A company’s success can’t be measured in a vacuum. While the balance sheet and income statement can show whether the company turned a profit and where it made internal investments, companies operate as part of an industry with other competitors focusing on the same target markets.
It isn’t enough for a company to look at its own numbers; companies must learn how to compare their financial decisions and results with their industry peers to capture a clearer picture of performance.
This being said, companies within the same industry can be different sizes with completely different histories and wildly varying available assets. Without somehow normalizing values, it isn’t practically useful to compare one company to another.
That’s where financial ratios come in: as a way of equalizing financial values within an industry so that companies and investors alike can get a better picture of individual, industry and overall economic performance.
A financial ratio is essentially as simple as it sounds: a ratio of two financial numbers compared to each other. Meaningful financial ratios are meant to give information about a company’s financial state by comparing two values in a ratio for evaluation over time or as compared to other values. Taking a ratio can help equalize values for comparison, allowing financial managers and analysts to make judgments on a company’s financial health and what decisions need to be made.
These ratios also help compare the financial status of multiple companies within the same industry. Since companies publish their financial statements, investors and analysts can use these ratios to equalize multiple companies and compare their financial states to one another in general.
For example, return on investment and return on assets are two commonly calculated financial ratios that are used in multiple ways to judge a company’s return on certain financial decisions. Since these are ratios other than net values, it’s easier to compare a larger company and a smaller company to see whose investments may be more successful.
Other example financial ratios fall into categories: profitability or return ratios, liquidity ratios and leverage ratios.
ROI and ROA count as two of the most important profitability ratios: a measure of the way that the company’s management is investing resources. These ratios capture the company’s current performance as a ratio of something put into the business. Examples include:
- ROI, being net income/owners’ equity, a measure of how well the company is using its equity to develop business
- ROA, being net income/total assets, a measure of how effectively and efficiently a company is using its assets to produce profit
- Net income/net sales, measuring the overall profitability of the company, which reflects on the effectiveness of current management
- Gross profit/net sales, which captures the margin on sales a company is seeing, usually a measure of the company’s operational efficiency
These financial ratios capture a company’s ability to pay where it’s needed. They measure the availability of cash and other short-term assets to make good on existing obligations like loans, accounts payable and other debts. Examples include:
- Current ratio: current assets/current liabilities, which measures the likelihood a company will be able to pay its obligations. The general industry rule of thumb is that the current ratio should be over 1.5:1, sometimes 2:1.
- Quick ratio, or acid test: quick assets/current liabilities, a stricter look at a company’s ability to pay its debts, limited to "quick assets" like cash and receivables. General best practices expect a ratio of 1:1.
These values measure how much a company is depending on borrowing to execute its operations. These include:
- Debt-to-equity ratio, being debt/owners’ equity, looks at the mix of the company’s available capital. The general rule is to keep debt between 50% to 80% of a company’s equity.
- Debt/total assets, which looks at the measure the company has borrowed against the company’s current asset capital. If this value is greater than 1:1, the company technically has a negative net worth.
Industry averages take certain financial ratios of a set of companies determined to be within a certain industrial segment and averages them to create a sort of benchmark to be used when analyzing financial data within that industry. This allows individual companies to compare their own financial situation with the average within their industry to determine where they stand in comparison with their competitors.
Industries can be defined in a number of ways, but most business and financial bodies use the International Standard Industrial Classification system to identify what exactly separates one industry from another. Depending on the nation in question, other standardization may be used (like the Dun & Bradstreet industry average). There are advantages to each set of classifications. These classifications help separate individual companies into industries with their peers.
Chemical manufacturing can be considered one broad industry, but polymer manufacturers differ from fuel manufacturers and so on. Within polymers, producers of rubber differ from producers of plastics, and these can be further refined by identifying either their key production output or their key target market.
This classification allows a company to determine its industry competitors. There is often some overlap since many businesses operate in more than one industrial sector, but the standardization gives analysts a baseline from which to work.
