Annual Audit Manual
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7035 Common ratios and knowledge management tools
Dec-2011
In This Section
Tips and tools for gaining an external perspective and accessing and using knowledge tools
Overview
This topic explains:
- Common ratios and definitions
- Tips and tools for gaining an external perspective and accessing and using knowledge tools
OAG Guidance
Ratios allow users to analyze a company’s performance by using relationships between financial statement items. Ratios also convert financial information to a "common size," which facilitates the comparison of a company to a benchmark (e.g., prior year, competitor, industry). Viewed in isolation, individual ratios are not always meaningful; however, combinations of ratios analysis can provide a meaningful, holistic view of a company. A thorough understanding of how ratios are calculated and what they mean will provide us with a powerful tool to identify business risks and value drivers; however, public sector auditors should be aware that relationships between certain individual financial statements items may not always be relevant in the audit of governments.
In instances where more than one ratio is provided for a particular category, select a ratio(s) that is most appropriate for the purpose of the procedure, considering the entity and industry.
Considerations when using ratio analysis
Ratios are rarely useful without benchmarks. A single ratio does not tell us much about a company. Compare that ratio with the same company in different years in order to examine the trend or with the same ratios of competitors in the industry. Even with these benchmarking comparisons, differences can exist across time or companies may require adjustment before meaningful comparisons can be made.
Most ratios implicitly assume linearity and size independence. These assumptions are rarely true. For example, a $1,000 increase in sales will affect inventory needs and receivables much differently than a $1,000,000 increase in sales.
Companies may engage in "window dressing" to improve ratios. Knowing that analysts and creditors may be watching a company’s ratios, these companies may, for example, pay off short-term debt at the end of the year and take on new debt shortly after year-end. This would improve the debt to equity ratio, but the effect is only temporary.
Accounting methods may differ significantly across companies (or time). Methods of depreciation, completed contract accounting, amortization of goodwill, and purchase versus pooling accounting for mergers, etc. can have significant effects on reported financial numbers.
Be careful when negative numbers are possible. Looking at only the ratios without examining the underlying financial statement data can lead to misinterpretation. For example, a company with negative income (loss) of $1 million with negative stockholder’s equity of $10 million (because of cumulative losses) will appear to have a 10 percent ROE (return on equity) just as if it had $1 million of income and $10 million of positive stockholder’s equity. Some programs may take the issue of negative numbers into account when performing calculations, but it is always wise to review the underlying data used to calculate the various ratios.
Common financial ratios
Provided below are summaries of some of the more common financial ratios, what they measure and how they might be interpreted. The following sections are included:
- Investment Ratios
- Productivity Ratios
- Liquidity Ratios
- Activity Ratios
- Leverage Ratios
- Profitability Ratios
- Coverage Ratios
INVESTMENT RATIOS
Investment Ratio Analysis
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What it Measures Investment ratios measure the amount the company is investing, the efficiency and effectiveness of a company’s decisions concerning the allocation of assets, and the amount of growth the company is experiencing given those decisions. |
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High Ratio A higher ratio indicates that a higher amount is being invested. When normalized by comparing it to sales, a higher percent generally means that it takes more dollars to generate sales. The cash retention and growth rates are viewed together. If a company is retaining (investing) cash, its cash retention rate will be higher than one, indicating that they are in a growth mode. |
Trending Upward If cash retention and growth rates are trending upward, the company may be in a high-growth industry and able to attract additional capital. An increase in investment in property, plant and equipment may indicate the company is upgrading facilities to improve the efficiency of operations. |
Trending Downward If investment ratios are trending downward, the company’s industry may be in a decline phase. If the cash retention rate is trending downward but the industry’s rate is trending upwards, indicating growth, the company may be losing ground on its competitors. On the other hand, this downward trend could represent better management of idle assets through better inventory, receivable and cash management techniques. A downward trend can also indicate aging property, plant and equipment. |
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Example For example, take an extreme case. If a company does not reinvest its cash into the company, net investment will continue upwards; however, the company may lose a competitive edge if its plant facilities become outdated. |
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Risk The company in this extreme example appears to be increasing its net investment; however, the long-term impact could be detrimental. |
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Interpretation Issue Another issue to be aware of in interpreting investment ratios is how a company classifies its assets and liabilities into current and long-term categories. In addition, it is helpful to understand their depreciation policies. |
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Common Investment Ratios
The investment ratios commonly used are:
- Net Investment
- Net Investment as % of Sales
- Cash Retention Rate
- Average Sales Growth Rate for Past 3 Years
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Ratio |
Calculation |
What It Measures |
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Net Investment |
