0452 · 6.3Inter-business comparison

Ratios for comparing businesses

0:00Two cycle shops can report different ratios even when both are well managed. Their prices, customers, borrowing and accounting methods may differ. This video covers the factors that may affect the ratios of two businesses and the problems of inter-business comparison. Inter-business comparison means assessing one organisation’s performance and financial position against another’s. An accounting ratio expresses the relationship between two accounting figures. Ratios help us compare businesses of different sizes because they express relationships rather than just total amounts.

0:31However, a fair comparison also requires similar activities, reporting periods and accounting methods. Revenue is the income a business earns from its main activity, such as selling goods or providing services. For a cycle shop, revenue comes mainly from selling bicycles. Expenses are the costs used up in running the business and earning revenue during a period. A cycle shop pays rent and wages, for example. Profit for the year is the amount by which revenue exceeds expenses over one financial year.

1:01Inventory means goods held for resale, while cost of sales is the cost of inventory sold during a period. Bicycles waiting for customers are a cycle shop’s inventory. Gross profit is revenue minus cost of sales, while gross profit margin measures gross profit as a percentage of revenue. This margin shows how much of each revenue dollar remains before other expenses. Assets are resources owned or controlled by a business that bring future benefit.

1:26A cycle shop’s bicycles for sale, its cash and its repair equipment are all assets. Current assets are assets expected to be turned into cash or used up within twelve months. The bicycles and cash belong in this group, although bicycles must usually be sold before they provide cash. Liabilities are amounts the business owes to others, while current liabilities are amounts due for payment within twelve months. The current ratio, also called the working capital ratio, compares current assets with current liabilities.

1:56Dividing current assets by current liabilities shows the resources available for each dollar due soon.

Comparing two cycle shops

2:02Nisha Cycles and Rowan Cycles are two competing shops in our worked comparison. Nisha Cycles has revenue of sixty thousand dollars and cost of sales of thirty-six thousand dollars. Sixty thousand minus thirty-six thousand gives gross profit of twenty-four thousand dollars. Divide twenty-four thousand by sixty thousand, then multiply by one hundred. Its gross profit margin is forty per cent, so forty cents of each revenue dollar remains before other expenses.

2:29The shop has current assets of nine thousand dollars and current liabilities of five thousand dollars. Nine thousand divided by five thousand gives a current ratio of one point eight to one. There are therefore one dollar and eighty cents of current assets for each dollar due within twelve months. Rowan Cycles reports revenue of one hundred thousand dollars and cost of sales of seventy thousand dollars. Its gross profit is one hundred thousand minus seventy thousand, which is thirty thousand dollars.

2:55Thirty thousand divided by one hundred thousand, multiplied by one hundred, gives a margin of thirty per cent. Nisha Cycles keeps forty per cent of revenue as gross profit, while Rowan Cycles keeps thirty per cent. Rowan Cycles still earns more gross profit in dollars because its revenue is larger. For Rowan Cycles, current assets are sixteen thousand dollars and current liabilities are eight thousand dollars. Dividing sixteen thousand by eight thousand produces a current ratio of two to one.

3:22This is higher than Nisha Cycles’ one point eight to one. Rowan Cycles has more current assets per dollar due soon, but the usefulness of those resources depends partly on how quickly its inventory sells.

Factors affecting business ratios

3:34Pricing policy can explain the margin difference. Nisha Cycles might charge higher prices and sell fewer bicycles, while Rowan Cycles might use lower prices to attract more customers. A high price, low volume policy can produce a higher gross profit margin. The low price, high volume alternative can still generate greater total gross profit, as our figures demonstrate. Size, type of business and products also affect the ratios of two businesses.

4:00Buying in greater quantities may earn a larger shop lower purchase prices, so its cost of sales falls and its gross profit margin rises. A specialist seller of expensive bicycles may hold slow-selling inventory for months, which raises its current assets and its current ratio. A repair-only business provides services and holds little inventory. Its ratios therefore reflect a different activity from selling bicycles. Location changes the conditions under which each business operates.

