Ratio Analysis - Comparison with competitors and Industry Averages

INDUSTRY AVERAGES AND COMPARISON WITH COMPETITORS

The analysis of an entity’s financial statements is more meaningful if the results are compared with industry averages and with results of competitors. Several financial services provide composite data on various industries.

The analyst faces a problem when the industries reported do not clearly include the company being examined because the company is diversified into many industrial areas. Since many companies do not clearly fit into any one industry, it is often necessary to use an industry that best fits the firm. The financial services have a similar problem in selecting an industry in which to place a company.

Thus, a financial service uses its best judgment as to which industry the firm best fits.

This section briefly describes some financial services. For a more extensive explanation, consult the service’s literature. Each service explains how it computes its ratios and the data it provides.

The Department of Commerce Financial Report is a publication of the federal government for manufacturing, mining, and trade corporations. Published by the Economic Surveys Division of the Bureau of the Census, it includes income statement data and balance sheet data in total industry dollars.

It also includes an industry-wide common-size vertical income statement (Income Statement in

Ratio Format) and an industry-wide common-size vertical balance sheet (Selected Balance Sheet

Ratios). This source also includes selected operating and balance sheet ratios. This government publication

uses NAICS for classification.

This report, updated quarterly, probably offers the most current source. It typically becomes

available within three to four months after the end of the quarter. It is a unique source of industry

data in total dollars and would enable a company to compare its dollars (such as sales) with the

industry dollars (sales). This service is free and is now on the Internet at http://census.gov/csd/qfr.

If you Google the Department of Commerce financial report, this website will likely be the first

one up.

Annual Statement Studies is published by the Risk Management Association, the association of

lending and credit risk professionals. Submitted by institutional members of the Risk Management

Association, the data cover several hundred different industries in manufacturing, wholesaling, retailing,

service, agriculture, and construction.

Annual Statement Studies groups the data by industry, using the SIC number, and the NAICS

number. It provides common-size balance sheets, income statements, and 16 selected ratios.

The data are sorted by assets and sales and are particularly useful because the financial position

and operations of small firms are often quite different from those of larger firms. The presentation

also includes a five-year comparison of historical data that presents all firms under a particular

NAICS or SIC code.

In each category, the ratios are computed for the median and the upper and lower quartiles. For

example:

Number of firms (9)

Ratio—Return on total assets

Results for the nine firms (in order, from highest to lowest):

12%, 11%, 10.5%, 10%, 9.8%, 9.7%, 9.6%, 7.0%, 6.5%

The middle result is the median: 9.8%.

The result halfway between the top result and the median is the upper quartile: 10.5%.

The result halfway between the bottom result and the median is the lower quartile: 9.6%.

For ratios in which a low value is desirable, the results are presented from low values to high—for

example, 2% (upper quartile), 5% (median), and 8% (lower quartile). For ratios in which a high value

is desirable, the results are presented from high values to low—for example, 10.5% (upper quartile),

9.8% (median), and 9.6% (lower quartile).

Because of the combination of common-size statements, selected ratios, and comparative historical

data, Annual Statement Studies is one of the most extensively used sources of industry data. Commercial

loan officers in banks frequently use this source.

Annual Statement Studies is available in two books, Financial Ratio Benchmarks and Industry

Default Probabilities and Cash Flow Measures.

There are 14 ratios presented for the upper quartile, median, and lower quartile. The 14 ratios are

as follows:

Solvency

Quick Ratio (Times)

Current Ratio (Times)

Current Liabilities to Net Worth (%)

Current Liabilities to Inventory (%)

Total Liabilities to Net Worth (%)

Fixed Assets to Net Worth (%)

Efficiency

Collection Period (days)

Sales to Inventory (times)

Assets to Sales (%)

Sales to Net Working Capital (times)

Accounts Payable to Sales (%)

Profitability

Return on Sales (%)

Return on Assets (%)

Return on Net Working Capital (%)

Dun & Bradstreet advises that the industry norms and key business ratios are to be used as yardsticksand not as absolutes. Industry Norms and Key Business Ratios is also published in an expanded set in the following five segments:

