As each year winds to a close, owners of established businesses can count on having plenty of at least one thing: information. That is, they have another full calendar year of financial results to peruse, parse and ponder over.
Indeed, you should not let this valuable data go to waste. Within your company’s financial statements lies a treasure trove of insights that can help you spot trends, both positive and negative.
That is where benchmarking comes in. It can take several forms, but let us focus on three types of internal benchmarking reports that can be particularly useful.
1. Horizontal analysis
A relatively easy starting point is to put two of your company’s financial statements side by side and compare them. In accounting, a comparison of two or more years of financial data is known as horizontal analysis. Differences between the years are typically shown in dollar amounts or percentages.
Naturally, what you are hoping to find is growth. For instance, if accounts receivable increased from $1 million in 2022 to $1.2 million in 2023, that is a difference of $200,000 or 20%. Horizontal analysis helps identify such trends. It is then up to you and your leadership team to explain what caused them and, in the case of this example, keep that trendline moving in a positive direction.
You can also use horizontal analysis to sharpen your understanding of your business’s profitability. While public companies usually focus on earnings per share, private companies generally want to look at profit margin and gross margin. Rather than analyze only the top and bottom of the income statement (revenue and profits), you may want to drill down and compare individual line items such as the cost of materials, rent, utilities, and payroll.
2. Vertical analysis
Vertical analysis works its magic within one year’s financial statements. Essentially, each line item in that set of financial statements is converted to a percentage of another item — often revenue or total assets. Accountants typically refer to financial statements that have been subject to vertical analysis as “common-size” financial statements.
For example, a common-size income statement that shows each line item as a percentage of revenue would explain how each dollar of revenue is distributed between expenses and profits. Alternatively, from a profitability standpoint, vertical analysis could show the various expense line items in the income statement as a percentage of sales. This would show whether and how these line items are contributing to your profit margin.
3. Ratio analysis
Ratios also depict relationships between various items on a company’s financial statements. For instance, profit margin equals net income divided by revenue. Ratios are typically used to benchmark a business against its competitors or industry averages. But you can use ratios internally as well.
Within a single set of financial statements, for example, you might calculate total asset turnover (revenue divided by total assets). This ratio estimates how many dollars in revenue the business generated for every dollar it invested in assets. Generally, the more dollars earned, the better. You can also, of course, compare ratios from one year to the next or over longer periods.
Know your options
Many companies use a combination of horizontal, vertical and ratio analyses over time to highlight positive trends and catch operating inefficiencies. What is important is knowing your benchmarking options and maximizing the value that your financial statements can provide. For help choosing and executing the optimal benchmarking methods for your company, contact us.
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