Working Capital (Total Current Assets—Total Current Liabilities) + Property, Plant and Equipment, net |
Net investment in the business |
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Net Investment as a Percentage of Sales |
Net Investment/Sales |
Net investment in the business as a percentage of sales |
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Cash Retention Rate |
(CY Net Investment—PY Net Investment)/Cash Provided From Operations |
The rate at which the company retains or invests cash. |
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Average Sales Growth Rate for Past Three Years |
(Yr 1 Growth Rate + Yr 2 Growth Rate + Yr 3 Growth Rate)/3 |
The average annual growth rate for each of the past three years. The growth rate is a function of changes in sales and allows owners to evaluate overall return on investment. |
PRODUCTIVITY RATIOS
Productivity Ratio Analysis
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What it Measures Productivity ratios measure the efficiency and effectiveness of the company’s employees. |
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High Ratio Generally a higher ratio is better. Higher sales per employee indicate adequate and appropriate staffing |
Trending Upward An upward trend generally indicates that sales volume per employee is increasing and business is growing. |
Trending Downward A downward trend generally indicates that sales volume per employee is decreasing and the business is in decline. |
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Example Take care in analyzing productivity ratios. The ratio is not an indicator of profitability. Although sales per FTE may be increasing at 20 percent per annum, if these revenues are not collectible, the company’s overall position will decline. |
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Risk In addition, the company could be increasing its advertising and promotion costs. This would also lead to decreased profitability. Understand the overall sales and marketing strategy of a company in order to analyze productivity ratios. |
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Interpretation Issue Another issue to be aware of in interpreting productivity ratios is the amount of outsourcing used by the company. Outsourcing will reduce overall FTE count, thus increasing the sales per FTE ratio. |
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Common Productivity Ratios
The productivity ratio commonly used is:
- Sales per Full Time Equivalent (FTE) Employee
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Ratio |
Calculation |
What It Measures |
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Sales per Full Time Equivalent (FTE) Employee |
Sales/Total Full Time Equivalent Employees + Full Time Equivalents Headcount is obtained by counting Full Time Equivalents (FTEs) based on a 40-hour workweek. An FTE is calculated by including all full time and part time personnel to obtain the number of FTEs it would take to do the job. FTE counts do not include personnel hired on a contract labour basis, third party outsourced labour, or non-employee temporary help. |
The portion of sales generated by one full time equivalent employee. |
LIQUIDITY RATIOS
Liquidity Ratio Analysis
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What it Measures Liquidity ratios measure the ability of a company to meet its obligations. They can be used to measure how quickly assets can be turned into cash. Liquidity ratios give a picture of how quickly operations create or consume cash. |
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High Ratio Generally, a higher ratio is better. However, a ratio that is too high may mean that the company has idle cash that could be better used to purchase other productive assets (e.g., plant and equipment) or to create valuable assets (e.g., R&D expenditures or advertising). A high Cost of Sales to Payables ratio could indicate that the company is not taking advantage of long-term debt at potentially lower interest rates. |
Trending Upward If liquidity ratios are trending upward, the company may be highly liquid (a plus for creditors), but highly liquid, low performing current assets can indicate under-investment in more productive, long-term assets. |
Trending Downward If liquidity ratios are trending downward, the company may be facing a cash crisis or solvency issue. On the other hand, this downward trend could represent better management of idle assets through better inventory, receivable and cash management techniques. |
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Example For example, take an extreme case. If a company was able to keep cash to zero (by having an open line of credit), inventories to zero (through an outstanding just-in-time system), and collect all accounts receivable within 24 hours, the company would have a current ratio equal to zero. But does this signal bad news? Maybe yes, maybe no. |
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Risk The company in this extreme example appears to be doing everything right according to current cash management strategies, but there may be a risk in relying on line-of-credit financing. If receivable collections change slightly or inventory suppliers fail to deliver on time, the company could face a crisis. Stable Trend Even a stable trend in liquidity ratios deserves attention. For example, a company’s current ratio could stay the same from year to year, but if the mix of current assets is changing (e.g., replacing cash with inventory), this could signal problems with inventory management. |
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Interpretation Issue Another issue to be aware of in interpreting liquidity ratios is how a company classifies its assets and liabilities into current and long-term categories. |
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Common Liquidity Ratios
The ratios commonly used to measure liquidity are:
- Current Ratio
- Working Capital
- Working Capital Turnover
- Cost of Sales to Payables
- Days in Payables
- Operating Cash Flow
- Cash Conversion Cycle
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Ratio |
Calculation |
What It Measures |
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Current Ratio |
Total Current Assets/Total Current Liabilities |
