Financial Benchmarking: How it Works & Why it Matters

Financial benchmarking is the process of comparing your company’s financial performance to financial benchmarks. CFOs, internal and external analysts, and consultants use financial benchmarking to get a contextual understanding of the company’s financial performance. 

For example, let’s say you manufacture umbrellas. During the current year, there was a surge in the demand for umbrellas because of the highest number of rainy days over the past decade. Your company’s revenue shot up 15%. 

That’s great news until you look at all the competitors’ figures and notice the average industry revenue increase was 20%. CFOs, analysts, and consultants can use this information to explore the causes and potentially fix them. 

• Financial benchmarking involves comparing your business KPIs with those of a similar company or industry average. 
• Financial benchmarking is a vital decision-making tool and helps identify potential areas of improvement in the business. 
• Industry associations often publish financial benchmarks. Alternatively, you can use a peer company’s KPIs as benchmarks or calculate an industry average or median.

Financial benchmarks offer several benefits, including:

Contextual performance evaluation

Benchmarks help compare your performance with industry standards or peers and rule out external factors that might be skewing your financial figures.

For example, 1% year-on-year revenue growth might not look that bad when you see that on average the industry’s revenue dropped 2% because of a poor economic landscape.

Realistic goal setting

Benchmarks help you set realistic and measurable goals by understanding where you stand compared to others in the industry.

A clear goal grounded in concrete data helps you develop practical strategies to improve financial performance or address existing problems.

Identifying inefficiencies

Benchmarks highlight inefficiencies or areas of weakness. Ratio analysis can help you pinpoint specific areas that need optimization.

For instance, a low inventory turnover ratio compared to the benchmark might indicate overstocking or poor demand forecasting.

Risk management

Significant deviations from benchmarks can indicate risks. For example, if the company’s debt-to-equity ratio is significantly higher than benchmarks, you should investigate the risk of an overleveraged capital structure for your company and optimise it if you feel the risk-reward isn’t justified.

Investor and stakeholder confidence

Performance better than benchmarks attracts investment and builds stakeholder confidence. If you’re looking to raise capital, especially through equity, aim to exceed benchmarks instead of matching them.

Smarter decision-making

Benchmarks play a key role in making various financial decisions, from budgeting and forecasting to pricing and capital allocation.

Comparing performance metrics with forecasts can guide decisions about where to invest resources for the highest returns.

Suppose your company’s working capital is too low compared to peers. However, instead of infusing more working capital, you look at other benchmarks like inventory and accounts receivable turnover.

Both of them are lower than industry averages, which tells you that you need to streamline inventory management and improve receivables collection–there’s no need for more capital.

Financial benchmarking requires two key things–a basic understanding of what you’re trying to achieve and the financial data required to establish benchmarks.

With that in mind, here’s a quick three-step guide to financial benchmarking:

Step 1: Define your objectives

You can benchmark and monitor dozens of financial metrics, but it’s best to focus on ones that help you achieve your goals.

Ask yourself if you’re trying to improve profitability, reduce costs, increase operational efficiency, or improve financial stability.

Once you have an answer, choose the metrics you want to monitor. Here are some common options you can choose from:

• Profitability ratios: Gross margin, net profit margin
• Efficiency ratios: Inventory turnover, receivables turnover, asset turnover
• Liquidity ratios: Current ratio, quick ratio
• Leverage ratios: debt-to-equity ratio, interest coverage ratio
• Return ratios: return on assets, return on equity

Step 2: Find benchmarking data

Benchmarks are available through multiple sources. Industry associations often publish financial benchmarks for the relevant industry.

When benchmarks aren’t readily available, you can establish them manually using the information in listed company filings.

They’re typically available on the company’s website or the Companies House portal. For example, here are Virgin Atlantic’s latest filings.

If you’re looking for US companies, you’ll find 10Ks of listed companies on the US Securities and Exchange Commission (SEC) or the System for Electronic Document Analysis and Retrieval (SEDAR+) system if you’re looking for Canadian companies.

Analyst reports are another good source of financial benchmarking data.

If you’ve sourced raw data from financial statements, you’ll need to convert it into a financial metric that represents a benchmark. Let’s say you’re trying to compare profitability with 10 peer companies. To do that, you’ll need to calculate their gross margin and net margin and prepare a list.

You can then take the average, median, or percentile of the data in your list to get your benchmark.

Step 3: Compare financial performance to benchmarks

A small variation in performance is normal–every business is different and you’ll rarely hit the benchmark number exactly.

However, it’s important to investigate substantial differences. Suppose the average gross margin in your industry is 50% while your gross margin for your manufacturing business is 30%. There are two possible reasons:

• Excessive discounts
• Higher cost of goods sold (COGS)

If both seem normal, you’ll need to explore other causes that could have driven down the revenue figure or driven up the COGS.