The Importance of Benchmarking in Financial Analysis

Analyzing a company’s financial performance requires an understanding of various financial statements as well as the ability to interpret important financial ratios. The main financial statements detailing the financial performance of an organization are the balance sheet, statement of cash flows, and the income statement. These statements provide information that can be used to calculate various financial ratios to better understand the financial performance of a company. Some important ratios include the current ratio, profit margin, return on assets, price-earnings ratio, etc. Each of the financial statements and ratios provide important information relevant to the financial aspect that each represents; however, without applying context and comparison, all of these numbers mean very little. Benchmarking is a method of establishing a standard for comparison to add context to the financial information provided in financial statements and ratios to derive meaning from these valuable data.




The first step to benchmarking is to analyze the financial statements and consider the context in which the company operates to determine appropriate measures and standards to apply for comparison. Financial competitive benchmarking uses financial information, most often in the form of ratios, to perform these comparisons. These financial metrics and ratios show average ranges of financial performance by firms in a given industry or specific context. When we use benchmarks, the main question we are trying to answer is: what is the average level of performance for a given ratio/metric in a specific industry. The use of various benchmarking methods allows the application of relevant context to interpret the financial performance accordingly.

The type of context and standards to be applied to a given firm often depends on a variety of factors as well as the type of information that we seek. One method of benchmarking is to conduct a time trend analysis, looking at financial performance over time. This method is particularly important to determine if the company’s performance is improving or declining. Perhaps comparatively the company seems to be doing poorly based on industry standards, but if we consider the age of the firm and discover consistent improvement year after year, perhaps we can derive that the company is performing very well for its level of maturity. This example highlights the importance of context and considering various factors when conducting financial ratio analysis.

Another method of benchmarking is peer group analysis. To establish this form of benchmark, one must identify firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. This method is obviously problematic, as no two companies are identical. Standard Industrial Classification (SIC) codes are four digit codes that were established by the U.S. government for statistical reporting, serving as one method of identifying potential peers for comparison. Firms with the same SIC code are frequently assumed to be similar. Once the benchmark is established, we can use financial ratios to compare the two companies on various performance attributes.

The financial information that is needed for financial benchmarking is available only from large commercial databases or from specialized reports and publications, from where it must be gleaned with difficulty. For the information to be brought closer to the active user, it must be processed, refined, and classified. The pre-processing of the financial benchmarking information “can be used in computerized benchmarking systems and executive support systems, making the task of competitive financial benchmarking easier and more effective." Brian Hamilton also points out the challenge of obtaining quality industry benchmark data, explaining that many companies that sell benchmark data gathered the data from tax return filings. The problem with this is that the data from tax returns provide inaccurate numbers for operating profits. Another challenge in acquiring good benchmark data is that “private companies are not compelled to publish their financial data,” limiting the amount of data that is available for accurate comparison.

Brad Schaefer explains that while benchmarking is an incredibly useful tool, it can be easy to make mistakes that misconstrue the findings of the analysis. For example, when comparisons become too subjective by focusing on a single business, the number of differences between the two businesses often precludes useful comparisons. Schaefer explains that "it is important to remember that a benchmark report is not the conclusion of your analysis, but rather the beginning. Once you have created a report that can clearly display these metrics as compared to the industry at large, you can begin to create a plan of action." By framing the problematic areas as opportunities for improvement, businesses can create a plan that makes the benchmarking process worth their time and money. It is also important for companies to note the areas that they excel in to understand the business aspects that are doing well as they are. Otherwise businesses could implement changes that were unnecessary and actually hurt the company’s financial performance.

In conclusion, financial benchmarking is an effective way that organizations can establish standards for comparison. This can be accomplished by viewing the company’s performance over time or by comparing the company’s performance to industry benchmarks; however, conducting both a time trend analysis and a peer group analysis will likely be most effective. When comparing a company’s financial performance with another company or an industry benchmark, it is important to consider context as objectively as possible before drawing any conclusions. The basic problem with financial statement analysis is that there is no underlying theory to help us identify which quantities to look at and to guide us in establishing benchmarks. For this reason, the benchmarking process requires an assessment of a wide variety of circumstances and information to develop relevant insights.

References

Ross, S., Westerfield, R., & Jordan, B. (2013). Fundamentals of corporate finance. (11th ed.). New York, NY: McGraw-Hill/Irwin.

Back, B., Irjala, M., Sere, K., & Vanharanta, H. (1995).Competitive financial benchmarking using self-organizing maps. Retrieved from http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.45.5529&rep=re 1&type=pdf

Hamilton, B. (2008, March 17). Understanding and using benchmark data. Retrieved from http://www.accountingweb.com/topic/technology/understanding-and-using-benchmark- data

Schaefer, B. (2013). Benefits of Benchmarking: Tactics and Techniques to Maximize Financial Analysis. CPA Practice Advisor, 23(10), 24.