How to Benchmark Financial Ratios

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Financial ratios allows shareholders to assess how well the CEO manages the firm.
Financial ratios allows shareholders to assess how well the CEO manages the firm. (Image: Jupiterimages/Goodshoot/Getty Images)

Financial ratios are among the most important measures by which the success of a business is determined. Financial ratios are relative magnitudes of two financial values, typically taken form the company's balance sheet or the income statement, also known as the profit and loss statement. In order to know whether a company does well or is under-performing, however, it is not enough to look only at the absolute values of its financial ratios. What you need to do is to benchmark, or compare, its financial ratios with the same ratios of companies operating in the same industry.

Determine the financial ratios you need to benchmark. The ratios you need to analyze depend on the objective of your analysis. For example, if you need to analyze whether to buy or sell the company's shares, you need to pay attention to the price-to-earnings ratio, price-to-sales ratio and the dividend yield.

Determine how to calculate the financial ratios you need to benchmark. For instance, if you need to calculate the price-to-earnings ratio, divide the company's price per share by the earnings per share value. To determine the firm's price-to-sales ratio, divide the price per share by the sales per share number. The dividend yield can be calculated by dividing the annual dividend per share by the stock price per share.

Collect the data and spread the financial ratios of the company you want to analyze and the key market players of its industry on a spreadsheet, such as Microsoft Excel. The possible sources of data can include firms' press releases, industry research data--supplied by Bloomberg or Reuters, for example--and annual and quarterly reports to shareholders filed with the U.S. Securities and Exchange Commission (SEC).

Calculate the averages as well as the highest and the lowest values of the financial ratios across the firms of the industry in which the company you need to analyze operates. For example, if you are analyzing whether to buy or sell the shares of McDonald's, calculate the average, the lowest and the highest values of the financial ratios of all major fast-food restaurant chains, such as Wendy's, Pizza Hut or the KFC.

Compare the financial ratios of the company you are analyzing against the averages and financial ratios of the the worst and best performers, calculated in Step 4. For example, if McDonald's outperforms its competitors in terms of the the price-to-earnings ratio, price-to-sales ratio and the dividend yield, then it appears to be a good "buy."

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