This ratio measures a company’s short-term liquidity; in other words, its ability to meet its short-term obligations. Potential Problem A potential problem with the Current Ratio is that accounts receivable and inventory may not be easily converted into cash. Obsolete inventory and. or uncollectible receivables included in the current assets numerator may provide misleading signals about a company’s solvency. |
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Working Capital |
Total Current Assets—Total Current Liabilities |
This measures the ability of a company to meet current obligations utilizing or liquidating current assets. Although an excess of assets over liabilities can indicate a healthy company, it may also indicate cash that is not being invested, receivables that are aging, or excess inventory. In addition, payables and cash management strategies can extend the life of payables and increase current liabilities. |
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Working Capital Turnover |
Sales/Average Working Capital |
This ratio measures the efficiency of a company’s ability to generate sales through efficient use of assets without incurring excessive liabilities. |
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Cost of Sales to Payables |
Cost of Sales/Average Accounts Payable |
It is a measure of how much of the cost of sales is funded by third party vendor financing through payables |
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Days Payable |
365/Cost of Sales to Payables |
It is a measure of the average number of days the company takes to pay its vendors. |
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Operating Cash Flow |
Net income plus or minus non-cash items and changes in Working Capital other than cash. |
Operating cash flow measures the amount of cash generated by the company from its operations. |
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Cash Conversion Cycle |
Days Receivable (DSO), plus Days Inventory, minus Days Payable. |
This measurement provides a snapshot of the company’s ability to turn accounts receivable and inventory into cash, fewer payments to vendors. A high ratio can indicate that the company has excess inventory on hand or is paying its vendors more quickly than it is being paid by its customers. For example, Days Receivable of 45 plus Days Sales in Inventory of 25 less Days Payable of 35 (a cash conversion cycle of 35) can be improved by collecting receivables 5 days sooner, to 40 days, yielding a cash conversion cycle of 30. The cash conversion cycle, or net operating cycle, determines the number of days the company’s cash is tied up in operations such as payments made for materials and labour into cash returns from sales. |
ACTIVITY RATIOS
Activity Ratio Analysis
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What it Measures Activity ratios are useful for understanding the relationship between a company’s operations and the assets needed to sustain those operations. They essentially measure the connection between a company’s inputs and outputs. Business advisors tend to focus on activity ratios as an area where they can demonstrate substantial benefits for the company. These ratios focus on the business operations and can point to existing inefficiencies. |
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High Ratio Usually high ratios represent more efficient operations. Fewer assets are needed to maintain a particular level of operations. These ratios are indicators of profitability because they tell us how a company puts its assets to work to generate revenue. However, these ratios don’t measure profitability directly, as profit margins, leverage, etc. also come into play. |
Trending Upward If activity ratios are trending upward, this could represent a company that is becoming more efficient, with faster inventory turnaround, quicker receivable collection, etc. On the other hand, an upward trend could be triggered simply by the depreciation of assets over time. If the activity ratio includes assets other than "current" assets, the book values of these assets are likely decreasing due to annual depreciation. Consequently, the activity ratios could appear to be improving, when in reality nothing has changed. |
Trending Downward If activity ratios are trending downward, the company may be becoming less efficient in its deployment of assets. This trend represents issues such as longer holding periods for inventory (possible obsolescence or fall in demand) and potential liquidity (cash flow) problems. |
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Potential Problems Differences across companies in how they acquire assets (lease versus purchase) and how they account for acquisitions (operating lease versus capital lease) can affect activity ratios. The life cycle of a company is very important in interpreting activity ratios. Early on in a company’s life, it may have excess capacity and the activity ratios may appear dangerously low. However, these low activity ratios merely indicate that the company is in "start up" phase rather than facing an efficiency problem. Likewise, high activity ratios for a mature company can indicate a problem such as the need to replace property, plant, and equipment. |
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Stable Trend Even a stable trend in activity ratios deserves attention. For example, a company’s inventory turnover ratio could stay the same from year to year, but if the industry is increasing the average inventory turnover through more efficient channels of distribution) this could signal problems with inventory management. |
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Common Activity Ratios
The ratios commonly used to measure activity are:
- Receivables Turnover, Accounts Receivable Collection Period
- Inventory Turnover, Days in Inventory
- Fixed Asset Turnover
- Current Asset Turnover
- Total Asset Turnover
Ratio
Calculation
What It Measures
Receivables Turnover, Accounts Receivable Collection Period
Receivables Turnover: Sales/Average Accounts Receivable
Accounts Receivable Collection Period: 365/Receivables Turnover
Receivable turnover ratio measures the efficiency of a company’s credit policies. It measures the number of times a year that the portfolio of receivables is collected and replaced with a new portfolio. A higher ratio indicates that receivables are collected quickly. This ratio also indicates the level of accounts receivable needed to maintain a given level of sales revenue.