4:27Profit margin measures profit for the year as a percentage of revenue. A shop in a busy shopping area may attract more customers but pay higher rent. That rent is an expense, so it lowers profit for the year and the profit margin. Gross profit margin is unaffected, because rent is not part of cost of sales. Accounting policies are the principles, bases and methods used to prepare and present financial statements.

4:50Different policies can change reported figures even when business activities are similar. For example, inventory valuation affects cost of sales and current assets. A higher closing inventory value reduces cost of sales and increases gross profit, so the reported margin and current ratio can both rise. Repair equipment is not a current asset, because non-current assets are assets held for continuing use in the business rather than for resale. Depreciation is the loss in value of a non-current asset over its useful life.

5:20It is an estimate that is charged as an expense in each year of use. Different depreciation methods can give similar equipment different annual charges. The shop with the higher charge reports a lower profit for the year and profit margin, even when the equipment does the same work. The age of non-current assets matters too. A shop with old, fully depreciated equipment has no depreciation charge, which raises its profit margin.

5:44That old equipment may also need frequent repairs, and those repair costs lower its profit for the year. A shop that has just bought new equipment faces the opposite pattern of high depreciation and few repairs. Financing decisions also affect the ratios. An owner-financed business may avoid the interest expense incurred by a loan-financed competitor. Loan interest lowers profit for the year and the profit margin. Any loan repayable within twelve months is a current liability, so it lowers the current ratio.

6:13A difference in ratios may reflect financing decisions rather than how efficiently bicycles are bought and sold.

Timing and one-off events

6:18Different financial year ends can place the shops at different points in their seasonal trading cycle. One shop might report just after its busy summer sales, when inventory is low and cash is high. The other might report just after buying bicycles for the next season on credit. Its inventory and the amounts it owes suppliers are then both high, so its current ratio can differ for seasonal reasons alone.

6:39One-off events can make a single period unrepresentative of normal trading. Suppose a flood damages one shop’s premises and destroys some of its bicycles. The lost inventory reduces its current assets, so its current ratio falls. Repairing the premises adds expenses that lower its profit for the year and its profit margin.

Limitations and exam comparison

6:59These factors create the problems of inter-business comparison. The businesses may differ in size, products or activities, so a gap between their ratios may reflect the type of business, not its performance. Even similar shops may apply different accounting policies, so their figures are not prepared on the same basis. Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date.

7:23A competitor’s published financial statements may provide totals without detailed explanations. Access to its product costs, customer arrangements and reasons for unusual changes may be limited. Nisha Cycles, for example, cannot see which bicycles Rowan Cycles sells at reduced prices. Financial statements may also be out of date when the comparison is made. A competitor’s statements for a year that ended ten months ago miss every change since then. Historic cost means assets are recorded at the price paid when they were acquired.

7:52Equipment bought many years ago may therefore have a recorded amount that differs greatly from its current replacement cost. Two shops with similar equipment can show different figures because they purchased it at different times. Ratios use financial information, so they do not directly measure customer satisfaction, staff skills or product quality. Those features can influence future sales without appearing as separate accounting amounts. Ratios also show results rather than establish their causes.

8:19Our margin comparison reveals a difference, but further evidence is needed to distinguish higher prices from lower purchase costs. A sound comparison separates the evidence from possible explanations. State which ratio is higher, describe what that relationship shows, then suggest reasons supported by the question. Treat an explanation such as different pricing as a possibility unless it is confirmed. A higher current ratio shows more current assets for each dollar due soon.

8:46Judge either business overall only after weighing several ratios and the reasons behind them. In examinations, compare means comment on similarities and differences, while explain means give reasons, why and how, supported by evidence. The exam card asks for two reasons why comparing Nisha Cycles with Rowan Cycles may be misleading. Each reason earns its marks when it names the difference and the ratio it changes. One reason is that the shops may use different depreciation methods.

9:14A higher annual charge lowers profit for the year and the profit margin, even when the equipment does similar work. Another reason concerns their financial year ends, which may fall at different stages of seasonal trading. Inventory and cash then reflect the season, so the current ratio may differ for reasons unrelated to management. In Paper One, a multiple-choice question may ask which circumstance makes a comparison less reliable. Structured questions in Paper Two can require a ratio comparison and explanations of its limitations.

9:44Use the figures to describe differences, then seek evidence about their causes before judging either business.