6.3 Inter‑firm Comparison
Learning Objective
Apply the required accounting ratios to compare the performance of two or more firms operating in the same industry and evaluate the implications for the different interested parties (owners, managers, lenders, investors, suppliers and customers).
Why Compare Firms? (Purpose)
- Identify strengths and weaknesses relative to competitors.
- Provide quantitative evidence for investors, lenders and other stakeholders when they make decisions.
- Give management realistic benchmarks for setting targets and improving performance.
- Assist in assessing the impact of different financing and operating policies.
Limitations of Inter‑firm Comparison
Results can be distorted by:
- Different accounting policies (e.g., inventory valuation, depreciation methods).
- Variations in firm size or market share.
- Distinct market conditions or geographic locations.
- One‑off or extraordinary items that are not reflected in the ratios.
- Non‑availability of comparable data (private‑company vs. listed‑company information).
Ratio Categories Required by the Cambridge IGCSE (0452) Syllabus
- Profitability ratios
- Liquidity ratios
- Efficiency (activity) ratios
- Solvency (financial stability) ratios
- Market ratios – optional enrichment material (not required for the core exam).
Core Ratios and Formulas (required)
All monetary figures should be expressed in the same units (e.g., £ 000). Ratios may be shown as a percentage or a decimal – be consistent throughout the analysis.
| Ratio |
Formula |
Typical Interpretation |
| Gross Profit Margin (GPM) |
\displaystyle \text{GPM}= \frac{\text{Gross Profit}}{\text{Sales}}\times100\% |
Higher = better control of production costs. |
| Net Profit Margin (NPM) |
\displaystyle \text{NPM}= \frac{\text{Net Profit}}{\text{Sales}}\times100\% |
Overall profitability after all expenses. |
| Current Ratio (CR) |
\displaystyle \text{CR}= \frac{\text{Current Assets}}{\text{Current Liabilities}} |
Ability to meet short‑term obligations. |
| Quick Ratio (QR) – Acid‑test |
\displaystyle \text{QR}= \frac{\text{Current Assets}-\text{Inventories}}{\text{Current Liabilities}} |
Liquidity test that excludes inventory. |
| Return on Capital Employed (ROCE) |
\displaystyle \text{ROCE}= \frac{\text{Operating Profit}}{\text{Capital Employed}}\times100\% |
Efficiency of using long‑term funds. |
| Debt‑to‑Equity Ratio (DER) |
\displaystyle \text{DER}= \frac{\text{Total Borrowings}}{\text{Equity}} |
Higher = greater financial risk. |
| Inventory Turnover (IT) |
\displaystyle \text{IT}= \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} |
Number of times inventory is sold and replaced. |
| Trade Receivables Turnover (RT) |
\displaystyle \text{RT}= \frac{\text{Credit Sales}}{\text{Average Trade Receivables}} |
How quickly credit sales are collected. |
| Trade Payables Turnover (PT) |
\displaystyle \text{PT}= \frac{\text{Purchases on Credit}}{\text{Average Trade Payables}} |
How quickly the firm pays its suppliers. |
Optional Market Ratios (enrichment)
| Ratio |
Formula |
Typical Interpretation |
| Earnings per Share (EPS) |
\displaystyle \text{EPS}= \frac{\text{Net Profit – Preference Dividends}}{\text{Number of Ordinary Shares}} |
Profit attributable to each ordinary share. |
| Price‑Earnings Ratio (P/E) |
\displaystyle \text{P/E}= \frac{\text{Market Price per Share}}{\text{EPS}} |
Market’s valuation of earnings. |
Step‑by‑Step Procedure for an Inter‑firm Comparison
- Select comparable firms – same industry, similar size, and the same reporting period.
- Obtain the latest financial statements (income statement & balance sheet) for each firm.
- Check the data – ensure totals balance and that the same accounting basis (e.g., accruals) is used.
- Calculate the required ratios using the formulas above. Use average balances for turnover ratios.
- Present the results in a comparative table.
- Comment on the results:
- Identify which firm performs better for each ratio.
- Explain possible reasons (cost structure, pricing, credit policy, capital structure, etc.).
- Link the findings to the interests of owners, managers, lenders, investors, suppliers and customers.
- Draw conclusions and suggest actions for the weaker performer (e.g., tighten credit control, renegotiate debt, improve inventory management).
Worked Example – Manufacturing Firms (Core Ratios)
Two companies, Alpha Ltd and Beta Ltd, manufacture similar products. Figures are in £ 000.
