Benchmarking Company Profitability and Growth: Some ... - TARA

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Apr 2, 1998 - under-value grant assisted asset purchases may be inflating asset ... (Government of Ireland, 1994; Department of Economic Development, 1990). ... the small business sectors in Northern Ireland and the Republic of Ireland.
The Economic and Social Review, Vol. 29, No. 2, April, 1998, pp. 201-208

Benchmarking Company Profitability and Growth: Some Measurement Issues for Small Firms i n Ireland*

NOLA HEWITT-DUNDAS S T E P H E N ROPER Northern Ireland Economic Research

Centre,

Belfast

Abstract: International

comparisons of productivity, purchasing power and inflation can depend crucially on differences in national statistical procedures. T h i s paper indicates that even in more localised comparisons of small firm performance, differences in accounting practice can have an important distortionary effect. In particular, the tendency for small firms in Northern Ireland to under-value grant assisted asset purchases may be inflating asset based profit measures. T h i s under-valuation is shown, however, to explain only part of the difference between the efficiency of asset utilisation in Northern Ireland and the Republic of Ireland. By contrast small firms in the Republic of Ireland had higher levels of both sales per employee and profit per employee.

I INTRODUCTION

I

t has long been recognised t h a t i n t e r n a t i o n a l comparisons of productivity, p u r c h a s i n g power a n d i n f l a t i o n depend c r u c i a l l y on differences i n n a t i o n a l s t a t i s t i c a l procedures a n d currency c o n v e r s i o n . Even i n more localised comparisons, however, differences i n firms' operating environment can make comparisons difficult. I n t h i s note we h i g h l i g h t a number of issues r a i s e d by a project designed to benchmark the p r o f i t a b i l i t y and g r o w t h performance of small firms i n N o r t h e r n I r e l a n d and the Republic of I r e l a n d . 1

• T h i s project was funded from the support given by the E U Special Programme for Peace and Reconciliation to C A M Benchmarking L t d . We are grateful for this support and to the companies which agreed to take part in the B e n c h m a r k i n g exercise. We are also grateful to B r e n d a n M c F e r r a n ( C A M Benchmarking Ltd); Donal Durkin ( L E D U ) and Peter McCarron ( I D B ) for their help with the study. L

See, for example, the discussion in C M a h o n y and Wagner (1994).

More specifically we consider the impact on the relative profitability, g r o w t h and asset u t i l i s a t i o n of small firms of differences i n accounting practice. The m o t i v a t i o n for the comparisons originated from a desire on the part of development agencies t h r o u g h o u t I r e l a n d to promote s m a l l f i r m g r o w t h (Government of I r e l a n d , 1994; Department of Economic Development, 1990). Small companies, w i t h less t h a n 100 employees account for around a t h i r d of m a n u f a c t u r i n g e m p l o y m e n t i n I r e l a n d , b u t " r e l a t i v e l y few s m a l l f i r m s graduate into the ranks of m e d i u m or large companies" (Gudgin et al., 1989, p. 64). The need to identify those companies w i t h significant g r o w t h potential led to a j o i n t b e n c h m a r k i n g i n i t i a t i v e between the Local Enterprise Develop­ ment U n i t ( L E D U ) and the I n d u s t r i a l Development Board ( I D B ) i n N o r t h e r n I r e l a n d and F o r b a i r t i n the Republic of Ireland. I I C O M P A N Y B E N C H M A R K S A N D M E A S U R E M E N T ISSUES A major element of t h i s j o i n t i n i t i a t i v e — called the Competitive Analysis M o d e l ( C A M ) project — has been the e s t a b l i s h m e n t of a database of performance b e n c h m a r k s for developing companies t h r o u g h o u t I r e l a n d ( M c F e r r a n et al., 1996). T h i s was based on an extensive i n t e r v i e w survey conducted between A p r i l and September 1995 w h i c h led to a final sample of 703 s m a l l i n d e p e n d e n t l y owned c o m p a n i e s . Response rates differed significantly between N o r t h e r n I r e l a n d (52 per cent) and the Republic of I r e l a n d (28 per cent) c o n t r i b u t i n g to a sample biased towards N o r t h e r n I r e l a n d companies. As part of the survey detailed information was sought on f i r m s ' p r o f i t a b i l i t y , g r o w t h and asset u t i l i s a t i o n d u r i n g the 1991 to 1994 business years. Values for each measure are given i n Table 1, w h i c h also reports t h e results o f M a n n - W h i t n e y tests for the independence of the N o r t h e r n I r e l a n d and Republic of I r e l a n d samples, i.e., whether the samples are — i n statistical terms — l i k e l y to have come from the same u n d e r l y i n g d i s t r i b u t i o n (population) of profitability or g r o w t h r a t e s . 2

