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Industry Ratio Analysis: Definition and Types
What is Industry Ratio Analysis?
In order to check the financial condition of a firm, the financial health of the firm may be compared with the other players in the industry. It gives an insight into the company’s performance vis-a-vis its competitors. The performance of a company may look very impressive when checked alone, but the overall quality of performance may be weak when its peers are considered. Therefore, financial ratios can be used to compare the overall performance in order to rank the company’s growth, profitability, and progress.
Types of Industry Ratio Analysis
Here are the most commonly used financial ratios types involved in industry ratio analysis:
Quick Ratio
Quick Ratio, also known as the ‘Acid Test’ ratio, offers a glimpse into the overall performance of a firm. It is given by the company’s total current liabilities into the cash and cash equivalents, and then deducting the inventory. The ratio is then formed by the value obtained above divided by current liabilities.
So, the Quick ratio will be given by −
$$\mathrm{Quick\: Ratio\:=\:\frac{Current \:Assets\:-\:Inventories}{Current\: Liabilities}}$$
Many organizations work below an average quick ratio of 1.0.
For example, the average for computer components is 0.33.
Inventory Turnover
Inventory Turnover shows how many times do the stocks of a product are cleared within a given timeframe. Therefore, we must concentrate on the number the inventory that is filled and cleared. A higher turnover is considered better. However, the number of changes may depend on the industry.
Example − A retail shop should have a turnover every 6.5 years whereas a computer component industry should have a turnover of 47 times on average in a year. Restaurants, on the other hand, have to deal with spoilage, so their inventory turnover figure should be near 26 or so.
Return on Sales
Return on sales is yet another tool for companies to judge their performance. It is defined as the amount of money required to gain profit.
Example − In the US, the amount of every dollar taken to turn into profit will be called the Return on Sales. For the retail stores which have a very thin margin of profit, the return on sale return stands around 3.4 percent. For a computer design firm, the average RoS figure is around 8.2 percent. The RoS value for manufacturers and restaurants are 7.8 and 7.7 percent, respectively.
Rent on Sales
This financial ratio shows the income per unit location of the manufacturing location. To calculate, one must divide the annual rent by the annual sales of the company. This figure also differs from one industry to another.
Example − The manufacturers and computer design firms have a Rent on Sales of 2.1 and 1.9 percent, respectively whereas restaurants and retailers average about 7.1 and 1.0 percent, respectively.
Conclusion
It is notable that the financial ratios that offer a comparative view of performances are a great tool for the companies to understand the relative profitability and growth of their own firm. As mentioned previously, looking at one's own performance without comparing it with peers may offer a wrong attitude toward the financial health of a company. That is why the companies look at the mentioned financial ratios to stay in safe waters in terms of finance and investments.
As is obvious, firms that follow the given mandate offered by these ratios can stay ahead and progress in their financial basics. Firms that don’t rely on Industry Ratios are often left at sea when it needs a fact-based solution. That is why the industry ratios are a great companion for owners and managers of a firm.
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