Inter- Firm Comparison

Inter-firm comparison is the process of comparing the financial performance and position of one business with that of another business (or several businesses) over the same time period, or comparing the same business over different time periods.

The most common forms are:

• Horizontal comparison: comparing two or more different businesses — e.g., comparing Business A's ROCE with Business B's ROCE for the same year.
• Time-series analysis: comparing the same business's ratios over several years to identify trends.
• Industry benchmarking: comparing a business's ratios with the industry average for that sector.

Why compare rather than look at absolute figures? A business reporting a net profit of $2 million sounds impressive. But if a competitor reporting $500,000 profit has the same ROCE (because it uses far less capital), the first business may actually be less efficient. Ratios adjust for scale and make comparisons meaningful.

Who conducts inter-firm comparisons?

• Investors and potential investors: to decide which company to invest in
• Banks and lenders: to benchmark a loan applicant against industry norms
• Management: to identify areas where their business underperforms relative to competitors
• Competitors: to understand their own position in the market
• Trade associations: to publish industry average ratios that members can compare against
• Potential buyers of a business: to assess whether an acquisition target is well-run

The most fundamental limitation of inter-firm comparison is that different businesses may use different accounting policies, which means their financial statements are prepared on different bases. Comparing ratios calculated from such statements can give misleading conclusions.

Depreciation policy: Two businesses own identical machinery worth $100,000. Business A uses straight-line depreciation over 10 years (annual charge = $10,000). Business B uses reducing balance at 25% (first year charge = $25,000). Their profit figures will differ by $15,000 in year 1 — not because of trading performance but purely because of accounting policy choice. This makes ROCE, profit margin, and net asset values incomparable.

Inventory valuation: In a period of rising prices, a business using FIFO will report higher closing inventory value (more recent, higher-cost purchases remain in stock) and therefore higher gross profit than a business using AVCO (weighted average cost), even if their actual trading activities are identical. GPM and profit margin will differ.

Provision for doubtful debts: One business provides 5% of trade receivables as doubtful; another provides 2%. Their net profit figures will differ even with the same sales revenue and costs.

Revaluation of assets: If one business revalues its land upward, its capital employed increases and its ROCE falls — even though trading performance is unchanged. A business using historical cost (no revaluation) will appear to have a higher ROCE.

The key message for Cambridge examiners: you cannot simply conclude that a business with a lower ROCE is performing less well — they may just be using different accounting policies.

Beyond accounting policies, several other factors limit the validity of inter-firm comparisons:

Different business size: A large chain of 50 stores and a small family-run shop in the same industry will have very different cost structures, buying power, and access to financing. Their ratios may not be meaningfully comparable even if both are profitable retailers. Large businesses can negotiate bulk discounts, reducing cost of sales, which inflates GPM relative to smaller competitors.

Different financial year ends: A toy retailer with a December financial year end will show very different inventory, receivables, and current ratios than the same business would at its January year end (after the Christmas peak). If Business A has a June year end and Business B has a December year end, their seasonal positions are opposite, making liquidity ratio comparisons potentially meaningless.

Different gearing levels (debt vs equity financing): Two businesses with the same operating profit will have different net profit after interest if one has large loans (high gearing) and the other is equity-financed. The highly geared business will report lower profit margin and lower ROCE even if its underlying trading efficiency is identical.

Historical cost accounting and inflation: Ratios are based on accounts prepared under the historical cost convention. During periods of inflation, the value of assets (especially land and buildings) shown in the statement of financial position may be far below current market value. This understates capital employed and inflates ROCE — a business with old, long-paid-for premises will show a higher ROCE than one with newly acquired premises at current prices, even if they are equally efficient.

Limited view — non-financial factors: Financial ratios capture only what can be measured in money. They miss: quality of management, brand reputation, staff morale, technological advantages, customer loyalty, pending litigation, and environmental risks. A business may look financially strong but be on the verge of losing a key contract.