Inter- firm and Intra-firm Comparison

 

Inter- firm and Intra-firm Comparison

 

v  Inter-firm Comparision

Financial statements provide basic information on the financial position of a firm to assist management in making operational decisions. Financial records represent composites of the major functions in the firm's operations expressed in monetary terms as a common denominator. This common denominator enables a manager or owner to make yearly comparisons of the different functions in the firm's operations. Accurate financial reports are necessary for making meaningful financial analyses of a firm's operations. A knowledge of the use of the information in financial statements is a prime prerequisite for this type of analysis. If a manager lacks the ability to effectively use the information provided in the financial statement, the statement is of little value to the manager in performing the management function. Thus, the analysis of a financial statement is only beneficial when the information is accurate and the capabilities of management will allow proper analysis of the data presented in the report. For many years research efforts have been directed towards analyses which would provide results which would assist country elevator managers in a more effective use of financial statements in making management decisions. Most studies have emphasized interfirm comparisons of hypothesized important relationships in financial statements. An assumption of homogeneity among firms is necessary for meaningful interfirm comparisons. This broad assumption means that the economic environment of all firms is the same, even though firms have different capital structures, perform different services and functions, and have different accounting systems.  The method by which one firm is compared with other firms particularly when technol­ogy, product characteristics, production method and general operating conditions are same in the same industry, the same is known as inter-firm comparison. It would be more significant and meaningful if the performances of the firms are compared with that of the others, belonging to the same group, for a year or for a few years. In that case, the position of the company can be judged in the industry. In other words, it is a technique by which one can evaluate the performances, efficiencies, profits and costs of a company with other companies in the industry.

            But one thing should be remembered, i.e., comparison between the firms becomes meaningful when it is based on common definitions, usage, information relating to costs, profits, productivity and efficiencies as a whole. Proper comparison is not possible between two unlike or different firms. So, needless to mention that in order to make an inter-firm comparison there must be a uniform costing system. For this purpose, a central organisation/trade association or Chamber of Commerce is to be set up for collecting, analysing, interpreting and presenting the information (data) in a suitable form which will be used by its member firms in the industry. Inter-firm comparison may be made not in the form of absolute figures but in the form of various ratios, usually the figures relate to cost accounting liquidity and profitability as well. Thus, inter-firm comparison helps a company to know its own drawbacks by measuring its own performances with an efficient firm in the industry and can locate easily its week points which ultimately helps the firm to take the corrective measures for the future.

            For this purpose, two cost accounting methods, viz, Standard Costing and Budgetary Control System can be applied for controlling cost and to increase the efficiency of the firm. Thus, from the above discussion it becomes clear that the inter-firm comparison will be significant and meaningful provided:

·         The firms must be under same age group (i.e., if comparison is made between a new firm and an old one, the same will not produce a clear picture);

·         They belong to almost same size (i.e., comparison between a small firm and a big firm (although they are producing the same articles) is of no use,

·         They must cater to the saipe market; and

·         They must be engaged with the same kind of business.

            Proper comparison between two firms is possible only when the above conditions are satisfied. However, in real world situation, it is really difficult to get firms which follow the above conditions except, to some extent, cement and sugar industry. Even then, if the three conditions [(i), (ii) and (iv)] are satisfied, it will be meaningful after leaving an allowance for that purpose. Moreover, the following procedure should carefully be followed for the purpose of inter- firm comparison between the firms:

                                                       I.            For the purpose of comparison, the data should be collected from a central body/ agency/or from the chamber of commerce or from trade association/agency;

                                                    II.            For the purpose of analysing, scrutinising and presenting the data, proper secrecy must be maintained i.e.. instead of using absolute figures/information, percentage or ratios may be used;

                                                 III.            In order to determine the efficiency and to compare the performances of other companies the management must be supplied with the necessary information; advanced financial analysis and planning

                                                 IV.            After realising the snags and weakness, an attempt must be made to show why the efficiency of the concerned firm is less than that of the other.

Purpose of Inter-Firm Comparison:

 

It has already been stated above that the purpose of inter-firm comparison is to compare the efficiency of one firm with that of other belonging to the same group of industry and helps the management to locate the problems or reasons for such inefficiency (if any) and to take the corrective measures for its improvement. It has also mentioned in the earlier paragraph that there must be a central body/agency (like Chamber of Commerce) who will work i.e., will collect and analyze the information on behalf of the members by which many snags or drawbacks can be controlled However, some of the problems are enumerated below

·         Is profit adequate ?

·         How efficient is production ?

·         How efficient is selling ?

·         Is Working Capital sufficient ?

·         Is stock-turnover adequate ?

·         Is Profit Adequate ?

 

Advantages of Inter-Firm Comparison:

 

Proper inter-firm comparison presents the following notable advantages:

·         There is no uncertainty in it as it is taken from a successful firm and as such, it helps the management to take corrective measures for its improvement in efficiency in near future.

·         Inter-firm comparison locates or points out the snags and weakness of the firm and thus assist the management to take all possible steps in order to improve the productivity of all factors which are directly connected.

·         It also helps the business world to run in the correct way.

·         This comparison helps the Government to regulate the prices of the commodity in the country.

·         Since the data are collected and presented by the central agency/body, biasness is absent.

·         Inter-firm comparison develops the cost consciousness amongst its members since various ratios are known.

·         Inter-firm comparison presents not only the difference between the two firms, it also explains the reasons for such difference and suggest the possible remedies for its improvement both for liquidity and profitability aspect of the firms.

Limitations of Inter-Firm Comparison

 

Inter-firm comparison is not even free from snags. Some of them are discussed here­under:

·         It is very difficult to maintain the secrecy of the firm since the data are presented to its members.

