the products they sell longer than the average business within the industry.

If an average business within the industry "grants" its customers 60 days to pay for purchases placed on credit, then the Widget Manufacturing Company's average collection period ratio of 54 days would be considered acceptable. If, on the other hand, an average business within the industry grants its customers only 30 days to pay for purchases placed on credit, then the Widget Company's accounts receivable as well as the industry average accounts receivable are not being collected efficiently enough. As a result, financial analysts would deem both average collection period ratios "unacceptable".

Inventory Turnover:

The inventory turnover ratio provides an indication on whether a company has an excessive or inadequate amount of inventory. The ratio determines the number of times per year a company uses or consumes an average stock of inventory. A higher inventory turnover ratio generally means a business is selling its inventory quickly or has less money "tied up" in inventory, or both. The Widget Manufacturing Company's inventory turnover ratio and the Industry Average inventory turnover ratio for 200Y are calculated below.

* Average inventory is calculated by adding the beginning inventory to the ending inventory and dividing by 2. Recall, The Widget Manufacturing Company's beginning inventory as of January 1, 200Y, is $22,500 and its ending inventory as of December 31, 200Y, is $26,470 . Assume the average beginning inventory for business within the industry as of January 1, 200Y is $20,659.

As you can see, The Widget Company used or consumed its inventory approximately 3.5 times during 200Y. This is considerably lower than the industry average of 4.3 times. As a result, the Widget Manufacturing Company has more money "tied up" in inventory than other firms within the same industry. Furthermore, the company is most likely not selling its inventory as quickly as other competing firms. As a result, the Widget Manufacturing Company requires larger inventory investments. Such inventory investments "tie up" cash that might otherwise be used to purchase more productive, revenue generating assets, for instance. At any rate, the company must re-evaluate its inventory management policy.

Debt Ratio

The debt ratio measures the extent to which borrowed money has been used to finance a company's operation. Recall, investors like to see a low debt ratio, since it shows a company is relying less on creditors (such as banks, suppliers, etc) to finance the operation. The Widget Manufacturing Company's debt ratio and the Industry Average debt ratio for 200Y are calculated below.

In 200Y, the Widget Manufacturing Company's debt ratio is .58. This means, 58% of the company's assets are financed by creditors such as banks, governments, etc. Or, for every one dollar the company has in assets, it has 58 cents in debt. On the other end of the continuum, an average business within the industry has a debt ratio of .42 This means, an average business within the same industry has 42% of its assets financed by creditors. As a result, the Widget Manufacturing Company will have higher principal payments and interest charges relative to other firms in the industry. Higher principal payments and interest expenses will ultimately reduce the company's cash flow and net income.

Debt-to-Equity Ratio

The debt-to-equity ratio compares the investments made by creditors to the investments made by the company's owners or shareholders. Investors like to see a low debt-to-equity ratio, since it indicates owners' investments into the company are higher than creditor's investments.  The Widget Manufacturing Company's debt-to-equity ratio and the Industry Average debt-to-equity ratio for 200Y are calculated below.

The Widget Manufacturing Company's 200Y debt-to-equity ratio is 1.37 . That is, for every $1.00 invested by the company's owners, investors such as bank and suppliers have invested $1.37 into the company. In 200Y, the average business shows a debt-to-equity ratio of 0.71 or 71%. That is, for every $1.00 invested by the company's owners, investors such as banks have invested 71 cents into the company. As a result, creditors of the Widget Manufacturing Company have invested more than the owners of the company. On the other hand, other firms within the industry see its owners investing more than creditors. This ratio certainly indicates that the Widget Manufacturing Company heavily relies on its creditors (rather than its owners) to finance the operation. Moreover, financial analysts would deem a debt-to-equity ratio of 1.37 as unacceptable.

Gross Profit Margin

The Gross Profit Margin ratio provides an indication of how well a company is setting its prices and controlling the production costs. Investors like to see a high gross profit margin since it indicates the company is making higher margins on each sale. The Widget Manufacturing Company's gross profit margin ratio and the Industry Average gross profit margin ratio for 200Y are calculated below.

In 200Y, the Widget Manufacturing Company's gross profit margin is 0.24 or 24%. This means, for every one dollar ($1.00) generated in sales, 24 cents remains in the company to pay operating expenses and taxes. Assuming, all products produced by the company sell for $1.00, the company would make 24 cents from each sale. As you can see, the 200Y industry average gross margin is 0.28 or 28%. This means, for every one dollar ($1.00) generated in sales, 28 cents remains in an average company to pay for operating expenses and taxes.

The Widget Manufacturing Company is making 4 cents less on every one dollar generated in sales compared to the average firm within the industry. This would lead us to believe that other businesses within the industry have a greater aptitude in setting prices and controlling production costs. Financial analysts would certainly suggest the Widget Manufacturing Company focus its attention on improving pricing and controlling production costs. By doing so, the company can improve its gross margin (the amount made) on each sale.

Net Profit Margin

The Net Profit Margin ratio assists a company in determining whether their selling prices are too low or if expenses are too high, or both. Investors like to see high net profit margins since it provides an indication of how well management is setting its prices and controlling both production costs and operating expenses. The Widget Manufacturing Company's net profit margin ratio and the Industry Average net profit margin ratio for 200Y are calculated below.