| Item |
Alpha Ltd |
Beta Ltd |
| Sales | 1,200 | 1,150 |
| Cost of Goods Sold (COGS) | 720 | 690 |
| Gross Profit | 480 | 460 |
| Operating Expenses | 180 | 170 |
| Operating Profit | 300 | 290 |
| Net Profit | 210 | 200 |
| Credit Sales (assumed = Sales) | 1,200 | 1,150 |
| Purchases on Credit (assumed = COGS) | 720 | 690 |
| Current Assets | 350 | 300 |
| Inventories (average) | 120 | 100 |
| Trade Receivables (average) | 90 | 80 |
| Trade Payables (average) | 70 | 65 |
| Current Liabilities | 200 | 180 |
| Total Borrowings | 250 | 300 |
| Equity | 400 | 350 |
| Capital Employed (Borrowings + Equity) | 650 | 650 |
| Number of Ordinary Shares | 20,000 | 18,000 |
| Market Price per Share (£) | 12 | 11 |
Ratio Calculations (Core Ratios)
| Ratio |
Alpha Ltd |
Beta Ltd |
| Gross Profit Margin | 40.0 % | 40.0 % |
| Net Profit Margin | 17.5 % | 17.4 % |
| Current Ratio | 1.75 | 1.67 |
| Quick Ratio | 1.15 | 1.11 |
| ROCE | 46.2 % | 44.6 % |
| Debt‑to‑Equity Ratio | 0.625 | 0.857 |
| Inventory Turnover | 6.0 times | 6.9 times |
| Receivables Turnover | 13.33 times | 14.38 times |
| Payables Turnover | 10.29 times | 10.62 times |
Summary Comparison Table
| Category |
Alpha Ltd |
Beta Ltd |
Better Performer |
| Gross Profit Margin | 40.0 % | 40.0 % | Tie |
| Net Profit Margin | 17.5 % | 17.4 % | Alpha |
| Current Ratio | 1.75 | 1.67 | Alpha |
| Quick Ratio | 1.15 | 1.11 | Alpha |
| ROCE | 46.2 % | 44.6 % | Alpha |
| Debt‑to‑Equity Ratio | 0.625 | 0.857 | Alpha (lower risk) |
| Inventory Turnover | 6.0 | 6.9 | Beta |
| Receivables Turnover | 13.33 | 14.38 | Beta |
| Payables Turnover | 10.29 | 10.62 | Beta |
Interpretation for Different Interested Parties
- Owners / Shareholders: Alpha’s higher ROCE and lower DER indicate more efficient use of capital and lower financial risk, but Beta’s slightly higher EPS (calculated later) and lower P/E (optional) suggest a more attractive return per share at a cheaper market price.
- Managers: Alpha’s marginally better net profit margin shows tighter control of non‑production costs. Beta’s superior inventory and receivables turnover highlight more efficient working‑capital management – an area for Alpha to improve.
- Bankers / Lenders: Alpha’s stronger current and quick ratios, together with a lower DER, make it a lower‑risk borrower. Beta’s faster turnover of assets improves cash generation, which may partially offset its higher leverage.
- Suppliers: Beta’s slightly higher payables turnover means it pays suppliers a little faster, potentially strengthening supplier relationships.
- Customers: Both firms have similar gross margins, indicating comparable pricing and cost structures for the products they sell.
Suggested Actions
- Alpha – Review inventory policies to raise its inventory turnover (e.g., adopt just‑in‑time ordering).
- Beta – Consider reducing borrowings to lower its DER and improve its credit rating.
- Both – Monitor EPS and P/E trends if they seek external equity or wish to communicate value to investors (optional enrichment).
Worked Example – Service Business (Consulting Firms)
Two consulting firms, ConsultCo and Advisory Ltd, provide professional services. Figures are in £ 000.
| Item |
ConsultCo |
Advisory Ltd |
| Sales (fees earned) | 800 | 820 |
| Operating Expenses | 480 | 500 |
| Operating Profit | 320 | 320 |
| Net Profit | 260 | 250 |
| Credit Sales (assumed = Sales) | 800 | 820 |
| Current Assets | 150 | 140 |
| Inventories (service firms have none) | 0 | 0 |
| Trade Receivables (average) | 70 | 65 |
| Trade Payables (average) | 40 | 45 |
| Current Liabilities | 80 | 85 |
| Total Borrowings | 120 | 150 |
| Equity | 200 | 180 |
| Capital Employed (Borrowings + Equity) | 320 | 330 |
| Number of Ordinary Shares | 10,000 | 9,000 |
| Market Price per Share (£) | 14 | 13 |
Ratio Calculations (Core Ratios)
| Ratio |
ConsultCo |
Advisory Ltd |
| Gross Profit Margin* | — (not applicable – no COGS) | — |
| Net Profit Margin | 32.5 % | 30.5 % |
| Current Ratio | 1.88 | 1.65 |
| Quick Ratio | 1.88 | 1.65 |
| ROCE | 100.0 % | 96.97 % |
| Debt‑to‑Equity Ratio | 0.60 | 0.83 |
| Inventory Turnover | — (none) | — |
| Receivables Turnover | 11.43 times | 12.62 times |
| Payables Turnover | 8.00 times | 9.11 times |
Interpretation for Service Firms
- Profitability: ConsultCo’s higher net profit margin and ROCE indicate better overall efficiency.
- Liquidity: Both firms have strong quick ratios (no inventory), but ConsultCo’s current ratio is slightly higher, giving it a modest advantage.
- Efficiency: Advisory’s faster receivables and payables turnover suggest tighter credit control and quicker settlement of supplier invoices.
- Solvency: ConsultCo’s lower DER points to a safer capital structure for lenders.
Common Errors to Watch For
- Using ending balances instead of **average** balances for turnover ratios.
- Confusing gross profit with operating profit when calculating margins.
- Mixing percentages with decimals in the same comparative table.
- Failing to verify that balance‑sheet totals balance before calculating ratios.
- Ignoring the impact of different accounting policies or one‑off items on the ratios.
Key Points for Students (ordered to match AO weighting)
- Knowledge (AO1)
- Remember the exact formulas for each required ratio.
- Know which ratio belongs to which category (profitability, liquidity, efficiency, solvency).
- Application (AO2)
- Calculate all core ratios correctly, using average balances where required.
- Present the results in a clear, side‑by‑side comparative table.
- Evaluation (AO3)
- Comment on the meaning of each ratio for the different interested parties.
- Explain why differences may exist (e.g., cost structure, credit policy, capital structure).
- Rank the ratios in order of importance for each stakeholder and justify the ranking.
- Identify any limitations that could affect the reliability of the comparison.
Suggested Extension Activity (Optional)
Using the data from either the manufacturing or service example, ask students to:
- Rank the eight core ratios from most to least important for a bank and a shareholder.
- Write a short recommendation (150‑200 words) to the management of the weaker firm, prioritising the three ratios that need immediate improvement.