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Entrepreneurial Firms: Looking at the Numbers

We address three important attributes of the EOY firms: working capital management, profitability, and growth. Table 1 contains the results of the financial comparisons of firm versus industry for each of these attributes. Given the skewed data distribution for many of the metrics used to describe the sample of entrepreneurial firms and the underlying industries, we report both the means and medians, as well as the results of paired comparison tests using both a parametric t-test and a non-parametric sign test.

Working capital management In the area of working capital management, we consider two factors: a firm's solvency and its liquidity. To assess the solvency-how much a firm's liquid assets exceed its short-term debt-we used the current ratio as our measure.

The comparison of the current ratio (Table 1) suggests that the entrepreneurial firms maintain approximately the same level of solvency as publicly-traded companies. The average current ratio for the EOY companies was 2.12 compared to only 1.72 for the industry. This difference is statistically significant in the parametric test (5% level). However, the median ratios are 1.50 for the entrepreneurial companies and 1.55 for the industry norms-now we see the average current ratio being greater for the industry, but the level of significance is only at the 10 percent level. The conflicting results indicate that the skewness in the distributions influences the results of the parametric test, and we conclude that solvency is not a distinguishing mark for the entrepreneurial firm.

Shulman and Cox (1985) suggest the use of a refined measure of firm liquidity based on the firm's working capital requirements (representing the firm's spontaneous sources and uses of funds over its operating cycle) and net liquid balances (the amount of liquid balances available to finance a firm's working capital needs).

TABLE 1
Comparison of Financial Profiles of Entrepreneur of the Year Firms and Industry Matched Publicly-Traded Firms

See the Appendix for the details of how each of these components was calculated. To facilitate comparisons across our EOY firms and their publicly-traded counterparts we normalize each firms' working capital requirements and net liquid balance by expressing each relative to sales:

For the entrepreneurial firms, the average working capital requirements per $1 in sales was $0.19, with $0.05 in net liquid balances. Thus, as sales expand $1, the firm would have to finance $0.19 in additional working capital requirements, of which $0.05 could come from the firm's liquid balances. For the median firm, the working capital requirements was $0.15 and net liquid balances of only $0.01. At the present time, we have no comparison measures of liquidity for the industry norms. Thus, we are not prepared to make any comments regarding the liquidity of entrepreneurial companies relative to the average firm in the industry.

Profitability In assessing the entrepreneurial firms' profitability, we relied on the following standard relationships:

The decomposition of the firm's return on assets highlights its dependence on net profit margin (net income sales) and total asset turnover (sales total assets). Return on equity is in turn determined by the return on assets and the company's financing practices--the mix of debt and equity.

The average return on assets for the sample of EOY businesses is 11 percent compared to only 4.1 percent for the matching industry data. (The medians are 7.8 percent and 4.6 percent, respectively.) Comparing the paired observations of firm and industry data, we find that the EOY firms significantly out-perform their industry counterparts using both the parametric and non-parametric tests.

The entrepreneurial firms and the respective industry norms produce roughly comparable profit margins. Average net profit margins for the EOY firms is 4 percent, compared to 3.9 percent for the paired industries-reflecting no statistically significant difference. Only when we compare the medians-3 percent and 2.5 percent-do we observe any statistical disparity. Thus, the net profit margin-the ability to effectively manage the firm's income statement-does not contribute to the difference in return on assets observed above.

Traditionally, corporate managers have been conditioned to measure their success in terms of the company or division earnings-frequently the growth in earnings-with little concern for the efficient use of the capital invested. A good part of the hostility that erupted from the takeovers in the 1980s was about managers' failure to assign an opportunity cost of capital to its assets, resulting in their under-utilization. On the other hand, given the limited access to capital for entrepreneurial firms, they are not thought to be tempted to over-invest as many larger companies have done.

We measure asset utilization using the ratio of firm sales to total assets, or the asset turnover ratio. The higher this ratio, the more sales a firm generates per dollar of investment in assets-thus, indicating the more efficient use of assets. As shown in Table 1, the EOY firms had an average asset turnover of 3.07 (median 2.82) compared to an average of 1.93 (median 1.66) for the matching industries. The differences in the sales-to-assets are statistically significant, both for the parametric and non-parametric tests. Thus, the entrepreneurial companies are clearly more effective in utilizing assets.

The average return on equity for the entrepreneurial firms is without question higher than the return on equity for the average publicly-traded firm in the same industryC28.1 percent compared to 9.9 percent. This outcome is driven by the entrepreneurial firms having comparatively high returns on assets, as already noted, and by their extensive use of debt financing. The average debt-to-equity ratio for the sample of entrepreneurial companies is 2.23 compared to only 0.83 for the industry comparison group (1.33 and 0.62 medians, respectively). The difference in the debt-to-equity relationship is statistically significant in both the parametric and non-parametric tests. This finding indicates that the EOY firms utilize far more debt than do publicly-held corporations in the same industries, which when combined with their superior return on assets results in returns on equity that are measurably higher than their publicly-traded counterparts.

We can gain additional insight regarding the firms' financing practices from the NCER survey results, in which the EOY firms reported their 1995 sources of financing. These sources are shown in Table 2. The heavy reliance on debt capital is substantiated by their responses, with 42 percent of the sources coming in the form of debt from banks and other financial institutions. Also, we surmise that much of the 34 percent coming from customers, friends and family members could have been debt-structured financing. It should also be noted that only two percent came from private investors and one percent from venture capitalists. Note that these results are consistent with Bhide's (1994) finding that venture capital is not even a secondary, much less a primary, source of financing even for high-potential businesses.

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