3

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2. To be included in the survey, firms had to be manufacturers, employ between 10 and 100 workers, be trading for at least four years and be thought by the development agencies to have significant growth potential (as identified by the development agencies). T h e survey was therefore biased towards the most dynamic companies within the relevant population. From an initial sample of 1,853 firms, usable responses were obtained from 406 firms in Northern Ireland and 297 firms in the Republic of Ireland. 3. T h e sample bias towards Northern Ireland firms reflected primarily a greater level of encouragement for firms to participate by the Northern development agencies. See B a r k h a m et al. (1996) for a survey of the performance characteristics of Northern Ireland firms compared to some other U K regions, and Gudgin et al. (1995) for an overview of the relative performance of the small business sectors in Northern Ireland and the Republic of Ireland. 4. Average profit rates were constructed as a simple average of the rates from 1991 to 1994, with 1991 to 1993 values being inflated in 1994 prices. Profit per employee values were inflated to 1994 prices before averaging and expressing in Sterling.

Table 1: Relative Profitability, Growth and Asset Utilisation of Small in Ireland: 1991-1994

n

Lower Quartile Limit

Median

Upper Quartile Limit

Firms

Mean

1. Return on Sales (% of turnover) Northern Ireland 294 Republic of Ireland 131

2.4 2.9

5.6 4.9

10.2 10.0

6.9 6.8

2. Return on Assets (% of net worth) Northern Ireland 264 Republic of Ireland 126

9.1 8.1

22.5 13.8

42.9 22.2

27.1** 17.9**

3. Profit per Employee (£'000 Stg. per employee) Northern Ireland 275 1.0 Republic of Ireland 133 1.2

2.0 2.9

5.1 6.2

3.5** 4.7**

4. Sales Volume Growth (% per year) Northern Ireland 324 1.0 Republic of Ireland 173 0.3

8.3 6

17.6 12.6

11.5 8.3

5. Employment Growth (% per year) Northern Ireland 302 -1.9 Republic of Ireland 184 0.0

2.6 3.5

12.5 10

5.7 5.1

6. Turnover to Asset Ratio Northern Ireland 280 Republic of Ireland 141

4.6 2.8

8.8 4.0

3.6** 2.2**

41.0 55.4

62.6 96.5

56.9** 85.1**

3.0 1.9

7. Turnover per Employee (£'000 Stg. per year) Northern Ireland 302 25.5 Republic of Ireland 173 33.4

Notes: L Profit for each business year was measured by firms' net profit on trading activities before bank interest and tax and excluding all extraordinary items (e.g., the sale of capital equipment). 2. Return on sales expresses net profit as a percentage of sales turnover. Return on assets is net profit as a percentage of net worth. Profit per employee is (real) net profit (in £'000) per person employed. Net profit figures were converted into 1994 prices using the producer price index and converted to sterling using an exchange rate of 1.0233 (Source: Financial Statistics, C S O , December 1995, Table 7.1A). 3. Sales volume is defined as turnover (less any discounts given) deflated by the national rate of producer price growth. For Northern Ireland this implied a price increase of 6.75 per cent from 1991-1994 (Source: Economic Trends, Table 3.1). F o r the Republic the implied price increase was 7.54 per cent (Source: Economic Series, November 1995, p. 15). Employment growth relates to the total number of employees. No allowance is made for any change in part-time employment. 4. 5.

The turnover to asset ratio expresses turnover as a multiple of net assets or net worth. Independence of the Northern Ireland and Republic of Ireland samples was tested using the Mann-Whitney test. **indicates non-rejection of the hypothesis of independence at the 5 per cent level. Source: C A M (1995) Survey Data.

