Financial Analysis Fundamentals: How to Analyze Financial Statements Like a Pro Part 7 | CFI Course

Let's turn now to peer and industry benchmarking. As we have already seen, financial ratios are valuable tools for assessing a company's performance, but their true significance lies in the context they provide. And benchmarking allows us to compare a company's ratios against those of its peers operating in the same sector. And by doing so, we gain insights into how the company performs relative to its Now, benchmarking is typically done against a small peer group and or an industry benchmark. Benchmarking against a small peer group provides a very focused comparison among direct competitors and so offers specific and actionable insights. On the other hand, benchmarking against the industry at large provides a broader context, Both approaches have their merits and are often used in combination to gain a comprehensive understanding of a company's performance and competitiveness. Benchmarking against the industry at large involves comparing financial ratios and performance metrics with a broader range of companies operating within the same industry. This approach considers companies of different sizes, market positions, and operational models. The industry benchmarks are derived from aggregating data from a diverse set of companies in that sector. Benchmarking against the industry at large does provide a broader context and helps identify overall industry trends, challenges, and opportunities. It also enables companies to gain a sense of their relative position within the industry and understand how their performance compares to the larger market. This perspective is valuable for strategic decision-making, such as setting long-term goals and identifying potential areas for growth or diversification. In contrast, when benchmarking against a small peer group, the focus is on comparing financial ratios and performance metrics with a selected group of companies that are similar in size, similar in market position, and similar in operational characteristics. The peer group is typically composed of direct competitors or companies operating within the same industry niche. Benchmarking against a small peer group allows for a more granular analysis and comparison. It provides a focus view of how a company is performing relative to its competitors. This level of detail can uncover specific strengths, weaknesses, and competitive advantages within a specific market segment. Realistically, picking relevant peers is the most important part of a peer group analysis, and it's where you should spend the bulk of your time, unless you are already a specific industry expert. The goal is to find peers with similar risk factors as the company you're analyzing. Now, if there are absolutely no good peers, you may want to look at companies in different sectors but that have similar characteristics to the company you're analyzing. But this should be done very rarely and very carefully. Ultimately, your benchmarking should be determined based on the closest and best peers to the company you're analyzing. Here we have a best practice peer group benchmarking checklist. First, you want to look at peer business characteristics. Are the two companies in the same industry or sector? Do they have similar geographies? Do they offer similar products and services? Do they service the same type of customers? And do they have similar distribution networks? We also want to analyze and find peers that have common financial or finance characteristics. So, are they of a similar size in terms of revenue? Are they similar in terms of the growth? Are they similar in terms of their margins, their gross margins, their EBITDA margins, and so on? Do they have the same seasonality or cyclicality to their businesses? And do they have similar leverage or credit ratings? All these things make up a good benchmarking checklist. Okay, now let's explore benchmarking against a peer group and against the industry. Once again, we've used CFI's modeling guidelines to lay out our workbook so it's very transparent and easy to follow. We have a cover sheet here. You see column A is free. We can click on those profitability, utilization, leverage, and growth ratios. This will look similar to the trend analysis we did, but now we're going to have the three retailers, large or big retailer, mid-retailer, and small retailer, plus some industry data that will graph. Again, when benchmarking, it's really important to use visualization to make the story come alive. Okay, so let's go to profitability ratios. And again, what we can see here is we can see a whole bunch of blue inputs. Remember, blue is for inputs. Anything in black is an average or a formula. But let's go right to the charts. Now, let's talk about return on equity. And here, let's explain what you're seeing. So the darkest blue line, which is horizontal, is the industry average for the period. The next dark blue line is large retailer or big retailer. The next darkest line is mid-retailer, and then the lightest line is small retailer. We can clearly see that mid-retailer is far and above the best in delivering return on equity, with small retailer being the worst, but the trend is at least up. Let's look at gross margins now. Again, gross margins-wise, we have mid-retailer that's way below the industry average, and the best gross margins are being delivered by that small retailer, significantly above the industry average and above large retailer. The story gets more mixed when we get down to EBIT down margins, EBIT margins, as you see a lot of volatility. It does look like small retailer, though, is still doing better than its peers and the industry when it comes to EBIT down margin. When it comes to EBIT margins, there is still small retailer in the lead, but that gap is closing, and by the time we get to net profit margins, I would argue it's all awash. They're all very similar and very close, and also close to the industry average. Okay, so now let's compare how these three retailers are doing as it relates to asset utilization, and how does that compare to industry. So here we have lots of blue font again, but we're going to go down to the actual graphs to see the stories. Okay, so in terms of asset turnover, what we have in terms of asset turnover is the best asset turnover clearly sits with mid-retailer, significantly above the other two. When we come to cash days, the cash days, again, of mid-retailer are the highest by far, and significantly better than the industry average. AR days, again, the axis on the left makes the difference maybe look larger than it really is. You can see that the axis on the left is really about two days to around six days. Again, this is just flagging. This is a cash industry or cash business. Our inventory days are similar, except we see that mid-retailer moves its inventory a lot quicker than the other two, which may indicate a different mix of retailing. Yes, they're all in general merchandise with groceries and clothes and other whole household items, but maybe mid-retailer is more skewed towards groceries that are perishable than the other two. When we look at accounts payable days, they're all very similar, and all of the retailers are higher than the industry average. And then with the cash conversion cycle, all of them have negative working capital for the most part, with the greatest negative working capital being, again, mid-retailer. So mid-retailer is really delivering in terms of asset utilization. We saw small retailer really delivering with margins. Now let's look at leverage and liquidity. When we look at leverage, the debt to equity ratios are somewhat similar, but mid-retailer has the lowest debt to equity. And we see debt to EBITDA being very similar, except for the fact which may suggest an acquisition funded by debt, but now as we move towards year eight, comes into line and all of them are in line roughly with the industry at large. Now let's look at liquidity ratios. When we look at the current ratio, they're all hovering around one, with mid-retailer having the highest current ratio. And then when we strip out inventory, the story becomes more evident. The quick ratio of mid-retailer is much, much stronger than the industry average or mid-retailer and large retailer. Okay, finally, let's benchmark growth. When we look at growth ratios, again, with that middle blue line is mid-retailer. So revenue growth looks strongest for mid-retailer. With EBITDA growth, there's a lot of volatility and something's happened in year six that impacted at least two of these retailers. But it's really hard to identify who's winning because of that volatility. With net income growth, again, by the end of year eight, they're all in the running, they're very similar. But when we look at total asset growth, we can see that mid-retailer has the highest asset growth, although it drops dramatically between year seven and year eight. So it looks like on margins, small retailer is really leading and does better than the industry. But in terms of the asset utilization and some of the other measures, it's clearly mid-retailer that's at the top.