Ratio Analysis and Industry Benchmarking Reveal Hidden Messages in Your Financial Statements
By themselves, financial statements provide limited insight into a manufacturer’s performance. To get a clearer picture of what is really occurring, there must be a relevant basis of comparison. Financial ratios and industry benchmarks provide management with the tools to identify strengths and weaknesses. This article examines several ratios that can uncover new insights to your business.
Which Ratios Should You Focus On?
Financial ratios are calculated by comparing two or more items on your balance sheet or income statement. While this can be done in a variety of ways, manufacturers tend to use certain ratios more often than others.
For example, the debt to assets ratio is calculated by dividing your total debt by total assets. A high ratio results from increased levels of debt. This ratio will likely be taken into consideration by a financial institution when you apply for a business loan. A ratio of 1 to 2, or 50%, will communicate that you are a reliable applicant with manageable debt. By keeping this ratio low, you will be provided greater financial flexibility.
The return on assets (ROA) ratio provides insight into how much profit you are generating for each dollar you have invested in total assets. This ratio is calculated by dividing net income by total assets. A higher ROA is associated with increased efficiency. This efficiency means you are able to earn more money on less of an investment.
Below are some additional ratios that provide helpful insight into operations:
- Current Ratio (current assets divided by current liabilities) — This ratio measures your ability to pay short-term obligations. It will let users of your financial statements know your ability to turn products into cash. As the ratio increases, so does your capability to cover your obligations. A ratio of 2 to 1 is generally preferred.
- Quick Ratio (current assets minus inventory, then divided by current liabilities) — By excluding inventory from current assets, this ratio gives insight to your liquidity. The higher the quick ratio, the better your liquidity position. A ratio of 1 to 1 is usually satisfactory. This means that you have $1 in liquid assets to pay $1 in short-term obligations.
- Sales to Inventory Ratio (annual sales divided by inventory) — This ratio can also be called inventory turnover and communicates how many times your inventory was sold and replaced over a period. A low turnover implies poor sales which results in excess inventory. You should compare your ratio against industry averages.
- Times Interest Earned Ratio (net earnings before interest and tax divided by interest expense) — This ratio reflects your company’s ability to meet interest expense obligations from earnings from operations. It is typically a warning sign if this ratio drops below 2.5.
How Do You Measure Up?
In addition to measuring the progress of your business over a certain period and unearthing trends and problems, benchmarking is useful. It presents a clearer view of where your manufacturing company stands in relation to your competitors.
Trade associations, such as the National Association of Manufacturers, provide up-to-date financial figures that can be used for benchmarking. These figures include industry averages for rent, utilities, materials costs and employee compensation. Trade journals, as well as the U.S. Department of Labor, can also be helpful sources for relevant financial statistics.
To find the applicable industry statistics, you will need to know your specific industry segment’s North American Industry Classification System (NAICS) code. Find your NAICS code by visiting the U.S. Census Bureau website.
What is the Upside of Benchmarking?
Benchmarking offers several benefits. First, it gauges your financial strength by comparing it to past company performance and industry averages. This allows your management team to gain insight into which goals the company has achieved and where it has fallen short, providing tangible ratios for your reference.
Benchmarking also puts your financial operations under a magnifying glass. A close-up view brings to light small problems that could affect your company’s overall financial well-being. It is important to catch undesired trends in the beginning stages. Early detection of these trends will allow you to make the necessary changes to your operations before it becomes unmanageable.
How Can You Avoid Potential Pitfalls?
However, calculating and evaluating these ratios can be time-consuming. Also, inaccuracy in financial information can provide misleading statistics and these incorrect figures may lead to knee-jerk responses. Before reacting to undesirable ratios, be sure to spend time evaluating the information used in the calculation.
Finding the Right Fit
Every manufacturing operation is unique. The generalized benchmarks discussed here are for a typical manufacturer. A financial advisor who specializes in manufacturing and distribution can provide customized guidelines that will fit your manufacturing specialty and company’s size.
If you work with your financial advisor to analyze your company’s financial ratios on a regular basis, your benchmarking efforts are more likely to be meaningful and reliable.
If you need assistance analyzing your financial statements or would like to discuss the topic further, contact Amy Jackson at 312.670.7444.
Manufacturing Contracts Face New Section 199 Rules
KEN TORNHEIM, CPA, CFE
The IRS issued new eligibility guidelines last year that attempt to clarify which companies are eligible for the manufacturers’ deduction under Section 199 of the tax code when multiple parties manufacture a product. Contractual manufacturing arrangements have historically been the source of much confusion when it comes to this deduction. This article explains the deduction and how the new guidelines are intended to make it easier for manufacturers to comply with its requirements.
