Many companies today rely on key performance indicators (KPI's) to gauge how effectively they are meeting various key business objectives. Tactical in nature, KPI's can be either lagging or leading indicators on a company’s performance. Some lagging indicators simply tell you how you performed and have little to no value in predicting future performance. (Examples include measuring working capital, sales growth, gross and net profit margins.) Leading KPI's offer guidance on future results, such as customer satisfaction or manufacturing quality control like Six Sigma.
But KPI's by definition only measure the performance of a company against itself, such as comparing one month to the next, thereby often failing to effect any positive change. Too often, KPI's become static within an organization over time and are glanced over by management.
Another option to evaluate performance is benchmarking, which compares a company’s performance against some form of standard, usually industry top performers. Marketing teams do this all the time: measuring market share or comparing product features or pricing models to that of the competition. In computer technology, benchmarking has been used for decades to compare one computer’s processing power to another.
In running any business there are always risks. The known risks can be dealt with. It’s the unknown factors that can adversely affect your company. Benchmarking helps identify unknown financial factors affecting your company that you won’t find through KPIs or analyzing your financial statements.
How Benchmarking Can Close Performance Gaps
Let’s look at two examples.
Example 1: An Underperforming Business Services Company
Recently, a private equity firm benchmarked an ostensibly underperforming business services company which they were considering acquiring. The PE firm wanted to know: What could be done with the company in a highly competitive market?
Based on sales, this business services company was operating in the top 10% of the industry of over 5,200 companies. Yet, the overall financial health of the company showed it to be operating in the median 50% of the industry. Closer examination against 35 same-size companies in the industry revealed that the company was operating with a COGS (cost of goods sold) 39% higher than their peers. Both the gross profit and EBITDA were 47% and 40% lower, respectively,
Just to close the performance gap (i.e., match industry peers operating in the middle 50% of the industry, the company would have to increase their prices substantially to move from a 20% gross margin to 46.8%.
Looking further into the company compared to its peers revealed the heart of the issue: the business model was based on outsourcing its services, contrary to how the rest of the industry was operating. The higher cost structure represented a real risk to the company and its ability to compete and grow.
Example 2: A $22 Million Plastics Manufacturing Company
Another analysis was performed on a $22 million plastics manufacturing company that needed to improve its liquidity position.
Based on sales, the company was in the top 25% of an industry consisting of 2,881 peers and competitors. The benchmarking analysis then honed the comparison down to 112 companies with sales between $18 million and $26 million.
Overall, the company’s financial health was in the industry’s bottom 25% — even though the quick and current ratio for the company showed it in the top 87% of the industry. Operational performance as measured by both inventory age (132 days) and collection period (51 days) were in the bottom 10% of the industry.
Clearly the company’s sales performance was not matching the industry’s operational performance. By closing the gap to match the top 25% of the industry in inventory age (25 days) and collection period (21 days), the company would be able to increase its liquidity by $5.5 million. If it went even further to match the performance of the top 10% of the industry, the company could increase its liquidity by an additional $2 million.
Benchmarking helps a business better compete against best-in-class competitors, who may operate with better profit margins and costs structures, utilize assets better for improved liquidity, and enjoy a competitive edge with higher valuations. Benchmarking helps you identify your business’s performance gaps and provides a roadmap to close these gaps, resulting in better positioning and higher exit valuations.
If you are already in a sale process, you may not be in a position to take action on some more complex or time-intensive areas. But benchmarking can help better position your company with a potential buyer, by providing transparency into opportunities to positively impact the company’s financial dynamics.
Benchmarking enables you to look at factors like:
Valuation: One of the first steps in moving to an exit is understanding the company’s valuation. Too often valuations are based on looking at previously sold companies, which are often apples-to-oranges comparisons with a limited sample rate. Benchmarking compares your financial performance to your industry peers, using a relatively large sample rate for accuracy.
Financial Health: Benchmarking also identifies a company’s overall financial health across a company’s liquidity, profitability, and growth. Just looking at a quick ratio (current assets / current liabilities) provides an overall guideline, but how does it compare to your competition? A quick ratio of 1.36 would generally be viewed as good, but in one industry it’s representative of performing at the bottom 10%.
Risk: Benchmarking cuts to the chase to define, identify, and measure areas of risk and the financial impact on the company, too often unknown to management. The management company at one manufacturing firm considered having 120 days of inventory the norm, while the industry’s best companies were operating with 10 days. This represented a financial risk and impact to the company of over $4 million.
If you are looking at an exit several years from now, benchmarking should be incorporated into your analytical DNA. It gives you a better understanding on the performance gaps and provides a target on how much improvement is need to operate at peak performance. Based on benchmarking results, strategies and action plans can be developed to close gaps. Moving from 120 days to 10 days of inventory, for example, is a goal that can be measured and the progress monitored.
The job of analytics is to provide information to management to make better informed decisions to improve the performance of a company. KPI's provide useful tactical information for daily business operations. Benchmarking provides the data and tools to drive a company to peak operating performance in the long-term, better positioning the company for an exit with a resulting higher valuation.
By Gary Samoluk