What are the potential benchmarks that you could use to compare a company's financial ratios? What are the pros and cons of these alternatives?

Answer 1

Comparison to Firm's Prior History.By comparing the company with itself over time, it is possible to document changes (improvements or declines) in the company's performance. Changes in capital structure or improvements in gross margins or return on assets may evolve slowly as the firm implements the necessary changes in operations and financing. Only by looking at the pattern of these changes over time can we see if the individual changes in financial ratios from year to year are permanent or temporary. However, this approach does not tell us how well the firm is doing compared to other companies. For example, a firm may appear to have performed poorly (well) relative to its own historical performance, yet relative to other firms in the economy or its own industry, it may have performed quite well (poorly).
Comparison to Firm's Expected or Budgeted Performance.This could be relative to management or external analysts' forecasts. These types of comparisons can be very helpful by showing how well the firm has performed relative to expectations. An obvious limitation is that the comparisons are only meaningful if the expectations are carefully constructed.
Comparison to Industry Average. Industry average financial ratios provide a benchmark against which to interpret individual company ratios. A firm's return on sales, asset turnover, and financial leverage can be compared to industry averages. What are the implications if a firm has a lower return on equity or lower days payable than the industry? Are any differences consistent with the firm's operating policies and goals? Industry comparisons can provide only a partial picture if the industry as a whole has performed well or poorly, or if the firm is following a different strategy from other firms in the industry. It can also be quite difficult to assess what the appropriate industry comparison group is, since many firms operate in more than one business segment.
Comparison to Market.Benchmarking the performance of an individual firm against the market can be informative. Ultimately, investors want to allocate resources within the economy as a whole. A firm that is a strong performer relative to its industry may therefore be a relatively weak overall performer if its industry is underperforming. However, market analysis can be difficult for many key financial ratios which are industry specific and do not lend themselves to cross-industry comparison or evaluation. For example, important ratios for banks include those on regulatory capital, which are not relevant for most other industries. Working capital ratios typically differ across industries, so that it makes little sense to compare days inventory or days receivable for a supermarket relative to the same ratios for a steel manufacturer. Finally, differences in ratios can arise because of differences in business risk across industries. For example, ROEs and leverage are likely to be very different for construction firms than for supermarkets.