Industry-specific ratios and using ratios to forecast

Why do some industries have their own ratios?

Because what matters differs by business. Industry-specific ratios track the drivers generic ratios miss. A retailer needs to know whether sales grew in the stores it already had. A bank needs to show it holds enough capital for the risk it carries. Regulators in sectors such as banking require specific ratios, and early-stage companies that are not yet profitable are often judged on operating metrics.

Any business can also be assessed on risk with the coefficient of variation of operating income : the standard deviation of operating income divided by its average. A higher value means a less predictable income stream, and the same measure can be used on net income or revenue.

$$\text{CV} = \frac{\text{standard deviation}}{\text{average}}$$

Which metric goes with which industry?

The exam asks you to recognize the metric and what it is for. Memorize the ones in this table.

Industry	Metric	What it shows
Banks	Capital adequacy	Capital held against risk-weighted exposure
Banks	Cash reserve ratio	Reserves at the central bank against specified deposits
Banks	Liquid asset requirement	Approved marketable securities against specified deposits
Banks	Net interest margin	Spread earned on interest-earning assets
Retail	Same-store sales	Growth from existing stores, not new openings
Retail	Sales per square meter	How hard the space works
Services	Revenue per employee	Productivity
Hotels	Occupancy rate	Demand against capacity
Hotels	Average daily rate	Price per room sold
Subscriptions	Average revenue per user	Monetization of the user base

Industry metricswhat generic ratios miss

• Business risk
  • Coefficient of variation Know the idea of operating income, net income or revenue
• Banks
  • Capital adequacy Know the idea capital ÷ risk exposure
  • Cash reserve ratio Know the idea reserves ÷ deposits
  • Liquid asset requirement Know the idea securities ÷ deposits
  • Net interest margin Use it net interest income ÷ earning assets
• Retail
  • Same-store sales Use it growth at stores open in both periods
  • Sales per square meter Know the idea
• Services
  • Revenue per employee Know the idea
• Hotels
  • Occupancy rate Use it rooms sold ÷ available
  • Average daily rate Use it room revenue ÷ rooms sold
• Subscriptions
  • Average revenue per user Use it revenue ÷ average users

Banking capital adequacy rules relate the capital a bank must hold to its specific risk exposure, using risk-weighted assets and other measures. The cash reserve ratio and liquid asset requirement show banking liquidity and reflect monetary and regulatory requirements. The bank’s own earnings metric is the net interest margin .

$$\text{NIM} = \frac{\text{net interest income}}{\text{interest-earning assets}}$$

$$\text{Capital adequacy} = \frac{\text{capital}}{\text{risk-weighted assets}}$$

Retailers report same-store sales because total sales growth blends two things: more sales in existing stores, and new stores. Sales per square meter is revenue over selling space. Service firms use revenue per employee and net income per employee.

$$\text{Same-store growth} = \frac{\text{sales at stores open in both periods, this year}}{\text{sales at the same stores, last year}} - 1$$

Hotels use two numbers that are easy to confuse. The occupancy rate measures demand against capacity, and the average daily rate measures price per room that was actually sold. A subscription business uses average revenue per user .

$$\text{Occupancy} = \frac{\text{rooms sold}}{\text{rooms available}}$$

$$\text{ADR} = \frac{\text{room revenue}}{\text{rooms sold}}$$

$$\text{ARPU} = \frac{\text{revenue}}{\text{average number of users}}$$

How do ratios feed a forecast?

Forecasting turns past ratios into assumptions. The results of common-size and ratio analysis are the raw material for a model of future performance.

1. Forecast revenue.
2. Apply expected common-size margins to get costs and profit.
3. Use days ratios to forecast the balance sheet: receivables = days sales outstanding (DSO) × revenue ÷ 365, inventory = days of inventory on hand (DOH) × cost of goods sold (COGS) ÷ 365, payables from purchases.
4. Build pro forma statements from these. Companies use pro forma statements internally for budgets and in presentations to lenders, and a full model is covered in the financial modeling module.

$$\text{Balance} = \frac{\text{days ratio} \times \text{forecast flow}}{365}$$

Why show a range?

A single forecast is almost certainly wrong, so analysts show how results change under different assumptions. Three techniques do that, from simplest to richest.

• Sensitivity analysis (“what if”) changes one assumption at a time and shows the range of outcomes.
• Scenario analysis changes several assumptions together for a defined event, such as losing a customer or a supply source. If the scenarios are exhaustive and have probabilities, you can also compute an expected value.
• Simulation is computer-generated sensitivity or scenario analysis. Each driver is given a probability distribution, and many runs give a distribution of outcomes.

For Sandmere, a sensitivity run on the gross margin alone, at 38% and 42%, gives gross profit of 13,200 × 38% = 5,016 and 13,200 × 42% = 5,544. A scenario would change margin, volumes and working capital days together.

Ratio-based forecast

• Point forecast revenue forecast, then ratios
  • Costs expected common-size margins
  • Working capital days ratios times forecast flows
• Range of outcomes Memorize
  • Sensitivity analysis Memorize one assumption at a time
  • Scenario analysis Memorize several assumptions, one event
  • Simulation Memorize probability models, many runs

Exam tip One input changed is sensitivity. Several inputs changed for one story is a scenario. Probabilities and many runs is a simulation.

Go deeper Why the coefficient of variation is a business-risk measure

Standard deviation alone depends on size, so a large company always looks more volatile in absolute terms. Dividing by the average puts companies on the same footing. A utility with steady earnings has a low CV, a cyclical equipment maker a high one. A high CV also limits how much debt the company can carry, because interest is fixed while operating income swings. The idea is the same as the coefficient of variation in the quantitative methods topic.

Go deeper Simulation in one paragraph

A simulation draws a value for each uncertain driver, such as growth, margin and days of receivables, from a probability distribution that reflects the analyst’s view. It computes earnings for that draw, repeats thousands of times, and reports the spread of results. It is also known as Monte Carlo analysis. Its value is the shape of the answer (how likely a shortfall is), not a single number. The simulation methods module covers how the draws are made.