The surprising factors that influence profitability – assets
In the first three 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 much more than executives. However, the model suggests that executive decisions could impede 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 this article we will move to a variable more unilaterally influenced by executives: total fixed assets. Modelling indicated that a £1 increase in total fixed assets correlates with reduced profitability of 10.2 pence. Bearing in mind that total fixed assets in our sample ranged from -£149,000 to £723,283,690, this equates to a swing in pre-tax profits of nearly £74 million or 64% of the total difference in pre-tax profits in the sample.
Total fixed assets can be broadly divided into tangible and intangible assets. It is not clear from the data set what contribution intangible assets make to the total fixed assets of the companies under study. Intangible assets often derive from the acquisition of another company. Given the size and age of the SME’s in the sample, it is possible that a significant number have been through at least one merger. Many studies have demonstrated that mergers and acquisitions tend not to create the operational benefits so often touted to justify such corporate events. Companies are often bought for multiples of EBITDA and strategic acquisitions usually involve large multiples. Any multiple greater than one will lead to a negative relationship between total fixed assets and pre-tax profit. Larger multiples, as high as 5-20x EBITDA are usually justified on synergies and operational efficiencies that can be gained by merging. As we have discussed previously, in practice, such operational efficiencies are rarely achieved in full. Taking into account the opinions and expertise of operational managers and other employees can help to develop more realistic plans to achieve such savings post merger and start the planning process before the merger is complete.
It is clear then that strategic decisions to over-pay to acquire another company may reduce profitability. While this may be acceptable, and even desirable in the short-term, the impact should not be ignored and such executive decisions should be taken in consultation with operational employees to maximise the opportunity.
In contrast, it is obvious that tangible assets can have an impact on profitability. Building and plant require maintenance, plant and equipment must be replaced from time to time. It is conceivable therefore that the costs of maintaining tangible assets may exceed the depreciation of them. The acquisition of additional tangible assets should therefore take into account not just the affordability of acquiring them, but also the ongoing impact on profitability.
While many may think that buying an asset will have a positive effect on profit, for example by reducing rental costs, etc. The model we have developed suggests that, at least for large SMEs we have sampled, this isn’t necessarily the case.
It is not unknown for the acquisition of tangible and intangible assets to be driven by ego or vanity as opposed to the supposed operational gains used to rationalise the decision. The data suggests that considerable care should be taken before adding fixed assets to the balance sheet, particularly those that are not directly involved in creating or improving income streams and profits.
In the next article we will turn our attention to the surprising impact of shareholders on profitability.