The calculation of industry averages is often done by an independent firm with experience in the area. These companies will do financial surveys and gather together financial reporting and then use their own classification system and accounting knowledge to calculate industry averages based on this information.
These independent third parties then offer or sometimes sell their industry standard values to interested parties, which include not only the companies within that industry but also potential investors, current stockholders and companies that may be looking to enter new industry markets. For example, most of the numbers shown below are from ReadyRatios.com, which shares industry averages over the last five years.
As an example, the current ratio is a straightforward financial ratio with known general practices, but its specific value can also vary depending on the industry itself. This is because depending on the industry, companies will have different practices with inventory and sales, different average company sizes, different turnover rates, different physical capital requirements and so on.
For example, the office-services industry may only require a small investment in grounds and buildings, whereas the manufacturing industry by its very nature requires a massive investment in grounds and property.
Wells Fargo shows the following industry averages for current ratio from January 2019:
- Construction: 0.97
- Manufacturing: 2.14
- Real estate: 1.48
- Retail: 1.47
The current ratio captures a company’s ability to pay its debts, measuring current assets/current liabilities. At a first glance, this shows that the manufacturing industry is expected to hold far more in assets and less in debts than the construction industry, for example, while the real estate and retail industries fall in between.
In addition, a manufacturing company with a current ratio of 1.5 would understand that it lags behind the industry average for this financial value. That doesn’t necessarily mean that the company needs to change its ways immediately, but it should alert financial advisers that the company may want to consider focusing more on eliminating current liabilities.
In 2018, the overall current ratio for all industries was just over 1.5 (different financial companies have different standards for calculation, but 1.5 is close enough for these purposes), which also tells investors that the real estate and retail markets operate financially like most other businesses, while the construction and manufacturing industries have different financial situations. This may make certain industries more or less attractive to the average investor looking for potential opportunities.
The return on assets is another value that can vary widely among industries. This ratio, net income/total assets, should capture how well an industry is making use of its assets to produce income for the business. A higher ratio is considered to be better, and in this case, the ratio can in fact be negative if an industry on average saw a net loss rather than net income.
In 2018, the overall ROA for all industries was 0.8%. Consider the figures for the industries detailed above:
- Construction: 6.8%
- Manufacturing: 2.3% to 6.7% depending on the industry
- Real estate: 0.2%
- Retail: 2.4% to 7.4% depending on the industry
Again, values can depend on the specific industries involved; petroleum-related industries saw an ROA of 5.7%, while the chemical industries measured at -42.4%, a net industry loss. (This is likely a result of the fact that most chemical industries are also involved in manufacturing of some sort, meaning they can take a loss in one industry for a gain in another through diversification.)
Thus, a manufacturing company whose annual ROA was near 3% might assume it is doing well as compared to the overall industry average, but within the manufacturing industries, it may not be performing as well as its real competitors.
The debt-to-equity ratio of a company is an important value at which investors look to decide whether or not to make an investment. This ratio compares the company’s current funding sources as debt/owner equity to measure how much of the company has been funded by debt. While a general rule of thumb is to keep this below 2:1 (0.66), the values also vary by industry.
In 2018, the overall debt-to-equity ratio for all industries was 0.88. In comparison:
- Construction: 1.06
- Manufacturing: 0.2 to 1.09
- Real estate: 0.39
- Retail: 0.7 to 1.8
Within these categories, further differences can be spotted. For example, general wholesale goods saw a debt-to-equity ratio near 1, but the automotive industry had a ratio near 1.8. Consider the debt dealerships need to take on in order to place cars on their lots, and this value makes more sense.
Again, a retail company will need to consider its specific industry for an accurate comparison as well as its comparison to the overall industry average to provide better judgment on future decisions. Investors tend to prefer a lower debt-to-equity ratio since debt always carries inherent risk, so companies that can show a ratio below their industry average may have advantages when in the market for investors.
These important financial ratios should be watched over time in addition to the industry comparisons. This can help a company track how its management decisions have affected its financial situation over the last few years and help guide future decisions, especially after large decisions like big capital investments or debt elimination.