The d i s t r i b u t i o n s of r e t u r n on sales, sales volume g r o w t h and employment g r o w t h rates were very s i m i l a r among small firms i n N o r t h e r n I r e l a n d and the Republic of I r e l a n d . By contrast, the distributions of profit per employee and r e t u r n on assets were significantly different as i l l u s t r a t e d by the M a n n W h i t n e y test statistics (Table 1). M e a n and median rates of r e t u r n on assets were h i g h e r (by 51 and 56 per cent respectively) among s m a l l firms i n N o r t h e r n I r e l a n d , reflecting higher average levels of t u r n o v e r per u n i t of assets. B o t h median and mean turnover to asset ratios i n N o r t h e r n I r e l a n d were 64 per cent h i g h e r t h a n t h e i r southern equivalents. T u r n o v e r per employee, on the other hand, tended to be higher i n the Republic of I r e l a n d leading to higher profit per employee (see Table 1). These contrasts may reflect differences i n small business performance or differences i n firms' operating environment or accountancy practices. I n the measurement of profit, for example, i t is i m p o r t a n t to use pre-tax indicators as business tax rates and thresholds differ between N o r t h e r n Ireland and the Republic of I r e l a n d . S i m i l a r l y , as the interest rates available on deposits and those charged by banks can also differ between the two areas i t is preferable to use a measure of t r a d i n g profit rather t h a n an indicator w h i c h includes investment income or takes account of interest charges. The profit indicator used i n the benchmarks was therefore firms' net profit on t r a d i n g activities before b a n k interest and tax and excluding all extraordinary items (e.g., the sale of capital equipment). Even this profit measure, however, is subject to uncertainties r e l a t i n g to directors' remuneration/drawings and the account­ ing approaches which firms use to take account of capital grants. I n large firms, or i n situations where a s m a l l firm's directors are not employees of the company, directors' d r a w i n g s or r e m u n e r a t i o n w i l l be included i n net profit. I n small firms, the directors of a business may also be employees. I n t h i s s i t u a t i o n , the directors of a business may choose to drawout money either as wages/salaries or i n the form of directors' drawings or remuneration. I n the former case, net profit w i l l be reduced, i n the latter, the situation w i l l reflect t h a t i n larger firms and, net profit w i l l be unaffected. Ex post i t is impossible to determine how an individual small f i r m is determining t h e s p l i t between wages and salaries and d r a w i n g s , r e s u l t i n g i n some uncertainty i n the measurement of net profit. There is no reason, however, to anticipate any systematic difference between the approaches being adopted by small firms i n N o r t h e r n Ireland and the Republic of Ireland. A second, and perhaps more i m p o r t a n t , issue relates to the accounting method firms use to take account of capital grants. I n the Republic of Ireland, firms are r e q u i r e d to include new capital assets i n t h e i r balance sheet at purchase value. A n y grant is t h e n added to the profit and loss account over a period of t i m e w h i c h reflects the depreciation profile of the assets purchased.

I n N o r t h e r n I r e l a n d around h a l f of a l l m a n u f a c t u r i n g f i r m s also adopt t h i s approach (Roper, 1993). The r e m a i n i n g N o r t h e r n I r e l a n d f i r m s adopt a net cost approach i n c l u d i n g new assets i n t h e i r balance sheet at purchase value less any g r a n t received. They t h e n depreciate t h i s smaller value. The impact of t h i s difference is twofold. F i r s t , the average book value of f i r m s ' assets i n N o r t h e r n I r e l a n d is l i k e l y to be lower t h a n t h a t i n the Republic of I r e l a n d . Second, t h e time-profile of c a p i t a l g r a n t receipts on the net p r o f i t of an i n d i v i d u a l f i r m w i l l be more heavily front-loaded i n N o r t h e r n I r e l a n d . I n aggregate the former of these t w o effects is l i k e l y to be most i m p o r t a n t , reducing asset values i n N o r t h e r n I r e l a n d and i n t r o d u c i n g an u p w a r d bias into asset-based profitability and efficiency measures. 5