·         It is not always possible to make a proper comparison between the two firms as identical position is hardly possible in the real world situation. Thus, it is not always effective.

·         In the absence of any. Proper cost accounting system, the data so collected and presented cannot produce any reliable information for the purpose of making proper comparison. Thus, it will become fruitful only when both the firms maintain good costing system.

·         Sometimes the member firms do not prefer to disclose their data about the financial and operational performances.

 

v  Intra-firm Comparison

 

Intra-firm comparison means comparison among different units/products/strategic business unit (SBU) of a firm. This comparison is possible only when uniform costing methods and practices are being adopted by all units and SBUs. Intra firm comparison helps the management in identifying the units/Strategic SBUs which have not been performing as per the internal benchmark or standards achieved by other units SBUs. This comparison is difficult sometime when the firm is dealing in different product/sectors and their working conditions are significantly different. The term intra firm comparison means comparison of two or more departments or division’s belonging to the same firm with the objective of making meaningful analysis for the purpose of increasing the effectiveness or efficiency of the departments or division’s involved. This may also mean comparison of results achieved by an organization over two different financial periods or period’s consideration. The idea is to compare the firm’s performance with its own performance in some other department other point in time.

 

Advantages of intra firm comparison:-

 

·         Intra firm comparison helps an organization to understand its own strengths and weakness and the way it has evolved over a period of time.

·         Cost controls decisions, pricing decisions, production planning, expenses planning’s, future investments are all those decisions which may very well be facilitated and helped by a sound intra firm comparison.

·         Comparisons with the departments within the organisation helps an organisation develop and promote a profit centre model and compare the ultimate results yielded by various departments.

 

Limitation of intra firm comparison:-

 

·         Top management of the organization may be reluctant or un cooperative in intra firm comparison as it requires an added effort and financials may be required to be re-grouped or presented in a different format to facility the comparison.

·         Various departments in the organization may not be functioning on same business environment. This may either make the comparison.

·         Since management over various different periods of comparisons may be different, the process of comparison and analysis may become a fault-finding exercise and may lose its real importance

v  Residual Income Approach

 Residual income valuation (also known as residual income model or residual income method) is an equity valuation method that is based on the idea that the value of a company’s stock equals the present value of future residual incomes discounted at the appropriate cost of equity.

 Residual Income Valuation

  The main assumption underlying residual income valuation is that the earnings generated by a company must account for the true cost of capital (i.e., both the cost of debt and cost of equity). Although the accounting for net income considers the cost of debt (interest expenses are included in the calculation of net income), it does not take into account the cost of equity since the dividends and other equity distributions are not included in the net income calculation.

 

Due to the above reason, the net income does not represent the company’s economic profit. Moreover, in some cases, even when a company reports accounting profits, such profits may turn out to be economically unprofitable after the consideration of equity costs.

 

On the other hand, residual income is the company’s income adjusted for the cost of equity. Remember that the cost of equity is essentially the required rate of return asked by investors as compensation for the opportunity cost and corresponding level of risk. Therefore, the value of a company calculated using the residual income valuation is generally more accurate since it is based on the economic profits of a company.

 

 Benefits of Residual Income Valuation

·         Generally, residual income valuation is suitable for mature companies that do not give out dividends or follow unpredictable patterns of dividend payments. In this regard, the residual income model is a viable alternative to the dividend discount model (DDM).

 

·         Additionally, it works well with companies that do not generate positive cash flows yet. However, an analyst must be aware that such an approach is based mostly on forward-looking assumptions that can be manipulated or are prone to various biases.

 

·         Along with the discounted cash flow (DCF) model, residual income valuation is one of the most recognized valuation approaches in the industry. Although the approach is less well-known, the residual income model is widely used in investment research. (Note that residual income valuation is an absolute valuation model that aims to determine a company’s intrinsic value).

 How to Calculate a Company’s Value Using the Residual Income Valuation Model?

The first step required to determine the intrinsic value of a company’s stock using residual income valuation is to calculate the future residual incomes of a company.

 Recall that residual income is the net income adjusted for the cost of equity. In most cases, the residual income can be calculated as the difference between the net income and equity charge. Mathematically, it can be expressed through the following formula:

 Residual Income = Net Income – Equity Charge

  Essentially, the equity charge is a deduction from net income accounted for the cost of equity. The equity charge is a multiple of the company’s equity capital and the cost of equity capital. The formula of the equity charge is:

  Equity Charge = Equity Capital x Cost of Equity

 After the calculation of residual incomes, the intrinsic value of a stock can be determined as the sum of the current book value of the company’s equity and the present value of future residual incomes discounted at the relevant cost of equity. The valuation formula for the residual income model can be expressed in the following way:

 Formula

 Where:

 BV0 – Current book value of the company’s equity

RIt – Residual income of a company at time period t

r – Cost of equity

 Example of the Residual Income Approach

 ABC International has invested $1 million in the assets assigned to its DAE  subsidiary. As an investment center, the facility is judged based on its return on invested funds. The subsidiary must meet an annual return on investment target of 12%. In its most recent accounting period, DAE has generated net income of $180,000. The return can be measured in two ways:

 Return on investment. ABC's return on investment is 18%, which is calculated as the $180,000 profit divided by the investment of $1 million.

 Residual income. The residual income is $60,000, which is calculated as the profit exceeding the minimum rate of return of $120,000 (12% x $1 million).

 Thus, the residual income approach is better than the return on investment approach, since it accepts any investment proposal that exceeds the minimum required return on investment. Conversely, the return on investment approach tends to result in the rejection of any project whose projected return is less than the average rate of return of the profit center, even if the projected return is greater than the minimum required rate of return.