Corporate Finance For Dummies
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Maybe the corporation you’re analyzing has improved dramatically over the years. Its common-size analyses make it seem like the corporation’s asset allocations are steadily improving, and a comparison of its financial metrics over the last ten years supports that by showing improved financial health. Is the corporation really doing well, though?

How can you even tell if you’re just looking at one company? If a corporation has a current ratio of 1.5, which is up from 5 years ago when its current ratio was 0.5, what does that even mean for its operations? If other corporations in the same industry (in other words, competitors) are maintaining current ratios of 5.5, then the improvement from 0.5 to 1.5 still sounds pretty risky.

It could simply be that the corporation you’re analyzing is better at managing its assets, or it could be that the industry it compete in takes a very long time to collect sales revenues, requiring businesses to maintain a lot of cash or other liquid assets or else risk insolvency.

In any case, whether it’s good or bad, you’d never know that the corporation you were analyzing was strange unless you compared it to other corporations in the same industry.

Use industry averages

Quite frequently you don’t compare the corporation against just one other competitor, or even several other competitors individually. When you’re comparing the financial performance of your corporation against the industry, it’s typical to use industry averages.

These are calculated using just a simple mean. If you want to know what the industry average is for current ratios, you find out the current ratio for all the competitors in the industry, add them up, and then divide by the number of competitors. For example:

Current Ratios in Industry: 0.5 + 0.6 + 0.6 + 0.9 + 1.0 = 3.6
Divided by the Number of Competitors in the Industry (5) = 0.72

So you know that the industry average current ratio is 0.72. Do you know why it’s 0.72? Not yet, but you know it’s common for companies in this industry to maintain very low liquidity at any given point. You also know that your company has a current ratio of 0.75. That’s very close to the industry average and probably doesn’t indicate anything important.

So, using a company that maintains liquidity that’s pretty average, you decide to take a look at its inventory turnover in days and receivables turnovers in days. You find that this corporation sells its inventories very quickly and even collects its money very quickly.

As a result of this very fast inflow of cash, it doesn’t need to maintain very high liquidity because it can safely assume that it will be getting more very quickly, allowing it to invest a greater proportion of its assets in longer-term investments that generate high yields. Spectacular!

So what would it mean if your corporation had a current ratio of 1.5? That would mean that it wasn’t efficiently using its assets to generate income. If it had a current ratio of 0.2, it might be at huge risk of becoming insolvent.

Even though all these numbers, by themselves, are very vague, when you add the context of the industry average, you can see how your corporation is doing compared to the competition. It gives you a chance to understand why the industry attempts to maintain certain metrics, why the corporation in question deviates from the average, and whether that’s indicative of something good or bad.

Compare changes in the industry

One additional thing to take into consideration is a comparison of changes in the industry over time. After you know what the industry average is for a particular metric and you know how your corporation compares, you can also track how this relationship changes over time.

Is your corporation increasing its liquidity faster than the industry average? Is it decreasing its profitability slower than average? Is it improving its asset management at exactly the same rate as the industry average?

All of these questions are very relevant to understanding how a corporation is doing in a competitive market. Like other time-based analytics, this analysis helps you to project future performance as well as evaluate the health of the corporation compared to the industry as a whole.

Keep in mind that an entire industry can quite possibly be demented, so don’t rely exclusively on industry-based comparisons. Look at how an individual company is changing over time as well as the spot rates.

Don’t forget to check the quality of the earnings a company is making, too. Just because it’s generating earnings now doesn’t mean those earnings have any quality; they may be one-time payments that will disappear in the next cycle.

About This Article

This article is from the book:

About the book author:

Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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