Because of i t s p o t e n t i a l significance i n the i n t e r p r e t a t i o n of the p r o f i t ­ a b i l i t y ratios i t is i m p o r t a n t to t r y to quantify — at least i n broad terms — the l i k e l y scale of any asset under-valuation i n N o r t h e r n I r e l a n d . Suppose, for example, t h a t a l l asset purchases by small firms i n N o r t h e r n I r e l a n d were grant-aided at 40 per cent. Then, as around h a l f of N o r t h e r n I r e l a n d firms were using the net cost approach, the underestimation of the t o t a l asset value w o u l d be 20 per cent. I n practice, however, the true level of under-valuation is l i k e l y to be lower t h a n t h i s because average c a p i t a l g r a n t rates are typically m u c h lower t h a n 40 per cent and because only a proportion of asset purchases by s m a l l firms are g r a n t assisted. F r o m 1991-1994, for example, only 30.1 per cent of N o r t h e r n I r e l a n d small firms received any support for investments i n plant, machinery and equipment (McFerran et al., 1996). F r o m the profitability and g r o w t h figures i n Table 1 i t is possible to derive the extent of asset under-valuation t h a t w o u l d be necessary to reduce the rate of r e t u r n on assets and turnover per u n i t of assets i n N o r t h e r n I r e l a n d to t h a t i n the Republic of Ireland. For example, assets would have to be under­ valued by 33.8 per cent to reduce the p r e v a i l i n g rate of r e t u r n on assets i n N o r t h e r n I r e l a n d (27.1 per cent) to equal t h a t i n the Republic of I r e l a n d (17.9 per cent). S i m i l a r l y , a 39.0 per cent u n d e r - v a l u a t i o n of assets w o u l d be r e q u i r e d to reduce the turnover per u n i t of assets r a t i o i n N o r t h e r n I r e l a n d (3.6) to t h a t of the Republic of I r e l a n d (2.2). I n both cases this is considerably greater t h a n the level of asset under-valuation w h i c h is likely, as seen above. T h e i m p l i c a t i o n is, therefore, t h a t only part of the differential between the r a t e of r e t u r n on assets and the turnover to asset r a t i o i n N o r t h e r n I r e l a n d a n d t h a t i n the Republic of I r e l a n d could be explained by asset under­ v a l u a t i o n , i.e., even a l l o w i n g for asset under-valuation both ratios w o u l d s t i l l be higher i n N o r t h e r n I r e l a n d . A s indicated earlier t h i s contrasts strongly

5. Although over the lifetime of an asset a similar capital grant would have an identical cumulative profit impact in Northern Ireland and the Republic of Ireland.

w i t h h i g h e r t u r n o v e r per employee and profit per employee i n Republic of I r e l a n d small firms. T h e q u e s t i o n t h e n is w h e t h e r these r e m a i n i n g differences can be a t t r i b u t e d to differences i n sample composition or other aspects of f i r m s ' c h a r a c t e r i s t i c s . F o r example, r e f l e c t i n g differences i n t h e u n d e r l y i n g populations, a larger p r o p o r t i o n of the Republic of I r e l a n d sample was i n mechanical and electrical engineering and food processing. I n the case of food processing, i n p a r t i c u l a r , t u r n o v e r per employee w o u l d be expected to be h i g h e r t h a n the average for a l l m a n u f a c t u r i n g b u t profit m a r g i n s w o u l d typically be below average. For example, sales per employee i n the I r i s h food, d r i n k and tobacco sector i n 1995 was £IR245,645 as compared to £IR161,898 for a l l m a n u f a c t u r i n g i n d u s t r i e s . P r o f i t a b i l i t y was, however, lower i n the I r i s h food, d r i n k and tobacco sector, at 4.3 per cent of sales, as compared to the average of 6.2 per cent for a l l m a n u f a c t u r i n g f i r m s . Given the s l i g h t l y h i g h e r concentration of food processing f i r m s i n the Republic of I r e l a n d sample i t w o u l d be expected t h a t t h i s w o u l d reduce the t u r n o v e r to asset differential between the N o r t h e r n I r e l a n d and Republic of I r e l a n d samples. Yet, t h i s was not found w i t h the i m p l i c a t i o n being t h a t sample composition was not an i m p o r t a n t factor i n explaining the performance ratios. 6

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I t is also possible t h a t differences i n capital i n t e n s i t i e s between the N o r t h e r n I r e l a n d a n d Republic of I r e l a n d firms could help to e x p l a i n the r e t u r n on assets and profit per employee differentials. Unfortunately as data was only collected on net assets, no accurate assessment of fixed and w o r k i n g capital could be made to relate to labour inputs. On-going analysis however, suggests t h a t i n v e s t m e n t p a t t e r n s and t h e age of capital equipment are r e m a r k a b l y s i m i l a r for N o r t h e r n I r e l a n d and Republic of I r e l a n d small firms (see Hewitt-Dundas, 1998). 8

O t h e r characteristics of the Republic of I r e l a n d a n d N o r t h e r n I r e l a n d samples suggest counteracting effects. For example, the share of firms' sales accounted for by new or i m p r o v e d products was greater i n the Republic of I r e l a n d w h i c h , product life-cycle models w o u l d suggest is l i k e l y to increase profit margins and firm g r o w t h rates (Kay, 1979). I n neither case, however, was this evident from the empirical comparisons (Table 1).

