Stand tall: a benchmarking analysis can help you increase your company's value

Comparing your company's key performance indicators against those of industry peers, known as benchmarking, produces valuable information to help you improve your company's financial performance and increase its value.

A challenge of effective benchmarking is using the right comparison with the right information. For example, companies often benchmark profitability indicators, such as margins or return on investment. A company's profitability indicators might portray it in a favorable light compared with its industry peers, but if those profits aren't being converted to cash, then the company's value might not be as good as its peers. In this case, the better indicator of a company's value might be free cash flow.

Benchmarking can be done against other companies within an industry, as well as across industries. For example, if a company that processes insurance claims has 200 offices nationwide, it may want to compare itself with businesses in the retail industry because they face similar challenges of managing multi-office or multi-store businesses.

WHY MEASURE VALUE?

Company value has an impact on public and private companies in areas such as:

Access to capital. The greater the value of your company, the greater return to the debt or equity investor, which should make additional sources of capital available to help meet growth or investment needs.

Cost of capital. Companies with greater value benefit in a competitive market from a lower cost of obtaining capital.

Exit value. The ultimate realization of value will be upon exit. Whether this is through a sale of the company, a public offering or succession plan, owners want to maximize their exit value.

While the concept of maximizing value is similar for public and private companies, determining the value is different. Value ultimately is determined by others.

For public companies, value is determined by financial analysts, institutional investors and others. For private companies, value is determined by financial institutions, individual investors and potential buyers.

The one thing those valuing public and private companies have in common, though, is that they need information about the company to do it. This is where benchmarking comes into play--but only if care is taken to find the appropriate company or information to benchmark.

A BENCHMARKING CASE STUDY

The CEO of a company that manufactures tribbles knows his competitor across town can sell the same tribble for 10 percent less. As a result, his company is losing market share and needs to decide on a course of action.

An immediate, but quickly rejected option is to drop the selling price by 10 percent. The CEO realizes that by only dropping the price, the company's profits will shrink and that will be unacceptable to the owners and stakeholders.

The CEO then identifies three key questions that need to be answered:

Are the company's costs properly controlled and in line with the cost structures of others in the industry?

Is the company's investment in working capital and plant and equipment comparable to its competitors?

Is the company's capital structure--the balance between the owners' investment and external borrowing--providing the best way to finance net investments?

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The CEO needs to direct corrective efforts at the right problem. For example, if the company's costs are the lowest in the industry, there wouldn't be much point in a cost-cutting program.

Benchmarking can help the CEO decide where to focus the company's efforts.

THE BENCHMARKING PROCESS

Step 1: Focus the scope of the analysis. In our example, the CEO identified three areas of focus: costs, net investment and capital.

Step 2: Understand the business drivers--those business activities that drive costs, investment and capital. Some of those activities might be:

Costs: Production, management of material labor and overhead costs; inventory management; control over general and administrative costs; managing the cost of capital; and tax management.

Net investment: Control over key items of working capital, such as accounts receivable, inventory and accounts payable; strategic decisions to invest in plant and equipment; and acquisitions of a business.

Capital: Borrowings and repayments of debt; equity infusions; and distributions to owners.

Step 3: Select the key performance indicators for each focus area that will be compared. Those might include:

Costs: Material, labor and overhead costs as a percent of sales; inventory turnover; selling, general and administrative costs; interest cost as a percent of sales; and effective tax rate.

Net investment: Accounts receivable, inventory and plant and equipment as a percent of sales; days sales outstanding; current asset turnover; working capital turnover; plant and equipment turnover; and return on net investment.

Capital: Leverage; debt to total assets; interest coverage; and operating cash flow to debt service.

Step 4: Collect the data to be used in the analysis.

For the company in our example, the CFO or controller can calculate the ratios for the current and one or more prior periods. The challenge is finding external data to compare performance.

Data for public companies is easy to obtain using EDGAR. Finding data for private companies is more difficult, but there are a number of subscription services available, including BenchmarkReport, IntegraInfo, ProfitCents, RMA and PricewaterhouseCoopers' AMMBIT.

In selecting comparables, consider the source of the data, the depth of the industries it covers, the quality control over the data, whether it reports in averages or quartiles and whether it includes the key performance indicators needed for the analysis.

Step 5: Calculate the difference and identify performance gaps.

Using the performance indicators above, the CFO or controller can identify whether any performance gaps exist between the company and its peers. But it's not enough to identify the gaps; understanding the reasons for the gaps is important.

Let's say that in our example, the most significant performance gap was that the company's inventory turnover was 2.5 times per year, but the peer group's was 6 times per year.

This causes the company to have far more of its resources invested in inventory, which requires a greater amount of capital (either debt or equity), results in a higher cost of capital and lower profitability and prevents it from reducing the sales price and becoming more competitive in the market.

To understand why the company's inventory turnover is so far below the peer group, the company needs to:

* Map its processes throughout the inventory cycle, from sales forecasting to purchasing to production to shipping.

* Compare its processes to "best practices," which are not necessarily industry-specific. For example, a best practice for managing inventory might not exist with tribble manufacturers, but within the aerospace industry.

* Identify processes to implement, modify or remove.

Step 6: Take corrective action.

In this example, the CEO might consider implementing such best practices as leveraging economies of scale and supplier relationships; seeking just-in-time delivery; or consolidating warehousing operations. You can find more at www.ammbit.com.

Step 7: Recalibrate and do it again.

Benchmarking is a tool for continuous improvement. The CEO will need to monitor progress toward company goals by comparing actual performance to the targets, recalibrating against peer groups and identifying areas for further improvement.

DETERMINING WHAT TO DISCLOSE

The concept of corporate transparency calls for companies to integrate financial and nonfinancial information to communicate to investors and others a more complete view of the enterprise, from marketplace opportunities and strategies, to the elements that create value in an organization and its financial outcomes.

Though public companies must adhere to strict rules and regulations about what information must be reported, no such regulations exist for private companies.

PricewaterhouseCoopers conducted a capital market surveys in nearly 20 different industries to identify the type of information, or value drivers, the market would like to see disclosed. Surveys were sent to company executives, sell-side analysts and institutional investors. Here's a summary of the key value drivers identified for selected industries:

Diversified Manufacturing: Product development cycle time; employee turnover; revenue from new products; sales and marketing costs; capacity utilization; product quality; and average age of plant.

Entertainment and Media: Customer demographics; employee turnover; backlog revenue; future revenue stream from existing asset base; revenue by product type; operating costs by product type; cash flow by product type.

Technology: Employee turnover; employee acquisition costs; revenue per employee; customer retention; product development cycle time; revenue from new products; new product success rate; brand development costs; licensing revenue of total revenue; and inventory write-downs.

Information/Communication: Customer churn rate; costs per gross additional customer; employee turnover; revenue by product type; operating costs by product type; and cash flow by product type.

So, no matter what your industry may be, there are performance indicators you can use to compare yourself against your peers and see where you stand.

BY BRADLEY J. ALLEN, CPA

Bradley J. Allen, CPA is a partner with PricewaterhouseCoopers LLP. You can reach him at bradley.j.allen@us.pwc.com.

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