The accounts receivable collection period, or days sales outstanding, is simply the inverse of this ratio and is often easier to understand. This measure tells us how many days’ receivables are held before collected. Fewer days are usually better.
Inventory Turnover, Days in Inventory
Inventory Turnover: Cost of Sales/Average Inventory
Days in Inventory: 365/Inventory Turnover
Inventory turnover ratio measures the efficiency of a company’s inventory management. A higher ratio indicates that inventory does not remain on the shelf (or in the warehouse) too long. That is, the inventory "turns over" quickly. This ratio can use either average or end-of-the-year amounts for inventory. Depending on the change in inventory from one year to the next, one or the other might be more relevant for the user. Day’s inventory is simply the inverse of this ratio and is often easier to understand. This measure tells us how many days inventory is held (on average) before it is sold. Fewer days are usually better.
Fixed Asset Turnover
Sales/Average Property, Plant and Equipment, Net
The fixed asset turnover ratio measures the company’s efficiency with long-term capital investment. The measure captures the level of fixed assets needed to support a given level of sales.
Current Asset Turnover
Cost of Sales/Average Total Current Assets
The current asset turnover ratio provides information on the efficiency of a company’s utilisation or leverage of current assets.
Total Asset Turnover
Sales/Average Total Assets
Total asset turnover consolidates both short- and long-term assets in order to provide an overall picture of the company’s efficiency with its deployment of assets.
LEVERAGE RATIOS
Leverage Ratio Analysis
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What it Measures Leverage ratios measure a company’s risk and return trade-off through its decisions on debt versus equity financing. Creditors often impose debt covenants on borrowers in order to protect their risk of default. Measurement of compliance with these debt covenants is often through the use of leverage ratios. |
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High Ratio A high ratio means that the company uses greater levels of debt financing. |
The Benefits of High Leverage Leverage is often the key to increasing returns to shareholders. So long as the return on projects funded with debt exceed the cost of debt, equity holders can increase ROE with increased use of debt. A company’s weighted average cost of capital is a function of both debt and equity costs. A greater reliance on the cheaper of these two sources of financing, all else equal, produces greater overall returns. |
The Dangers of High Leverage Notwithstanding the benefits of leverage, increased use of debt brings with it higher risks. Unlike dividends, debt payments are usually fixed and required regardless of annual profitability. Companies with high debt levels can face serious problems with even short-term downturns in their sales or profitability. |
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Potential Problems All debt is not created equal. Debt can have different costs and different maturities. Long-term debt of $10 million at a favorable rate is not equivalent to short-term debt at an expensive rate. Examine the underlying nature of the debt. The use of market versus book values for debt and equity can create different interpretations of the ratio. If the market value of a company’s debt is less than its book value because the company is nearing default, use of the market value of the debt rather than the book value could make the debt-to-equity ratio look relatively smaller. Consequently this would make the company look less risky even though the opposite is true. If the market value of a company’s equity is greater than its book value, the debt to equity ratio will be lower if market value is used, indicating that the company could attract additional capital at favorable costs. |
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Common Leverage Ratios
The ratios most commonly used to measure leverage are:
- Total Debt to Equity
- Long-Term Debt to Equity
- Tangible Equity
- Total Debt to Tangible Equity
- Fixed Assets to Tangible Equity
- Total Debt to Assets
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Ratio |
Calculation |
What It Measures |
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Total Debt to Equity |
Total Liabilities/Total Owners’ Equity |
This ratio measures the relative risk of the company. |
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Long Term Debt to Equity |
Long-Term Debt/Total Owners’ Equity |
This ratio measures the relative risk of the company based on only its long-term debt obligations. |
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Tangible Equity |
Total Owners’ Equity less Goodwill and Intangible Assets, net of Amortization |
This ratio measures the amount of owner’s equity reduced by any intangible assets to determine the equity that exceeds liabilities and obligations. |
