The surprising factors that influence profitability – shareholder funds

In the first four articles I introduced a model that implicated five rarely considered factors in the profitability of commercial organisations. While strategies to increase profitability are usually operational measures, such as increasing prices and productivity or reducing costs and waste, the model shows that working capital, number of employees, share capital, share funds and total fixed assets explain a significant amount of the variability in the profitability of companies regardless of sector, monopolisation or market conditions.

The idea that operational managers hold more tools to improve profit may lead to a bias that they have the responsibility to do so. However, the model suggests that executive decisions could get in the way of operational efforts to increase profits. On the other hand, carefully considered strategies to manage the variables implicated by the model could enhance operational efforts. In the second and third articles we have looked at two operational variables, working capital and number of employees, and demonstrated how both operational management and executive decision-making working together can have a synergistic effect on profitability. In the fourth article, we examined how executive decisions to acquire tangible or intangible fixed assets is remarkably, and unexpectedly, tied to overall profitability.

In this, the fifth, article, we will turn our attention to probably the most surprising of the five variables in the model that impact profitability: shareholder funds per year.

Round Of Financing Startup Finance  - viarami / Pixabay
viarami / Pixabay

Shareholder funds are the value of shares held by shareholders. For many SMEs, the value of shares is a nominal value, often £1 per share and bears no resemblance to the actual value of the business. For older, larger SMEs that may have been through mergers and acquisitions, the total share value, may reflect a formal or transactional valuation of the company. This may affect both the number of shares held in the company and the nominal value per share. This indirect effect of company age may explain why shareholder funds per year was a more pertinent variable in the model than total shareholder funds.

Specifically, the model implies that adding £1/year of share funds correlates with a reduced pre-tax profit of £1.54.

This is completely counter-intuitive – why would altering the number or face value of shares affect profitability? It is worth reminding ourselves that correlation does not mean that it is causative. However, the earlier suggestion in the fourth article in this series, that mergers and acquisitions tend to over-value the acquired company supports the idea that “excessive” shareholder funds is related to reduced profitability. It remains an open question whether participation in a merger or acquisition could be even more predictive of reduced pre-tax profits than other variables in the model.

Another mechanism by which this correlation occurs could be via the introduction of capital from new shareholders or by expanding shareholding of existing shareholders. One potential, transient mechanism might apply if the introduction of equity capital was used to increase working capital over an extended period of time. As we have seen previously, increasing working capital correlated with decreased pre-tax profits. Another mechanism would apply if the additional equity was used to acquire fixed assets as this is also associated with decreased pre-tax profits. However, the model is far more predictive of pre-tax profits when shareholder funds per year is included than when it is excluded indicating that other mechanisms may also be involved. The opposite situation is also possible – decreasing profitability results in expanded shareholding as a mechanism to introduce additional capital as a way to prop up a struggling, or even failing, business. The potential causative steps require further study.

In conclusion, various mechanisms may be involved in the effect of shareholder funds on pre-tax profits or vice versa. It is therefore worth considering the purpose of introducing new equity capital and its potential impact on the operational effectiveness of the business before signing the deal.

In the next article we will turn our attention to the final variable in the model, share capital, and how this is related to stronger pre-tax profits.