6. C S O , 1995. Census of Industrial Production, Table A, p. 11, Dublin: Central Statistics Office. 7. Forfas, Enterprise Policy and Planning Division, 1997, Irish Economy Expenditure Survey, Preliminary Results from 1994 and Trends 1988-1994, Table 3, Forfas, Dublin. 8. O u r thanks go to an anonymous referee for highlighting the potential effect of capital intensities on relative profit per unit of assets and profit per employee ratios.

III IMPLICATIONS I n t e r n a t i o n a l profitability and g r o w t h comparisons depend significantly on the regulatory and legislative regimes w i t h i n w h i c h f i r m s operate. Even i n localised comparisons, such as t h a t between N o r t h e r n I r e l a n d a n d t h e Republic of I r e l a n d , these issues are not u n i m p o r t a n t . I n particular, because of differences i n accounting practice, firms i n N o r t h e r n I r e l a n d tend to under­ value assets relative to t h e i r counterparts i n the Republic of Ireland. This is a consequence of the fact t h a t around h a l f of N o r t h e r n I r e l a n d f i r m s include assets i n t h e i r balance sheet net of any government grants. The effect of t h i s u n d e r - v a l u a t i o n is to d i s t o r t any relative p r o f i t a b i l i t y calculations w h i c h depend on asset values. I n the particular case considered here, however, allowing for the differences i n asset v a l u a t i o n was insufficient to account for higher rates of r e t u r n on assets and turnover to asset ratios i n N o r t h e r n I r e l a n d . Other p r o f i t a b i l i t y indicators, less seriously affected by differences i n accounting practice, suggested t h a t profit per employee a n d t u r n o v e r per employee were h i g h e r i n the Republic of I r e l a n d t h a n i n N o r t h e r n Ireland. These contrasting strengths suggest the potential develop­ m e n t a l value of continued cross-border benchmarking i n i t i a t i v e s . A n y such i n i t i a t i v e s must, however, t a k e careful account of possible d i s t o r t i o n a r y effects due to differing accountancy practice. REFERENCES BARKHAM, R., G. GUDGIN, M . HART, and E. HANVEY, 1996. The Determinants of Small Firm Growth — An Inter-Regional Study in the UK: 1986-90, London: Jessica Kingsley. CENTRAL STATISTICS OFFICE, 1995. Census of Industrial Production, Dublin: Central Statistics Office. DEPARTMENT OF ECONOMIC DEVELOPMENT, 1990. Competing in the 1990s, Belfast. FORFAS ENTERPRISE POLICY AND PLANNING DIVISION, 1997. Irish Economic Expenditure Survey, Preliminary Results from 1994 and Trends 1988-1994, Dublin: Forfas. GOVERNMENT OF IRELAND, 1994. Task Force on Small Business, Dublin. GUDGIN, G., M . HART, J. FAGG, E. D'ARCY, and R. KEEGAN, 1989. Job Generation in Manufacturing Industry, Belfast: Northern Ireland Economic Research Centre. GUDGIN, G., R. SCOTT, E. HANVEY, and M. HART, 1995. "The Role of Small Firms i n Employment Growth in Ireland, North and South", i n J. Bradley (ed.), The Two Economies of Ireland, Dublin: Oak Tree Press. HEWITT-DUNDAS, N . (forthcoming). Equipment Vintage and Investment Appraisal: A Comparative Analysis of Small Firms in Northern Ireland and the Republic of Ireland, Belfast: Northern Ireland Economic Research Centre. KAY, N.M., 1979. The Innovating Firm: A Behavioural Theory of Corporate R&D, London: Macmillan.

McFERRAN, B., N . HEWITT-DUNDAS, and S. ROPER, 1996. Performance Bench­ marks for Developing Firms, The CAM Project, Belfast: Northern Ireland Economic Research Centre. O'MAHONY, M . , and K. WAGNER, 1994. Changing Fortunes: An Industry Study of British and German Productivity Growth over Three Decades, Report Series, 7, London: National Institute for Economic and Social Research. ROPER, S., 1993. Government Grants and Manufacturing Profitability in Northern Ireland, Belfast: Northern Ireland Economic Research Centre.