Analyzing a company's historical financial ratios and understanding industry benchmarks are a critical resource in advising clients within the distribution industry. Throughout my experience in collaborating with companies, financial ratios have been helpful in analyzing trends, comparing financial performance to peers, and monitoring the results of strategic change.
There are three specific financial ratios that are highly important for distributors to monitor and scrutinize:
- Gross profit percentage (gross profit divided by sales) provides insight on the effectiveness of a company’s procurement and sales departments. It is a common mistake for distributors to focus on gross sales volume without keeping a keen eye on the contribution of the sale. Distributors must understand the contribution of various products being sold, since some contribute more profit than others. Oftentimes products outside of the main deliverable create the most contribution, such as the service and parts department of a car dealer.
- Inventory turnover (cost of goods sold divided by average inventory) measures the number of times stock is sold in a period. Just-in-time inventory may be a goal of distributors but it is often far from the norm, as they tend to buy on incentives offered from the manufacturer versus understanding future customer demand. Maintaining excess inventory levels poses a significant risk for the company's capital. It also creates a major issue with burden rates (the impact on the final cost of the buy) and exposes the company to obsolescence concerns.
- Return on invested capital (net income divided by equity) provides a sense of how well a company is using its money to generate profit. In my experience, this ratio is often overlooked in an owner's assessment of the company. However, it is essential to understand the returns an owner is making on his or her invested capital and to assess the company's ability to leverage debt to operate the business. Depending on the specific sector within the distribution industry, it may be advisable to leverage up the balance sheet of the operating company and to use proceeds that will be invested in other readily accessible options. How is your return on invested capital compared with the significant investment indexes?
When thinking about how these financial ratios play out in your company, it is important to note that benchmarks can vary significantly across the distribution industry. For example, it is not advisable to compare the financial ratios of a food distributor to a lumber wholesaler.
We are in an era of big data in which information overload may create significant stress. My advice is to focus on your company's critical historical financial ratios and to understand the industry trends. This process often provides an opportunity to understand key issues and maximize the owner's returns on corporate assets.
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