🚀 Chapter 6.3: Inter-Firm Comparison – Comparing Your Business to the Competition
Hello future accountants! You've mastered calculating accounting ratios (Section 6.1) and interpreting your own business's performance over time (Section 6.2). Now, we take the next logical step: looking outside! This chapter is all about comparing your business results with those of your competitors.
Why is this important? Calculating ratios for just one year or comparing them to your own past years tells you if you are improving. But comparing them to similar businesses (your rivals!) tells you if you are performing better, worse, or just average for your industry. It helps management set realistic goals.
Don't worry if this seems tricky at first; we will break down the process and, more importantly, discuss why these comparisons are often harder than they look!
1. Defining Inter-Firm Comparison (IFC)
Inter-Firm Comparison (IFC) is the process of comparing the financial performance and position of one business with another business (or several others) within the same industry, typically using accounting ratios.
Analogy Alert!
Imagine you run a small coffee shop. If your Profit Margin is 10%, is that good? If you compare it to last year's 8%, it looks like an improvement! However, if you find out all other similar coffee shops in your city have an average Profit Margin of 15%, you realize you are actually underperforming. IFC gives you context.
The main tool for IFC is the application of the accounting ratios you already know.
2. Applying Accounting Ratios to Inter-Firm Comparison
To compare two or more businesses, you simply calculate the key ratios for all of them and then compare the resulting percentages or numbers.
The ratios are generally grouped into two categories for comparison:
(a) Profitability Ratios
These ratios help you see which business is making the best use of its resources to generate income.
- Return on Capital Employed (ROCE): This is perhaps the most important ratio for IFC. It shows how efficiently a company uses its long-term funds (Capital Employed) to generate profit.
If Firm A has a ROCE of 20% and Firm B has 12%, Firm A is clearly more efficient at generating profit from the money invested in it. - Gross Margin / Profit Margin: Comparing these tells you which firm manages its cost of goods sold (Gross Margin) and its operating expenses (Profit Margin) most effectively.
If your competitor has a higher Gross Margin, they might be buying stock cheaper or pricing their goods better than you.
(b) Liquidity Ratios
These ratios show which business is in a better position to meet its short-term debts.
- Current Ratio and Liquid (Acid Test) Ratio: These ratios show the immediate financial health of the companies.
If Firm X has a Current Ratio of 0.8:1 and Firm Y has 2.5:1, Firm X is in serious trouble compared to Firm Y and may struggle to pay its suppliers.
Key Takeaway: Ratios provide an objective, standardized measure (like a percentage) that makes comparing businesses of different sizes possible. You compare the *rate* of return or the *level* of liquidity, not just the raw profit figures.
3. Understanding the Problems of Inter-Firm Comparison (IFC Limitations)
While IFC is useful, it is often complicated by factors that make a truly accurate "apples-to-apples" comparison impossible. The syllabus specifically requires you to understand these problems.
Problem 1: Differences in Accounting Policies and Methods
Businesses have choices about how they record certain transactions, and these choices heavily affect the final profit and asset figures.
- Depreciation Methods: Firm A might use the Straight-Line Method, resulting in lower depreciation expense and higher profit in early years. Firm B might use the Reducing Balance Method, resulting in higher depreciation and lower profit in early years. Comparing their Profit Margins directly is misleading.
- Inventory Valuation: While IGCSE typically focuses on the lower of cost and net realisable value, a company’s chosen method for assigning cost (e.g., FIFO) can subtly change the Cost of Goods Sold and, therefore, the Gross Profit.
Quick Tip: If the firms use different methods, the resulting ratios are not truly comparable because they are based on different underlying assumptions.
Problem 2: Non-Financial Aspects (Qualitative Differences)
Ratios only use numbers from the financial statements. They ignore crucial factors that influence performance but are not measured in dollars or pounds.
- Management Quality: A brilliant manager in Firm A might be the reason for its high ROCE, but this skill isn't in the balance sheet.
- Customer Service and Reputation: Firm B might have a low profit margin this year because they spent heavily on excellent customer service training, which will pay off in reputation and future revenue.
- Location: One firm might operate in a busy city centre (high rent, high revenue) while the other is in a quiet suburb (low rent, low revenue). Their cost structures are fundamentally different.
- Product/Service Differences: Two clothing retailers might be compared, but one sells cheap, fast-fashion items while the other sells expensive, bespoke (custom-made) suits. Their profitability models are completely different.
Problem 3: Differences in Scale, Age, and Structure
- Size and Scale: It is difficult to compare a small sole trader (unlimited liability) with a massive limited company (limited liability). The limited company benefits from economies of scale (buying in bulk cheaper) that the sole trader cannot access.
- Age of Non-Current Assets: Firm X may have older machinery that is fully depreciated (meaning low depreciation expense this year), resulting in high reported profit. Firm Y may have brand-new machinery (high depreciation expense), showing a lower profit. However, Firm Y's new machinery is more efficient. Ratios hide this difference.
- Capital Structure: How the business is financed matters. Firm A might rely heavily on loans (debt), incurring large interest costs. Firm B might be mainly financed by equity (owner's capital). This difference affects the Profit for the Year and the calculation of Capital Employed.
Problem 4: Different Reporting Periods and Economic Conditions
If Firm A prepares its financial statements to December 31st and Firm B to March 31st, they cover different periods. If a major economic event (like a sudden recession or a boom) occurred in January and February, only Firm B's results would fully capture it.
Problem 5: Historic Cost
Accounting statements record assets at their historic cost (the cost when they were purchased). If Firm A bought land in 1990 and Firm B bought similar land last year, the value listed for land on their Statements of Financial Position will be vastly different, making comparisons of asset-related ratios (like ROCE) less meaningful.
Did you know? Even within large companies, different divisions sometimes use "shadow accounting" or internal adjustments to allow for fairer comparisons between departments that operate in different countries or economic environments.
💡 Quick Review: Why is IFC difficult?
4 Key Problems to Remember
| Problem Area | Explanation |
|---|---|
| Accounting Policies | Firms may use different methods (e.g., depreciation), leading to incomparable profit figures. |
| Non-Financial Factors | Ratios ignore things like management skill, quality, reputation, and customer loyalty. |
| Scale/Age | Differences in size or the age of non-current assets distort profitability comparisons. |
| Time Periods | Different financial year-ends mean the firms faced different economic conditions. |
Key Takeaway: When applying ratios for inter-firm comparison, you must always state that the comparison is only useful if the businesses are very similar in size, structure, and the accounting policies they use. If they aren't, you must consider the limitations when drawing conclusions.