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Total Debt to Tangible Equity |
Total Liabilities/Tangible Equity |
Tangible Equity is similar to Debt to Equity; however, it reduces owners’ equity by the amount of intangible assets the company holds, since these cannot be readily turned to cash to meet debt obligations. |
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Fixed Assets to Tangible Equity |
Property, Plant and Equipment, Net/Tangible Equity |
This ratio measures the amount of owners’ equity tied up in fixed assets that generally cannot be readily sold to generate cash for operations. |
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Total Debt to Assets |
Total Debt/Total Assets |
This ratio measures the proportion of a company’s assets funded with liabilities. |
PROFITABILITY RATIOS
Profitability Ratio Analysis
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What it Measures Profitability ratios provide a measure of a company’s ability to generate, sustain, and increase profits. |
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High Ratio Higher ratios are better, indicating that a company is generating a return on its assets, equity, etc. As with all ratios, this information is relative. A 10 percent return on assets may be good or bad depending on alternative equal risk returns available. |
Trending Upward An upward trending profitability ratio generally indicates a healthy company. However, if the returns are below alternative returns, even with an upward trend, this represents a company facing potential problems. |
Potential Problems The relationship between income and assets or equity is not linear. That is, if a company is operating at full capacity, an increase to income may require a substantial investment in assets at least partially funded by equity (e.g., a new plant or new retail stores) and thus, at least for a time, ROE may decrease until sales increase to match the new, higher level of equity. |
Common Profitability Ratios
The ratios commonly used to measure profitability are:
- Net Income as a Percent of Sales
- Operating Margin as a Percent of Sales
- Gross Margin Percent
- Return on Assets, Pre-Tax Return on Assets
- Return on Equity
- Return on Net Investment
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Ratio |
Calculation |
What It Measures |
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Net Income as a Percent of Sales, Operating Margin as a Percent of Sales |
Net Income/Sales |
These ratios measure the relationship between sales revenue and operating or net income and indicate the portion of a dollar of sales that contributes to overall profit. Operating margin measures the relationship between sales revenue and income from operations. This measure differs from gross margin percentage because it considers other operating expenses. This measure does not consider non-operating income or expenses (e.g., investment income). Net income as a percent of sales includes non-operating income or expenses in the calculation. |
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Gross Margin Percent |
Gross Margin/Sales |
Gross margin percentage measures the relationship between sales revenue and cost of sales and indicates the portion of a dollar of sales that contributes to overall profit. This measure is after cost of sales, but before other expenses. Consequently, high gross margin numbers can be observed even when the company is not profitable overall. |
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Return on Assets, Pre-Tax Return on Assets |
Net Income, or Net Income Before Income Taxes/Average Total Assets |
Return on Assets (ROA) measures the relationship between profits and total assets. One way of interpreting ROA is that it tells us how much our assets produce in terms of returns to all providers of capital (debt and equity). Another interpretation is that ROA tells us the level of assets needed to support a particular level of income. |
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Return on Equity |
Net Income/Average Total Owners’ Equity |
Return on Equity (ROE) measures the relationship between profits and stockholders’ equity. This measure is similar to Return on Assets (ROA), but focuses more on the returns accruing to the company’s shareholders. ROE tells us how much the company’s assets produce in terms of returns to all equity providers of capital. Another interpretation is that ROE tells us the level of equity capital needed to support a particular level of income. |
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Return on Net Investment |
Net Income/Average Net Investment |
Net Investment = Working Capital + Property, Plant & Equipment. Return on Net Investment (ROI) measures the relationship between profits and net investment. One way of interpreting ROI is that it tells us how much our net investments produce. Another interpretation is that ROI tells us the level of net investment needed to support a particular level of income. |
COVERAGE RATIOS
Coverage Ratio Analysis
