6.3 Inter-firm Comparison

This section focuses on using accounting ratios to compare the performance of different companies within the same industry. By calculating and analyzing ratios, we can gain insights into a company's financial health, profitability, liquidity, and efficiency relative to its competitors.

Why Compare Firms?

• Assess relative performance: Understand how a company stacks up against its peers.
• Identify strengths and weaknesses: Pinpoint areas where a company excels or lags behind.
• Inform investment decisions: Help investors make informed choices about where to allocate capital.
• Evaluate management effectiveness: Provide insights into how well management is running the business.

Key Areas for Comparison

• Profitability: How well a company generates profit from its operations.
• Liquidity: A company's ability to meet its short-term financial obligations.
• Efficiency: How effectively a company uses its assets to generate revenue.
• Solvency: A company's ability to meet its long-term financial obligations.

Common Accounting Ratios for Inter-firm Comparison

Profitability Ratios

• Gross Profit Margin: $$ \frac{Gross\, Profit}{Revenue} \times 100 $$

  Indicates the percentage of revenue remaining after deducting the cost of goods sold. A higher margin is generally better.

• Net Profit Margin: $$ \frac{Net\, Profit}{Revenue} \times 100 $$

  Shows the percentage of revenue that translates into net profit after all expenses. A higher margin is desirable.

• Return on Capital Employed (ROCE): $$ \frac{Net\, Profit}{Capital\, Employed} \times 100 $$

  Measures how effectively a company uses its capital to generate profit. Capital employed includes both equity and debt.

Liquidity Ratios

• Current Ratio: $$ \frac{Current\, Assets}{Current\, Liabilities} $$

  Indicates a company's ability to pay off its short-term liabilities with its short-term assets. A ratio of 2 or more is generally considered healthy.

• Quick Ratio (Acid Test): $$ \frac{Current\, Assets - Inventory}{Current\, Liabilities} $$

  A more conservative measure of liquidity, excluding inventory which may not be easily converted to cash. A ratio of 1 or more is often desired.

Efficiency Ratios

• Inventory Turnover: $$ \frac{Cost\, of\, Goods\, Sold}{Average\, Inventory} $$

  Measures how many times a company sells and replaces its inventory during a period. A higher turnover generally indicates efficient inventory management.

• Receivables Turnover: $$ \frac{Revenue}{Average\, Accounts\, Receivable} $$

  Indicates how quickly a company collects its debts from customers. A higher turnover is generally better.

• Payables Turnover: $$ \frac{Cost\, of\, Goods\, Sold}{Average\, Accounts\, Payable} $$

  Measures how quickly a company pays its suppliers. A lower turnover might indicate the company is taking longer to pay its debts.

Solvency Ratios

• Debt to Equity Ratio: $$ \frac{Total\, Debt}{Total\, Equity} $$

  Indicates the proportion of debt and equity used to finance a company's assets. A lower ratio generally suggests lower financial risk.

• Debt to Assets Ratio: $$ \frac{Total\, Debt}{Total\, Assets} $$

  Shows the proportion of a company's assets that are financed by debt. A lower ratio is generally preferred.

Interpreting Ratio Comparisons

When comparing ratios, it's crucial to consider the following:

• Industry Benchmarks: Compare the ratios to the average ratios for companies in the same industry.
• Trend Analysis: Examine how the ratios have changed over time for the company.
• Contextual Factors: Consider any specific circumstances that might affect the ratios (e.g., a company entering a new market).

Example Comparison Table

Ratio	Company A	Company B	Company C (Industry Average)
Gross Profit Margin	45%	40%	42%
Net Profit Margin	10%	8%	9%
Current Ratio	1.8	1.5	1.6
Debt to Equity Ratio	0.8	1.2	1.0

By systematically calculating and comparing these ratios, we can gain a comprehensive understanding of how different companies are performing and make more informed assessments of their financial health.