Inter-firm Comparison (Cambridge (CIE) O Level Accounting)
Revision Note
Written by: Dan Finlay
Reviewed by: Lucy Kirkham
Comparison of Accounting Ratios
How can I make inter-firm comparisons using the accounting ratios?
You can compare the performance of similar businesses using the accounting ratios
Ratio | Possible comparisons |
|---|---|
Gross margin |
|
Profit margin |
|
Return on capital employed (ROCE) |
|
Current ratio |
|
Liquid (acid test) ratio |
|
Rate of inventory turnover |
|
Trade receivables turnover |
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Trade payables turnover |
|
Problems of Inter-firm Comparison
What are the potential problems of inter-firm comparisons?
The businesses might be in different trades
Comparisons should only be made between businesses within the same trade
Inventory, expenses and profit margins are usually different for businesses in different trades
A business selling food is likely to sell inventory quicker than a business selling new cars
The businesses might have been operating for different amounts of time
Comparisons should be made between businesses which are roughly the same age
Newer businesses are likely to have higher expenses and liabilities
More experienced businesses are likely to have developed a loyal customer base and a good reputation
The businesses might have different financial periods
The end date of a financial year can impact the financial position of the business
Inventory levels can be affected by the seasons and holidays
The businesses only report on financial information
Comparisons cannot be made about the employees' satisfaction or experience
The businesses might have different policies
One business might buy on a cash basis whereas the other might buy on a credit basis
This can affect current assets and current liabilities
The businesses might be different types of organisations
The type of organisation can affect its ability to raise capital and purchase assets
A limited company might have more available resources whereas a sole trade might just have one employee
Case Study
Cool Clothes Ltd and Sheer Style Ltd are companies, of a similar size, that sell a range of clothes. The financial year for both companies ends on 31 March. The accounting ratios for the year ended 31 March 2024 are shown below.
Cool Clothes Ltd | Sheer Style Ltd | |
|---|---|---|
Gross margin | 32.25% | 28.50% |
Profit margin | 15.45% | 18.06% |
Return on capital employed | 11.11% | 9.83% |
Current ratio | 1.94 : 1 | 1.45 : 1 |
Liquid (acid test) ratio | 1.01 : 1 | 0.89 : 1 |
Rate of inventory turnover | 13.21 times | 14.88 times |
Trade receivables turnover | 28 days | 45 days |
Trade payables turnover | 32 days | 40 days |
Comparisons
Cool Clothes Ltd has a higher gross margin than Sheer Style Ltd which suggests that it is better at passing on more of the costs to the customers by using higher selling prices. However, the difference between the gross margin and profit margin is larger for Cool Clothes Ltd (16.8% compared to 10.44%), which suggests that its control of expenses is not as effective as Sheer Style Ltd. Cool Clothes Ltd is making more profit on their capital employed which suggests it is using its money more efficiently.
The current ratio for both companies shows that they have enough current assets to cover the short-term debts. Cool Clothes Ltd is likely to be able to repay short-term debts more easily as its current ratio is higher. The liquid ratio for Cool Clothes Ltd is ideal and shows that it will be able to convert its most liquid current assets into cash to cover short-term debts. Sheer Style Ltd, on the other hand, might struggle to repay short-term debts using its most liquid current assets as the liquid ratio is less than 1 : 1. This means it might need to take out extra short-term loans if its existing payables ask for the owed money to be paid immediately. Sheer Style Ltd should look at ways to increase its liquid (i.e. non-inventory) current assets. For example, it could sell some non-current assets and lease them instead. However, this would increase its expenses and reduce its profit margin.
Sheer Style Ltd sells its inventory at a faster rate as its rate of inventory turnover is higher, however, the rate for Cool Clothes Ltd is not much lower. Cool Clothes Ltd receives money from credit customers faster than Sheer Style Ltd as its trade receivables turnover is smaller. Also, Cool Clothes Ltd receives payment from customers before paying suppliers, which means it does not have to rely on other sources of finance to fund the goods. Sheer Styles Ltd, on the other hand, pays its suppliers on average 5 days before receiving payment from its customers. This means that Sheer Styles Ltd might have to rely on short-term finance to cover the costs of goods; this could be a reason why its liquid ratio is low.
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