In 200Y, The Widget Company's net profit margin is 0.04 or 4%. This means, for every one dollar ($1.00) generated in sales, 4 cents remains in the company, or is available to be distributed to the owners of the company, or a combination of both. If we assumed, all products sold by the company have a selling price of $1.00, then 4 cents would contribute to net income. As you can see, the average firm within the industry has a profit margin of 0.08 or 8%. This means, for every one dollar ($1.00) generated in sales, 8 cents remains in the company, or is available to be distributed to the owners of the company, or a combination of both.

The Widget Manufacturing Company is earning 4 cents less on every one dollar generated in sales compared to the average firm within the industry. This would lead us to believe that other businesses within the industry have a greater ability to set prices, control production costs (cost of goods sold), and manage operating expenses . Financial analysts would certainly suggest The Widget Manufacturing Company focus its attention on improving its pricing policy, and on lowering its production and operating expenses. By doing so, the company should earn a higher net profit margin.

Return on Total Assets

The Return on Total Assets ratio measures how well a company is using its assets to generate after tax profits (net income after taxes). Investors like to see a high return on total assets since it indicates a company is using its assets efficiently to generate after tax profits. The Widget Manufacturing Company's return on total assets ratio and the Industry Average return on total assets ratio for 200Y are calculated below.

In 200Y, The Widget Company's net profit margin is 0.06 or 6%. This means, for every one dollar ($1.00) spent on purchasing assets, 6 cents is generated in after tax profits. The after tax profits may remain in the company or may be distributed to the owners of the firm, or a combination of both. As you can see, the 200Y industry average return on total assets is 0.12 or 12%. This means, for every one dollar ($1.00) an average business within the industry spends on purchasing assets, it will generate 12 cents in after tax profits. The after tax profits (net income after taxes) may remain in these companies or may be distributed to their owners, or both.

In summary, The Widget Manufacturing Company earns 6 cents less on every one dollar spent on assets compared to other businesses within the industry. This would lead us to believe that other businesses within the industry are using their assets more efficiently to generate revenue. Financial analysts would suggest the company's low Return on Total Assets ratio is a direct result of its average collection period ratio, its inventory turnover ratio, and its low profit margin ratios.

Return on Equity

The Return on Equity ratio measures how well a company is using owner's investments to generate after tax profits (net income after taxes). Investors like to see a high return on equity since it indicates the company is using the owner's investments efficiently to generate after tax profits. The Widget Manufacturing Company's return on equity ratio and the Industry Average return on equity ratio for 200Y are calculated below.

In 200Y, The Widget Company's return on equity is 0.13 or 13%. This means, for every one dollar ($1.00) invested by the owners, the company generated 13 cents in after tax profits. As you can see, the 200Y industry average return on equity is 0.20 or 20%. This means, every one dollar ($1.00) invested into an average business within the industry generates 20 cents in after tax profits for its owners. The after tax profits (net income after taxes) may remain in these companies, or may be distributed to their owners, or a combination of both.

Therefore, The Widget Manufacturing Company earns 7 cents less (20 cents - 13 cents) on every one dollar invested by its owners, compared to owners of an average business within the industry. Financial analysts would suggest the company's low Return on Equity ratio is a direct result of its average collection period ratio, its inventory turnover ratio and its low profit margin.

PART 3  - Summarized:

Part 3 above evaluated the performance of the Widget Manufacturing Company, relative to other businesses within the industry. We can summarize our findings by saying in 200Y;

- the average business within the industry has a greater ability to use its current assets to pay short-term debt, compared to the Widget Manufacturing Company. (Current Ratio).

- the average business within the industry can rely less on selling its inventory to pay short-term debt then The Widget Manufacturing Company can. (Quick Ratio).

- the average business within the industry collects its accounts receivable quicker than the Widget Manufacturing Company. (Average Collection Period Ratio).

- the average business within the industry uses or consumes its inventory faster than the Widget Manufacturing Company. (Inventory Turnover Ratio).

- the average business within the industry has less debt compared to The Widget Manufacturing Company. (Debt Ratio). Moreover, The Widget Manufacturing Company relies heavily on its creditors compared to other businesses within the industry.

- the average business within the industry relies more on the owners to finance the company than on creditors to finance their operation. The Widget Manufacturing company rely on creditors more than on the owners to finance its operations (Debt-to-Equity Ratio).

- the average business within the industry makes more from each sale than the Widget Manufacturing Company. (Gross Profit Ratio).

- the average business within the industry earns more, after expenses and taxes are paid, than the Widget Manufacturing Company. (Net Profit Ratio).

- the average business within the industry uses their assets more efficiently to generate profits, than the Widget Manufacturing Company. (Return on Total Assets Ratio).

- the average business within the industry generates a higher rate of return for their owners compared to the Widget Manufacturing Company. (Return on Equity Ratio).

As a result, The Widget Manufacturing Company, in most cases, would experience great difficulty in receiving additional debt financing from banks, for example. Furthermore, the company should seek equity financing (money from owners or solicit more owners) if it requires additional financing. In other words, creditors may be reluctant to provide additional financing to The Widget Manufacturing Company; feeling the company is relying too heavily on creditors to finance their operations.

Below provides examples of ratios for several factious companies. PLEASE NOTE: ratio calculations are only provided in these examples. Morever, the trend analysis nor the industry average comparison is not included in the following examples.

Examples of Ratio Calculations:

J&B Incorporated
Scholarship Information Services
The Internet Company