1. Agriculture/Mining/Construction/Transportation/Communication/Utilities

2. Manufacturing

3. Wholesaling

4. Retailing

5. Finance/Real Estate/Services

All five segments are available in three different formats, for a total of 15 books. The three formats are:

1. Industry Norms and Key Business Ratios, three-year edition

2. Industry Norms and Key Business Ratios, one-year edition

3. Key Business Ratios, one-year edition

Value Line Investment Survey is in two editions; the Standard Edition and the Small & Mid-Cap

Edition. The Standard Edition places companies in 1 of 97 industries. The Small & Mid-Cap Edition places companies in 1 of 84 industries. There are approximately 1,700 stocks in the Standard Edition and approximately 1,800 stocks in the Small & Mid-Cap Edition. The Value Line Investment Survey is very popular with investors.

The full-page Ratings & Reports are similar for the Standard Edition and the Small & Mid-Cap

Edition. Each stock is rated for timeliness, safety, and technical. The Standard Edition includes an analyst’s comments, while the Small & Mid-Cap Edition does not include an analyst’s comments.

The data included in Value Line for a company are largely for a relatively long period of time

(11 to 17 years). The data provided vary somewhat by industry. Some of the data provided for many companies are as follows:

1. Revenues per share

2. Cash flow per share

3. Earnings per share

4. Dividends declared per share

5. Capital spending per share

6. Book value per share

7. Common shares outstanding
8. Average annual P/E ratio
9. Relative P/E ratio
10. Average annual dividend yield
11. Revenues
12. Operating margin
13. Depreciation
14. Net profit
15. Income tax rate
16. Net profit margin
17. Working capital
18. Long-term debt
19. Shareholders’ equity
20. Return on total capitalization
21. Return on shareholders’ equity
22. Retained to common equity
23. All dividends to net profit
As indicated previously, comparison has become more difficult in recent years as more firms
become conglomerates and diversify into many product lines. To counteract this problem, the SEC
has implemented line-of-business reporting requirements for companies that must submit their
reports to the SEC. These reports are made available to the public. SFAS No. 14 also addresses lineof-
business reporting requirements. Such reporting requirements ease the analysis problem created
by conglomerates but cannot eliminate it because the entity must decide how to allocate administrative
and joint costs.
If industry figures are unavailable or if comparison with a competitor is desired, another firm’s
statements may be analyzed. Remember, however, that the other firm is not necessarily good or bad,
nor does it represent a norm or standard for its industry. It also can be said that industry figures do
not necessarily represent good or bad, nor do they represent a standard for its industry.
Alternative accounting methods are acceptable in many situations. Since identical companies may
use different valuation or expense methods, it is important to read statements and notes carefully to
determine whether the statements are reasonably comparable.
Ideally, the use of all types of comparison would be best. Using trend analysis, industry averages,
and comparisons with a major competitor will give support to findings and will provide a concrete
basis for analysis.
In analyzing ratios, the analyst will sometimes encounter negative profit figures. Analysis of
ratios that have negative numerators or denominators is meaningless, and the negative sign of
the ratio should simply be noted.

CAUTION IN USING INDUSTRY AVERAGES

Financial analysis requires judgment decisions on the part of the analyst. Users of financial statements
must be careful not to place undue confidence in ratios or comparisons.
Remember that ratios are simply fractions with a numerator (top) and a denominator (bottom).
There are as many ratios for financial analysis as there are pairs of figures. There is no set group, nor
is a particular ratio always computed using the same figures. Even the industry ratio formulas vary
from source to source. Adequate detailed disclosure of how the industry ratios are computed is often
lacking. Major problems can result from analyzing a firm according to the recommendations of a
book and then making comparisons to industry ratios that may have been computed differently.
The use of different accounting methods causes a problem. For example, identical firms may use
different valuation or revenue recognition methods. Read statements and notes carefully to determine
the degree of comparability between statements. Trend analysis for each firm, however, will usually
be meaningful. Industry averages group firms together that use different accounting principles.
Different year-ends can also produce different results. Consider the difference in the inventory of
two toy stores if one ends November 30 and the other ends December 31. The ratios of firms with
differing year-ends are all grouped together in industry averages