The financial characteristics of an industry are closely related to that industry’s production process, marketing activities, and financial practices and customs. The characteristics of a company in the wholesale business may depend on large inventories but little long-term plant and equipment. The reverse would be true for an electric utility, which would be characterized by a very low asset-turnover ratio but a better profit margin. Many manufacturing companies would fall between the extremes of a utility and a merchandising firm.
For example, the following major differences between retail food stores and a basic chemical manufacturing business might help understand the characteristics of two different industries.
Manufacturing is more capital intensive, with owned fixed assets comprising a high proportion of total assets. Thus, there are more assets to be depreciated. In addition, many smaller retail stores lease their buildings for periods that do not require the leases to be capitalized. This leads to less depreciation and more rental payments.
Long-term leases are often capitalized, however, so that the lease obligation will appear as long-term debt with a corresponding figure in the fixed-asset account. Retail chains with large stores generally sign long-term leases.
2. Current Ratio:
Retailers usually do not carry accounts receivable because their customers pay cash or use credit cards, but accounts receivable is a significant item in the current assets of a manufacturing firm. Thus, retail stores may have lower current ratios than manufacturing firms. Because of the high proportion of inventory in a retailer’s current assets, its acid test ratio also may be worse than a manufacturer’s.
3. Net Sales to Net Working Capital:
Net working capital in this context means current assets minus current liabilities. The retail food store turns its inventory (sales / average inventory) much more rapidly than a manufacturing firm — and even than a furniture store.
This, coupled with no receivables, leads to a much higher working-capital turn. If the manufacturing company had used LIFO for many years to calculate its inventory, however, the low valuation of the inventory might create an artificially high working-capital turnover. It would therefore not be a useful number to use in estimating increases in working capital that would be needed to support increases in sales.
4. Net Profit Before Tax:
The manufacturing company turns its assets (sales / assets) fewer times in a period than the retailing company does. Therefore, to earn an adequate return on assets employed, the manufacturing company needs to earn more profit as a percentage of sales than the retailing company.
5. Net Income to Net Worth:
Retail food stores, despite a much lower profit margin on sales, can have a higher return on net worth because they have a higher proportion of debt compared with equity and also a higher turnover of assets.
These industry comparisons illustrate the dangers of trying to apply universally accepted ratios. Each industry has its own characteristics that can affect ratios significantly. With practice in analyzing various industries, the analyst will become familiar with industry characteristics and interpret a company’s financial ratios in the proper context.
The Risk Management Association publishes the Annual Statement Studies: Financial Ratio Benchmarks, which provides ratio data by performance quartiles for a wide range of industries. Commercial banks use this information and may make the book available to customers. BB&T Bank, for example, offers small business owners a compact disk that contains performance data for similar businesses.