How the Deduction Works
The manufacturers’ deduction — also known as the Sec. 199 or domestic production activities deduction — allows a federal income tax deduction when manufacturers derive income from selling, leasing or renting items made in the United States, as well as from unrelated energy and motion picture production. This deduction equals 9% of the lesser of a business’s qualified production activities income (QPAI) or its taxable income (or adjusted gross income for individuals, estates and trusts). Also, the deduction cannot exceed 50% of W-2 wages paid to the manufacturer’s employees.
For most domestic manufacturers, QPAI usually equals taxable income. Products manufactured entirely outside the United States, as well as leasing or licensing activities to a related party, typically are not eligible for the manufacturers’ deduction.
You may, however, qualify for the deduction if your products are partially produced in the United States. Safe harbor rules allow a deduction if at least 20% of a product’s total costs result from domestically incurred direct labor and overhead costs incurred domestically.
Why New Guidelines Were Needed
A lack of specificity in the law and the complexity of the contractual agreements make it difficult to determine exactly who is eligible for the deduction. In July 2013, the IRS issued new guidelines for tax examiners to use when determining manufacturers’ deduction eligibility for manufacturing contracts that involve unrelated parties.
Only one taxpayer may claim the deduction for a qualifying activity performed with respect to a qualifying property. But sometimes multiple manufacturers work on the same product. Tax regulations provide that, if more than one taxpayer performs a qualifying activity pursuant to a contract with another, only the taxpayer with the “benefits and burdens of ownership” will be treated as the producer and, therefore, be eligible for the deduction.
For example, a medical device manufacturer might source components from three dozen different suppliers for its line of replacement knees and hips. Here, the company that markets the final product is considered the producer for tax purposes. Consequently, the company is eligible for the manufacturers’ deduction — because it assembles the medical devices, takes legal liability for any defects and pays taxes on the proceeds of the finished products.
What to Expect During an IRS Examination
The IRS decided its nine-part “benefits and burdens” test was impractical, overly complicated and costly for manufacturers and the tax agency, so it modified the requirements. When deciding who is eligible for the manufacturers’ deduction under the new guidelines, IRS examiners will request three documents:
- A statement that explains the basis for the taxpayer’s determination that it had the benefits and burdens of ownership in the year(s) under examination;
- A certification statement signed by the taxpayer; and
- A certification statement signed by the counterparty.
These three statements are required for each manufacturing contract and cannot be amended during the life of the contract.
Manufacturers and their counterparties have 30 days to respond to IRS requests. Those who fail to provide the required forms are likely to undergo further IRS scrutiny — and may be ineligible for tax savings under Sec. 199.
How to Minimize IRS Scrutiny and Maximize Eligibility
If you enter into contractual manufacturing arrangements, do not automatically assume you are eligible for the manufacturers’ deduction. Before contracting with another entity, discuss who will legitimately possess the benefits and burdens of ownership for a qualifying activity performed under the contract and make sure everyone is willing to complete the requisite paperwork.
Will Expanded Section 179 Expensing Go Away in 2014?
A tax incentive designed to encourage companies to invest in new equipment and other fixed assets, Section 179 expensing, was reduced sharply effective January 1, 2014. As of this writing, Congress has yet to extend the enhancements.
Fixed assets are generally capitalized and depreciated over their useful lives, which can be up to 39 years. But Sec. 179 allows businesses to immediately deduct a certain amount of qualifying purchases for federal income tax purposes. Expanded Sec. 179 expensing has saved manufacturers significant taxes in recent years.
A wide variety of assets qualify for Sec. 179 expensing, including machines, large tools, heavy-duty vehicles, computers, software and office furniture. Purchases and leases of both new and used equipment that are put into service before December 31 are typically eligible.
For 2010 through 2013, the Sec. 179 expensing limit was $500,000, phasing out by $1 for every dollar of expense beyond $2 million. On January 1, 2014, these limits dropped dramatically, to $25,000 and $200,000 respectively. So, manufacturers that have become accustomed to this tax incentive may want to set aside additional funds for their year-end tax obligations.
However, many consider it likely that Congress will extend the 2013 limits, or at least make some sort of increase to the 2014 amounts, retroactive to January 1, 2014. In fact, it may have even happened by the time you are reading this. Check with your financial advisor for the latest information on Sec. 179 expensing.
If you have questions or would like to further discuss how these new rules may affect you, contact Ken Tornheim at [email protected] or call him at 312.670.7444.