understand the problems of inter-firm comparison

6.3 Inter‑firm Comparison

Objective

To recognise the problems that can distort a comparison of the financial performance and position of different firms and to learn how to adjust the data so that a fair, exam‑level comparison can be made.

Why Compare Firms?

Inter‑firm comparison helps investors, creditors, managers and other stakeholders to:

• Assess relative profitability and efficiency.
• Identify best practice and areas for improvement.
• Make informed decisions about investment, lending or strategic change.

Key Problems that Affect Comparability

When two companies are compared, the figures may not be directly comparable for a number of reasons. The table shows each problem, a short description of the issue and the effect on profit, position or ratio interpretation.

Adjustments Required Before Analysis

Analysts normally make the following adjustments so that the data are comparable.

• Currency conversion – use a single spot or average rate for the period.
• Restate to a common accounting policy – e.g., recalculate depreciation using the same method.
• Standardise the time period – use twelve‑month rolling totals or adjust figures to the same reporting date.
• Size neutralisation – express items per £1 000 of sales, per £1 000 of assets, or use common‑size statements.
• Inflation adjustment – restate historic‑cost figures using a price index (CPI, RPI).
• Tax‑rate adjustment – compare pre‑tax profit or restate net profit to a common tax rate.
• Industry & presentation alignment – ensure you are comparing firms in the same sub‑industry and re‑classify line items where necessary.

Step‑by‑step Worked Examples

1. Depreciation policy adjustment

Assume:

• Firm A uses straight‑line (SL) depreciation on a £100 000 plant over 10 years, no residual value.
• Firm B uses reducing‑balance (RB) at 20 % per year on the same plant cost.

Both firms report profit for the first year.

1. SL depreciation for Firm A: £100 000 ÷ 10 = £10 000.
2. RB depreciation for Firm B: 20 % × £100 000 = £20 000.
3. Restate Firm B’s depreciation to SL: £10 000.
4. Adjusted profit for Firm B = Reported profit + (RB – SL) = Reported profit + (£20 000 – £10 000) = Reported profit + £10 000.
5. Now both firms have depreciation calculated on the same basis, allowing a fair profit comparison.

2. Tax‑rate adjustment

Firm X: Net profit £30 000 after a 20 % tax rate.
Firm Y: Net profit £27 000 after a 30 % tax rate.

1. Pre‑tax profit for Firm X = £30 000 ÷ (1 – 0.20) = £37 500.
2. Pre‑tax profit for Firm Y = £27 000 ÷ (1 – 0.30) = £38 571 (rounded).
3. Comparison of pre‑tax profit removes the distortion caused by different tax rates.

3. Size adjustment (profit per £1 000 of sales)

Firm M reports sales £2 000 000 and profit £120 000.
Firm N reports sales £800 000 and profit £60 000.

1. Profit per £1 000 sales – Firm M: (£120 000 ÷ 2 000) = £60 per £1 000 sales.
2. Profit per £1 000 sales – Firm N: (£60 000 ÷ 800) = £75 per £1 000 sales.
3. Although Firm M’s total profit is larger, Firm N is more efficient on a sales‑per‑unit basis.

4. Currency conversion

Firm P (UK) reports revenue £5 000 000.
Firm Q (EU) reports revenue €6 000 000.
Average exchange rate for the year: £1 = €1.20.

1. Convert Firm Q’s revenue to pounds: €6 000 000 ÷ 1.20 = £5 000 000.
2. Now both firms have revenue expressed in the same currency, making ratio calculations comparable.

Ratios – The Preferred Tools for Inter‑firm Comparison

Ratios express performance relative to a common base, neutralising size differences and many of the problems listed above.

Interpretation & Recommendations

• After making the necessary adjustments, calculate the relevant ratios for each firm.
• Compare the ratios and comment on:
  • Owners/Shareholders – profit‑margin, gross‑margin, ROA, ROCE.
  • Creditors (banks, trade payables) – current ratio, debt‑to‑equity.
  • Management – inventory turnover, asset utilisation, any efficiency ratios.
• State any assumptions made (e.g., exchange‑rate used, price index applied, tax rate assumed) – exam markers award marks for clear methodology.
• Give a concise recommendation, e.g.: “Firm B is more liquid (current ratio = 2.1 vs 1.4) but less profitable (profit‑margin = 6 % vs 9 %). Management should investigate ways to improve margin while preserving liquidity.”

Limitations of Accounting Statements (Syllabus 6.5)

Even after adjustments, financial statements have inherent limitations:

• They are prepared on a historic‑cost basis and may not reflect current market values.
• Only monetary information is recorded; qualitative factors such as brand reputation, employee morale or market conditions are omitted.
• Many figures rely on estimates and judgments (e.g., provisions, useful lives), which can differ between firms.

Practical Tips for Students (Exam Focus)

• Read the notes to the accounts – they disclose accounting policies, tax rates, currency used and any changes during the year.
• If the data include different currencies, year‑ends or sub‑industries, look for clues that an adjustment is required.
• Prefer ratios and common‑size statements to raw figures when firms differ in size.
• Show every adjustment you make, state the method (e.g., “converted €6 000 000 at £1 = €1.20”) and justify it – this gains marks for methodology.
• Link your conclusion to the interests of owners, creditors and management, using the exact terminology from the syllabus.