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Guide

Financial Benchmarking: The Next Step in Your KPI Analysis

Companies monitor financial performance & progress using KPIs. Read how Banks use financial ratios to evaluate a company’s performance & credit worthiness.

Measuring key performance indicators (or KPIs) has become a useful management analysis tool at many mid-sized companies. KPIs are metrics that help companies monitor financial performance and measure their progress toward meeting specific financial goals and objectives. Banks, too, use financial ratios to evaluate a company’s performance and credit worthiness, which were discussed in our last article.
 
For KPIs to be the most useful, however, companies should take measuring and monitoring KPIs one step further by comparing them to a standard. This comparison process is referred to as benchmarking.
 

 

 

A Simple Premise

The premise behind financial benchmarking is simple: Numbers in isolation have little meaning in and of themselves. They need to be compared to some objective standard in order to have true context or meaning. With financial benchmarks, numbers measuring financial performance are either compared internally against previous periods or externally against similar companies or industry averages.
 
“Financial benchmarking is a meaningful way for mid-sized companies to improve their financial performance and thus help boost their profitability,” says T.K. Wood, Business Banker at Cadence, “It’s tremendously valuable to determine how your company’s performance is trending and how it stacks up against your competitors and industry peers from a financial perspective.”
 
The first step in financial benchmarking is to set goals for different aspects of your company’s financial performance. These goals must be specific and measurable. For example, you could set a goal of increasing sales by 20 percent and profits by 10 percent over the next year, as opposed to just saying you want to increase sales and profits.

 

 

 

Choosing Your KPIs

The next step is to decide which aspects of financial performance, or which KPIs, you want to measure and monitor. Here, we share four important financial KPIs that mid-sized businesses should consider tracking:
 

 

 

Net Profit Margin

Net profit margin assesses how well your company is generating profit on each dollar of revenue it earns. This ratio is closely monitored by investors and shareholders as it’s evidence of how effectively a company converts sales into profits for them. Profit margins vary by industry, but most have target ranges that can help a company gauge profitability and see how they are performing against their competition.

 

 

 

Net Profit / Total Revenue

Debt-to-equity ratio: This is another key ratio as it indicates how much debt a company is using to fund its growth relative to its shareholder investments. The lower your debt-to-equity ratio, the higher your debt capacity and ability to borrow money if you need to. The debt-to-equity formula is: Debt / Shareholder’s Equity
 

 

 

Debt / Shareholder’s Equity 

Inventory turnover ratio: This ratio will tell you how many times your inventory turns over in a year. By measuring your inventory turnover ratio and comparing it to previous periods, you can spot items that are moving slowly and discount them to make room for more popular merchandise. The inventory turnover formula is: Cost of Goods Sold (CGS) / Inventory
 

 

 

Cost of Goods Sold (CGS) / Inventory

Accounts receivable days: This ratio will tell you the average length of time it takes to collect your receivables. Compare your AR days to industry averages to see how you fare against your competitors, and to previous periods to see whether collections are improving or slowing down. The AR days formula is: AR x 365 / Annual Sales
 

 

 

Ready to Benchmark

Once you’ve decided which KPIs to measure and monitor, you can begin the financial benchmarking process. For internal benchmarking, compare ratios from one quarter or year to the next in search of historical trends that can help you improve performance in these areas.

For external benchmarking, turn to your industry association or trade group for industry-specific KPI averages. Most trade groups compile extensive data regarding financial KPIs and ratios for benchmarking use by their members.
 
Also consider purchasing a copy of Annual Statement Studies, published by the Risk Management Association. This includes comprehensive financial statistics arranged by North American Industry Classification System (NAICS) codes. Or check with your local library, Small Business Development Center (SBDC) or Chamber of Commerce — they may have a copy you can use.
 
To understand the ratios that banks use in evaluating financing requests, read our article: The Financial Ratios Banks Care About Most.
 
 

 



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