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What it Measures The ability of a company to cover its debt service and pay principal and interest when due. |
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High Ratio A high ratio indicates that a company can easily meet its principal and/or interest payments. Coverage ratios are another way of examining leverage issues, or how the use of debt affects a company’s financial health. |
Common Coverage Ratios
The ratios most commonly used to measure leverage are:
- Interest Coverage
- Operating Cash Flow to Debt Service
- Total Debt to Operating Cash Flow
- Fixed Charge Coverage
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Ratio |
Calculation |
What It Measures |
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Interest Coverage |
Income before Income Taxes and Interest/Interest Expense |
This ratio measures the ability of a company to meet its interest payments. |
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Operating Cash Flow to Debt Service |
Cash Provided by Operations/(Principal Payments of Debt + Interest Expense) |
This ratio measures the ability of a company to meet its principal and interest payments. |
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Total Debt to Operating Cash Flow |
Total Liabilities/Cash Provided by Operations |
It measures the entity’s ability to meet debt obligations from earnings received from operations. |
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Fixed Charge Coverage |
Income Before Income Taxes and Interest/(Interest Expense +/- Provision (Benefit) for Income Taxes + Principal Payments of Debt) |
This ratio indicates an entity’s ability to satisfy fixed financing expenses. |
OAG Guidance
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News and Business Factiva.com (formerly DJI) Factiva Feedback Survey Factiva Training Search News/Articles Track News (formerly CustomClips) Publications Wall Street Journal Financial Times Case Studies/Management Theory (Harvard) Business Web Search Engine (Alacra) Competitor News |
Company Information Stock Quotes/Dividends Factiva Company Profiles Company Tear Sheets (S&P NetAdvantage) Analyst Reports (MultexNet) D&B International Business Locator Public and Private Company Info (D&B Million Dollar Directory) International Public and Private Company Information (D&B Million Dollar Directory) |
Industry Information Industry Surveys (S&P NetAdvantage) Trade Associations Analyst Reports (MultexNet) Target Lists (D&B Million Dollar Directory) International Target Lists (D&B Million Dollar Directory) Industry Central |
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Country Profiles IMF Staff Country Reports Global Holidays World Bank Country Profiles |
Economic Information Foreign Exchange Rates (Factiva) Interest Rates/Market Indices Europa GDP Economic Analysis (Oxford Analytica) World Development Indicators |
Benchmarking perspective
Ratios, such as liquidity, activity, profitability could be benchmarked against competitors or industry aggregated data to help auditors detect risk. For example, comparison of sales and accounts receivable (e.g., Days Sales Outstanding or accounts receivable as a percentage of sales) over time, compared to competitors or industry data, could indicate problems with revenue recognition if sales are growing faster than accounts receivable or, vice versa, valuation of accounts receivable if accounts receivable is growing faster than sales.
Benchmarking provides an external perspective for enhancing the value of analytical procedures at key stages of the audit such as:
- understanding the business
- preliminary analytics
- substantive analytics
- overall conclusion analytics
- client communications
Understanding the business. Obtain an understanding of the business and the industries in which it operates, before we can begin to develop expectations and set thresholds for analytical procedures. Using appropriate knowledge sources, we can develop our own point of view of the business risks facing the company, understand the company’s strategy, and identify key performance indicators, and key value drivers.
- Factiva—With comprehensive search capabilities covering nearly 8,000 sources, access articles and press releases on our entity, its industry and its competitors. Additionally, Factiva allows to access company and industry reports from Wall Street analysts and company reports from Media General.
- Global Best Practices® (GBP)—Uses the Business Analysis Framework (BAF) as a roadmap to Process Appraisal Tools, Internal Control Assessment Primers and Process Maps to help develop an understanding of the business and its key business processes.
- S&P NetAdvantage (S&P)—For United States publicly-held companies, obtain 5 page Stock Reports that include a summary of the company’s business, valuation estimates, sub-industry outlook, and a list of the company’s peers. S&P also contains 52 US Industry Surveys to help understand the company’s industry, including industry-specific key performance indicators.
