6.3 Inter-firm Comparison: Problems of Comparison

Inter-firm comparison involves analyzing the financial statements of different companies to assess their relative performance. While useful, comparing financial data across firms presents several challenges. This section will explore these problems in detail.

1. Different Accounting Policies

Companies often have the freedom to choose accounting policies within the guidelines of accounting standards. These choices can significantly impact the reported figures and make direct comparisons difficult.

• Depreciation Methods: Different companies may use different methods to allocate the cost of assets over their useful lives (e.g., straight-line, reducing balance). This affects the reported depreciation expense and profitability.
• Inventory Valuation: Methods for valuing inventory (e.g., FIFO, weighted average) can lead to variations in cost of goods sold and profit.
• Provisions: Companies have discretion in making provisions for items like doubtful debts or employee compensation. Different levels of provisions can distort profitability.
• Capitalisation vs. Expensing: Decisions on whether to capitalise certain expenses as assets or expense them directly can affect the balance sheet and income statement.

2. Different Industries

Companies operate in various industries, each with its own unique characteristics and financial norms. Comparing companies from different industries can be misleading.

For example, a high profit margin might be typical in the software industry but unusual in the retail sector.

3. Different Size and Scale

Comparing a large multinational corporation with a small local business can be problematic. Differences in scale can affect financial ratios and profitability.

Larger companies may have economies of scale that smaller companies do not.

4. Different Ownership Structures

The ownership structure of a company (e.g., private vs. public, family-owned vs. investor-owned) can influence its financial decisions and reporting practices.

Public companies are subject to greater scrutiny and may be more inclined to adhere to stricter accounting standards.

5. Timing Differences

Companies may have different accounting periods (e.g., financial year-ends). This makes it difficult to compare financial results across different timeframes.

Table Summarizing Problems

Problem	Description	Impact on Comparison
Different Accounting Policies	Variations in depreciation, inventory valuation, provisions, and capitalisation/expensing.	Distorts reported profits and asset values.
Different Industries	Unique characteristics and financial norms within different industries.	Makes comparisons of financial ratios meaningless.
Different Size and Scale	Differences in economies of scale and operational capacity.	Affects the interpretation of financial ratios.
Different Ownership Structures	Influence on financial decisions and reporting practices.	Can lead to inconsistencies in financial reporting.
Timing Differences	Different financial year-ends.	Makes comparisons across time periods difficult.

Despite these challenges, understanding the problems of inter-firm comparison is crucial for making informed financial assessments. Analysts often use techniques like ratio analysis and industry averages to mitigate these issues.