Uses and Limitations of Industry Ratios

by Chad Thompson

Ratio analysis is a powerful tool for the financial statement analyst. From a company's financial statements, one can calculate a host of meaningful ratios including profitability, efficiency and leverage. While one can calculate these ratios for a given company, there are services available that compile ratios for dozens, if not thousands, of companies within a given industry. These are often referred to as "industry ratios." Most services categorize the industries consistently with the North American Industry Classification System.

Industry ratios are often used in forensic accounting engagements such as business income loss evaluations or business valuations. When used correctly, they effectively buttress the accountant's conclusions. But on the flip side, using these ratios inappropriately will compromise an entire engagement. To provide insight into how to use these ratios, I've compiled the top three uses and misuses of industry ratios.

Top Three Uses

1. Gaining an understanding of an industry.

Balance sheet and income statement ratios are often a great first place to start when learning about an industry. Balance sheet ratios such as accounts receivable, fixed asset turnover and debt to equity allow the reader to determine if customer credit is an important element of the industry, and whether the industry is capital intensive. If accounts receivable turnover is high, then customer credit is not important and all sales proceeds are collected quickly. If, however, accounts receivable turnover is relatively low, one can conclude the industry is competitive, which causes customers to demand high terms, or the average selling price for the industry is high, thus requiring customer financing. A low fixed asset turnover ratio would imply the industry is capital intensive, as would a high debt to equity ratio.

The income statement ratios also paint a picture of the industry landscape. For instance, a net profit margin less than the average stock market return implies the industry is not especially profitable. The lack of profitability may stem from competition from within the industry, or outside competition which is causing downward pressure on the demand for the goods and services within the industry. In contrast, the ratios for a different industry may show a high gross profit margin. This could imply the presence of government protection (such as patents for drug companies), or the presence of intellectual capital that is not easily replicated (as is the case for the software industry).

2. Supplementing incomplete records.

When preparing a business income loss evaluation, sometimes the records of the insured company may require supplementation with industry ratios. There are several scenarios under which records for the insured business are incomplete. First and foremost, the company may not keep complete and accurate records. Also, the company's records may have been lost or destroyed by fire or other casualty. Finally, the business may be new and not have an extensive operating history.

When any of the foregoing situations arise, industry ratios are a valuable tool in preparing income statement projections. In these cases, sales are determined by bank statements, sales tax returns, or other third-party documents. One can obtain major operating expenses such as rent and payroll through lease agreements, payroll filings, and/or inquiries. Industry ratios are then used to construct the remaining unknowns on the income statement.

3. Correcting obvious errors.

I once evaluated a business income loss claim for a pizza restaurant that was closed due to a fire. The company's tax return reflected an approximately 15% cost of sales ratio, which is beyond abnormally low. I believe the company presented a doctored tax return, in order to make the business appear highly profitable and thus collect more insurance proceeds. However, I was able to correct the obvious error by relying upon an industry average cost ratio for a similarly-sized pizza restaurant of around 36%. Had every single expense item appeared out of line, I would not have used the industry averages. Rather, I would have performed a more exhaustive audit of the company's records to reveal the true numbers. However, industry ratios are especially useful when correcting only a few obvious errors within the records.

Top Three Misuses

1. Comparing a company to the industry average

The biggest misuse of industry averages is in fact something that is routinely done--comparing a specific company to an industry average and drawing a conclusion. I see this exercise performed in business valuation engagements. For instance, a practitioner may evaluate a retail store and conclude the subject company has an area of weakness in that its gross margin is 48% when the industry average is 41%. One has to recognize that the "industry average" company does not exist. It is simply the mathematical average (or median depending on the reporting service) of an aggregation of many different companies, with many different products, many different customers, many different goals/operating philosophies, and many different locations. An average is a collection of numbers that are higher and lower than the average. With this in mind, a flat out comparison of a given company to an industry average is meaningless.

There is an exception to this general premise, however. If the subject company is a franchised operation, a comparison of its ratios to the average ratios for other franchisees is meaningful. Why? Franchised operations have standardized procedures, training, products and marketing. Therefore, deviations from the averages of other franchised operations can be a good indicator of management effectiveness, customer loyalty or location.

In the context of a business valuation, it is meaningful to compare a company's own operating and balance sheet ratios over a period of several years. This highlights positive or negative trends within the organization. But, as previously stated, a comparison of the company's ratios to industry ratios is meaningless.

2. Adjusting records for slight deviations from the average.

Some practitioners may have cause for alarm with a 5% to 15% deviation between the subject company's ratios and the industry average. They may then be prompted to make adjustments. Deviations are not only acceptable, they are expected. For instance, a retailer with a high sales mix of house brands likely has a better gross margin than the industry average. Thus, there is no cause for alarm, and certainly no cause for adjusting the records. This concept differs from the example of the obvious errors that I explained earlier. The point is that practitioners must not treat industry averages as absolutes.

3. Using mismatched data

For those times when it is appropriate to use industry averages to correct obvious errors, or supplement incomplete records, it is critical that the practitioner use correct industry averages. I worked on a lost profits case for a startup retailer. Since there was no operating history both the opposing accountant and I developed a set of projections that involved industry averages. There was one huge difference, though. My data was based on the industry average for companies with an asset base similar to the subject company, while his was based on Wal-Mart. That's right Wal-Mart--the world's most efficient retailer. It wasn't too far into the case that his analysis was discredited.

The foregoing example was relatively obvious. But potential mistakes are often more subtle. For instance, if a restaurant has both dine-in and catering services, an industry average for restaurants probably wouldn't be meaningful. A breakfast-only restaurant is another good example. Breakfast foods enjoy huge margins. As such, industry average for restaurants wouldn't be meaningful for a breakfast-only restaurant. The point is that one has to obtain relevant information. Sometimes this involves multiple sets of industry data, if the subject company has more than one business. Some services offer industry ratios based on company size and location, which is also helpful. Simply, use the right ratios to avoid the garbage in, garbage out situation.

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