Risk assessment analytics. The use of external information for performing preliminary analytics will significantly increase the rigor and value of the analytics. This use of knowledge sources external to the company in this process allows for reliable and comprehensive analysis and a more risk-focused and efficient audit approach.
- iDataPlatform—For publicly-held companies, use iDataPlatform to locate SEC filings and identify the company’s peers. Use the data from these peers in the Benchmarking Assistant to develop expectations and thresholds.
- Factiva—Apply the information from company-specific and industry reports for the company and its competitors to develop expectations and thresholds.
- S&P NetAdvantage (S&P)—Use the information from Stock Reports and Industry Surveys for a US company and its peers to develop expectations and thresholds.
Substantive analytics. The use of external knowledge sources when developing expectations and setting thresholds for substantive analytics results in stronger audit evidence that account balances and classes of transactions are fairly stated and allows for the identification of potential misstatements in account balances.
- Global Best Practices® (GBP)—obtain benchmark datasets in the areas of cost, quality and time for key business processes for the company’s peers on the basis of industry, size and/or geography. Apply this data to develop expectations and thresholds.
Overall conclusion analytics. The use of external knowledge sources for performing overall conclusion analytics allows for a more thorough assessment of the propriety of audit conclusions reached and evaluation of the overall financial statement presentation.
- iDataPlatform Benchmarking Assistant—For companies with SEC-registered competitors, perform a benchmark analysis for the company against its peers using the Benchmarking Assistant to help assess conclusions formed during the audit on individual financial statement components and the reasonableness of the financial statements taken as a whole.
Client communications. During the performance of analytical procedures, we may identify performance gaps between the company and its peers. This is particularly true when using external knowledge sources, such as benchmarking tools, industry reports and competitor data. These performance gaps represent potential areas for improvement where we can add value to our clients. Certain knowledge sources contain resources that allow us to translate performance gaps into significant recommendations.
Global Best Practices® (GBP)—GBP contains a wealth of tools designed to assist the company identify performance gaps and implement best practices. GBP’s Process Appraisal Tools assess individual processes to determine whether the company is aligned with best practices. The Internal Controls Assessment Primers help to evaluate the strength of a company’s internal controls environment for commonly recognized control objectives for a company. Best practice tools, recommendations, and other resources are organized by the Process Classification Framework and the Business Analysis Framework, allowing us to navigate and access information throughout the value chain.
Practical tips. Here are some practical steps that can be followed to facilitate adding an external perspective to analytical procedures.
- Determine the scope of our benchmarking. Based on the understanding we have obtained of our client’s Market Overview, Strategy, Value Creating Activities and Financial Performance, identify those areas where gaining an external perspective would be beneficial to performing analytical procedures. For example, if Customers is a value driver whose relative level of importance is high to our client, and our client is experiencing difficult market conditions, this might be an area where we would like to gain an external perspective.
Identify the business activities that drive our area of scope. In the above example, some of the activities that drive issues surrounding customers might include:
- Customer acquisition
- Customer retention
- Sales growth
- Selling and marketing activities
- Credit and collection activities
- Determine the key performance measures that capture the business activities. Again, following the above example, some of the performance measures that we might want to benchmark include:
- Average sale per customer
- Percentage of customers retained
- Number of new customers per year
- Average sales growth rate
- Sales and marketing costs as a percentage of sales
- Credit and collection costs as a percentage of sales
- Accounts receivable as a percentage of sales
- Days sales outstanding
- Accounts receivable turnover
- Perform the benchmark analysis:
- Select a comparison group.
EdgarScan’s Benchmark Assistant will automatically identify peers/competitors based on the SIC (Standard Industrial Classification) codes for US registered companies only. S&P NetAdvantage identifies peers using a proprietary S&P classification scheme. Factiva Company Quick Search lists companies identified as competitors and S&P provides the analysis and opinions of analysts for the industry. It will be helpful to ask the entity who their most comparable peers/competitors are.
Most entities have identified peer groups for management comparisons of operating data, and may even use different peer groups for different metrics—e.g., local companies for employee data, and national/global companies for customer data, depending on where and how they compete for people and customers.
Global Best Practices® will provide disaggregated industry/geography data for global companies for primarily operational measures, such as those highlighted above.
