Chapter 23 – Inter-Firm Comparison

← Chapter 22All chaptersChapter 24 →
Chapter 23

Inter-Firm Comparison

Inter-firm comparison means comparing the financial performance and position of one business with another similar business. A business may perform well compared with last year but still perform poorly compared with competitors, so ratios help judge performance against other firms in the same industry.

BenchmarkingSimilar firmsComparison problemsKelsey exampleLiquidity actionsExam technique
Inter-firm comparison and benchmarking dashboard

Topic 1: Meaning and Purpose of Inter-Firm Comparison

Inter-firm comparison uses accounting ratios to compare a business with competitors, industry averages and trade standards.

1. What is Inter-Firm Comparison?

Inter-firm comparison means comparing the financial performance and position of one business with another similar business.

A business may look successful when compared with its own previous year, but still be performing poorly compared with other firms in the same industry. This is why ratios are useful for judging performance against competitors.

2. Why Use Inter-Firm Comparison?

Accounting ratios allow a business to:

Benchmarking: comparing business performance with an industry or trade standard.

3. Ratios are Better than Absolute Figures

Absolute figures can be misleading. A larger profit does not always mean better performance if much more capital was used to earn that profit.

Example: Profit alone can mislead

Business A profit$50,000
Business B profit$80,000
Capital invested by A$100,000
Capital invested by B$500,000
Business B has the larger profit, but Business A may actually be using its capital more efficiently. Ratios such as ROCE provide a more useful comparison than profit figures alone.

Topic 2: Problems with Inter-Firm Comparison

Comparisons are most useful when businesses are genuinely similar and use similar accounting methods.

Nine problems to check before making inter-firm comparisons

4. Problem 1 – Businesses Must be in the Same Industry

Businesses should normally be compared only if they operate in the same industry. Comparing a supermarket with an electronics shop would not be very useful.

A supermarket may sell large quantities of goods quickly, while an electronics shop may sell expensive products much more slowly. If the supermarket has inventory turnover of 20 times and the electronics shop has inventory turnover of 5 times, this does not automatically mean the electronics shop is inefficient.

5. Problem 2 – Businesses Should be Similar in Size

Even businesses in the same industry may be difficult to compare if one is much larger. A large supermarket and a small convenience store may sell similar products, but their sales volumes, expenses, purchasing power and inventory levels may be very different.

6. Problem 3 – Different Accounting Methods

Businesses should ideally use the same accounting methods. Differences may exist in:

These differences can change profit, asset values and accounting ratios, which may make comparisons misleading.

7. Problem 4 – Different Financial Year Ends

Businesses being compared should ideally have similar financial year ends.

A stationery business closing its accounts before the back-to-school season may hold a large amount of inventory. Another stationery business closing after the back-to-school season may already have sold much of its inventory. Their inventory figures and ratios may therefore be very different even though both businesses are operating successfully.

8. Problem 5 – Different Pricing Policies

Business A

  • Higher selling prices.
  • Lower volume of sales.
  • Higher profit margin.

Business B

  • Lower selling prices.
  • Higher volume of sales.
  • Lower profit margin.

Different ratios do not always mean one business is being badly managed; the firms may be following different pricing strategies.

9. Problem 6 – Different Capital Structures

Some businesses may use loans while others rely mainly on owner's equity. This changes their capital employed and can affect ROCE. ROCE should therefore be compared carefully when businesses have different methods of financing themselves.

10. Other Problems with Comparison

Stage of business life

A new business may not yet have established customers, strong sales or a loyal customer base, so comparing it with a long-established business may be unfair.

Production methods

One business may use more machinery while another uses more workers. Their overhead costs will therefore differ.

Owning vs renting premises

One business may own its premises while another rents. This can affect expenses and profitability ratios.

Topic 3: Kelsey Inter-Firm Comparison Example

The chapter compares Kelsey's ratios with the average for her trade and shows how each ratio should be interpreted.

