The surprising factors that influence profitability – share capital

In the first five 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.

Tower Urban Skyscraper Business  - serbuxarev / Pixabay
serbuxarev / Pixabay

The idea that operational managers hold more of the tools that can be wielded to improve profit, may lead to a bias that they have the sole responsibility to do so. However, the model suggests that decisions made by executives 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 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 has a remarkable, and unexpected, overall effect on profitability. And in the fifth article, we saw that introducing equity funds into the business was associated with decreased pre-tax profits.

In this, the sixth and penultimate article, we will turn our attention to a variable that is unilaterally under the control of executives: share capital.

Share capital, specifically the net total assets of the company, positively influences profitability. Adding £1 to the share capital correlates with 16.7 pence greater pre-tax profit.

Share capital is calculated as the difference between total assets and total liabilities (including share funds). However, we have already seen that increasing net current assets has a negative relationship with pre-tax profit and that greater total fixed assets is also associated with lower pre-tax profit. The implication, therefore is that lower liabilities is key to profitability. Liabilities comprise formal debt in the form of bank loans as well as informal debt in unpaid expenses. It’s reasonable to conclude that a company with high levels of informal debt is a business in difficulty, struggling with cashflow issues. While it is true that profitable businesses, particularly high growth businesses, can struggle with cashflow, it is also true that businesses with low profitability struggle with cashflow. This would suggest that cause and effect is flipped in this case: low share capital due to high levels of “informal debt” does not cause low pre-tax profit, rather low pre-tax profits leads to low share capital caused by high levels of informal debt.

It is also possible that increasing liabilities by taking on formal debt could reduce pre-tax profit. Interest repayments are one obvious way for this to occur. But if £1 of debt results in average interest payments of 16.7%, that implies that the borrowing taken on by large SMEs at the moment is very expensive. With interest rates generally at low levels, there are likely to be additional mechanisms or explanations. Another possible mechanism is the use of formal debt to acquire fixed assets, since we have already seen the negative association between fixed assets and pre-tax profit, potentially caused by the increase in overhead exceeding depreciation.

An alternative explanation is that successful businesses take on debt to grow faster, but success and/or the easy access to debt, results in executives taking bigger risks resulting in, on average, less successful projects, effectively bleeding the profits from existing income streams.

We have seen in this article that keeping debt low is related to higher pre-tax profit. We saw in the last article that keeping equity investment growth low (share funds per year) was also associated with higher pre-tax profit. There is a conundrum here that debt and equity investment are the two main ways a business can fund growth. How then can a business grow if the taking on of debt and equity is associated with lower pre-tax profit?

The answer implied by this model is to focus on organic growth: growth funded by the profits and cashflow of the existing income streams. Retaining profits within the business and reinvesting for profitable growth (not vanity acquisitions) increases share capital without a concomitant increase in current assets (i.e. cash). Such reinvestment might mean adding fixed assets or employees with the warnings already given about these factors, although reinvesting can also involve non-balance sheet expenditure such as branding, product R&D, systemisation for efficiency and productivity.

An addendum to this conclusion is that if you do decide to use other people’s money to fund growth plans, only use it to invest in projects that you would be prepared to invest in yourself.

While this is a complex equation to balance, there is one other simple explanation that can be given which might subsume all others. Withdrawing funds, in the form of dividends irreversibly reduces share capital and will therefore be associated with reduced pre-tax profit. To be specific, every £1 withdrawn as a dividend is associated with a 16.7 pence reduction in pre-tax profit. To put that in perspective, the median pre-tax profit of the sample companies was £411,536, representing a pre-tax profit margin of 2.5%. If 50% of the pre-tax profit is taken as a dividend (regrettably, dividends commonly approach such a figure), then pre-tax profit margin the following year would be predicted to be 8% lower at 2.27%. Such a shift is small enough to pass off as general fluctuation, but this hypothesis implies that large year-on-year dividends will have a devastating effect on long-term pre-tax profits.

While there are no absolutes and the model is probabilistic, it does point to some rarely considered factors that could be taken into account by operational managers and executives before making decisions that could impact on profitability. In the final article in this series we will list all of the key takeaways for managers from all six of the previous articles.