- Perform the comparisons. A variety of tools exist to facilitate analysis of the data. Many of these tools consist of downloads or exports into MS Word or Excel. However there are also a number of tools, such as iDataPlatform Benchmarking Assistant and Global Best Practices® that provide for on-line analysis.
Interpret the results. Including external information in analytical procedures is helpful in understanding our client’s relative position against peers, competitors and the industry and it is also helpful in identifying potential risk areas. This improved context will enhance the reliability of the underlying data of our analytics and our ability to “form a point of view,” develop expectations and evaluate other analytical procedures we perform.
Where significant differences exist between the entity’s trends and ratios and the trends and ratios of peers and competitors, further investigation is warranted. The nature of the investigation will depend on the comparability of the entity to peers and competitors, the precision of the expectation, and the purpose of the analytical procedure (i.e., attention-directing or obtaining evidence).
Use of benchmarking in analytical procedures
Benchmarking in analytical procedures
Benchmarking can play an important role in analytical procedures, primarily in steps 1 and 4. Both the stage of the audit and professional judgment can have a significant affect on the approach to using benchmarking. The following details the benefits of using benchmarking in steps 1 and 4:
Develop an expectation
Develop expectations by identifying plausible relationships that are reasonably expected to exist based on our knowledge of the entity, business, industry, trends, or other accounts. By considering industry and comparison group data during the expectations stage of analytics, we can develop better, more detailed knowledge necessary to increase the precision of expectations. In return, we achieve our audit objectives more effectively and efficiently.
Investigate significant differences and draw conclusions
Differences between expectations and actual results indicate an increased likelihood of misstatements. The greater the degree of precision, the greater will be the likelihood that the difference is a misstatement. By analyzing industry and comparison group data during the investigation and conclusion stage of analytics, we can more effectively understand and/or corroborate the differences. Again, this leads to achieving our audit objectives in a more effective and efficient way.
Benchmarking data availability
Identifying high quality benchmark data generally requires the following:
- Understand the factors impacting the availability of data.
- Determine the uniqueness of those factors and decide whether appropriate benchmark data may be available in other regions, territories, industries, etc.
- Identify sources of benchmark data and assess the costs/benefit of obtaining the benchmark data.
- Consider the likelihood that we can overcome any dissimilarity in the expectations setting phase of the analytical procedure. Further, consider the effect on the effectiveness and efficiency of achieving our audit objectives.
- As necessary, consult with the engagement leader and/or team manager before proceeding.
Generally, benchmark data availability issues are overcome by performing broader searches for data. Adjustments to expectations may need to be made to recognize differences between the company’s data and the benchmark data. The potential effectiveness (precision and rigor) of an analytical procedure and the degree of reliance that can be placed on the procedure is directly affected by the quality of the expectation that is developed.
If fundamental differences between company and benchmark data are too significant to make broad benchmark data comparisons, consider the feasibility of individual benchmarks, such as:
- Benchmark significant operational measures. For example, the government heavily subsidizes a company and the company’s operations are unique within the country. Consider benchmarking inventory turns against a similar company in another Territory.
- Benchmark significant financial measures. For example, an asset-intensive manufacturing company operates in a highly dissimilar region of a Territory with no direct competitors. Consider benchmarking cost of capital to another asset-intensive manufacturing company in the region.
- Industry association reports or public company reports from similar companies, from another Territory that comment on the global market for the company’s products.
Factors impacting the availability of benchmark data
Publicly accessible financial benchmark data may not be available in many circumstances. The following factors may impact the availability of benchmark data:
- Industry Specific:
- Few public companies.
- Private companies are not required to publicly file financial information, or they do not comply with requirements to file publicly.
- Company Specific:
- Significantly smaller or larger operations than competitors.
- Operating as a monopoly.
- Vertical or horizontal integration or degree of control over the supply chain that is different than competitors.
- Significant inter- or intra-company transfer pricing issues.
- Minimisation of tax-liability versus shareholder profit maximization.
- Unique line of business within the Territory.
- Industry not represented by an industry association or group within the Territory.
- Company operates in a region of a Territory that has factors (i.e. social, economic, governmental, or legal) that make it dissimilar from Competitors in the remainder of the Territory.
While additional effort may be required to obtain benchmark data, the benefits of using such data in analytical procedures may be substantial and are carefully considered.