Inter-firm Comparison (Cambridge (CIE) O Level Accounting)

Revision Note

Written by: Dan Finlay

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	The business with the higher gross margin might be better at passing the cost of goods on to the customers by applying a higher mark-up
Profit margin	The business with the higher profit margin might be more profitable The business with the smaller difference between the gross margin and profit margin is likely to have better control of its expenses
Return on capital employed (ROCE)	The business with the higher ROCE might be deploying its capital more effectively
Current ratio	The business with a higher current ratio might be able to pay off its short-term debts more easily
Liquid (acid test) ratio	The business with a higher liquid ratio might be able to convert its most liquid current assets into cash more easily to pay off its short-term debts
Rate of inventory turnover	The business with the higher rate can sell its inventory more quickly It is less likely to lose money by writing off inventory
Trade receivables turnover	The business with the lower number of days receives payments from its credit customers faster It is less likely to need to write off debts It might have a better credit control policy Check if the trade receivables turnover is less than the trade payables turnover This means the business receives money from credit customers before paying credit suppliers It is efficient with its cash flow
Trade payables turnover	The business with the lower number of days pays its credit suppliers faster It is less likely to be charged interest on overdue amounts It is more likely to benefit from cash discounts It might have a better relationship with its suppliers The business with the higher number of days might prefer to take full advantage of the interest-free periods It might keep the cash in the business for as long as possible in case of emergencies

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.

Last updated: 24 May 2024

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