Kelsey's ratios compared with trade averages

11. Example of Inter-Firm Comparison

RatioTrade AverageKelsey
Gross margin53%56%
Profit margin25%19%
Current ratio2.3 : 13.3 : 1
Liquid ratio1 : 10.9 : 1
Trade receivables turnover56 days69 days
Trade payables turnover35 days25 days

12. Interpreting Gross Margin

Kelsey's gross margin is 56%, while the trade average is 53%. This means Kelsey earns $56 gross profit for every $100 of sales compared with the industry average of $53.

Her gross margin is therefore better than the trade average.

13. Interpreting Profit Margin

Kelsey's profit margin is 19%, while the trade average is 25%. For every $100 of sales:

Kelsey's profit margin is worse. Since her gross margin is good but her profit margin is poor, the likely problem is high expenses.

14. Expenses-to-Sales Comparison

Kelsey

Gross margin = 56%
Profit margin = 19%
Difference = 37%

Trade average

Gross margin = 53%
Profit margin = 25%
Difference = 28%

Kelsey spends $37 per $100 of sales on expenses, while the trade average spends only $28. This suggests that Kelsey's expense control is less efficient.

15. How Could Profitability Be Improved?

Kelsey could:

Topic 4: Liquidity and Efficiency Comparisons

Liquidity and efficiency ratios must be judged against business context, trade averages and credit terms.

16. Interpreting Current Ratio

Kelsey's current ratio is 3.3 : 1, while the trade average is 2.3 : 1. Although Kelsey's ratio is higher, the textbook considers this less favourable because she may be holding too many current assets.

This could mean money is unnecessarily tied up rather than being used productively. A higher current ratio is not automatically better.

17. Interpreting Liquid Ratio

Kelsey's liquid ratio is 0.9 : 1, compared with the trade average of 1 : 1. Her liquid ratio is lower, indicating that she may have difficulty meeting current liabilities from her most liquid assets.

The large difference between her current ratio of 3.3 : 1 and liquid ratio of 0.9 : 1 suggests that a large amount of current assets consists of inventory.

18. Trade Receivables Turnover

Kelsey's customers take 69 days to pay, while the trade average is 56 days. Her customers therefore take:

69 − 56 = 13 days longer

This is unfavourable because money remains tied up in trade receivables for longer.

Possible Improvements

19. Trade Payables Turnover

Kelsey pays suppliers in 25 days, while the trade average is 35 days. She is therefore paying suppliers 10 days earlier than the industry average.

This may not be the best use of the available credit period. However, she should still pay in time to obtain any cash discounts offered by suppliers.

20. Improving Liquidity

The chapter suggests that Kelsey could:

Topic 5: Exam Answer Technique

A strong comparison answer states figures, compares them, explains the meaning, interprets causes and recommends action when required.

Five step answer pattern for inter-firm comparison questions

21. How to Answer an Inter-Firm Comparison Question

1State the figures
2Compare
3Explain
4Interpret
5Recommend
StepExample
State the figuresBusiness A has a gross margin of 40%, compared with Business B's 30%.
CompareBusiness A's gross margin is 10 percentage points higher.
ExplainBusiness A earns $40 gross profit per $100 of sales compared with $30 for Business B.
InterpretBusiness A may have lower cost of sales or higher selling prices.
Recommend if requiredBusiness B could investigate cheaper suppliers or its selling-price policy.

Quick Guide to Comparing Ratios

RatioUsually favourable compared with competitor
Gross marginHigher
Profit marginHigher
ROCEHigher
Current ratioAppropriate for the industry, not simply highest
Liquid ratioAdequate and close to industry norm
Inventory turnoverUsually faster, depending on industry
Trade receivables daysLower
Trade payables daysEffective use of supplier credit period

Key Problems with Inter-Firm Comparison

Before deciding that one business is better, ask:

Remember

Inter-Firm Comparison

Compare ratios, not just absolute figures.

Benchmarking

Compare business performance with an industry or trade standard.

Good Comparison

Businesses should have similar industry, size, accounting methods and circumstances.

Most Important Exam Point

Do not automatically assume that the highest ratio is the best ratio. Interpret the ratio in the context of the business and the industry.

← Chapter 22All chaptersChapter 24 →