TABLE 2
Sources of Financing for EOY Firms: 1995
Financing Source Used: | Percentage of Funding |
Banks, Lending institutions | 42% |
Customers | 16% |
Family, friends, self | 18% |
Public offering(s) | 9% |
Private investors | 2% |
Vendors/suppliers | 2% |
Venture capitalists | 1% |
Other | 11% |
Operating profitability Unfortunately we did not have access to operating profits so our measure of return on investment relies on the ratio of after-tax net income to total assets. However, we are able to approximate the median after-tax operating return on total invested capital for the EOY firms and the industry sample. Our results are presented in Table 3. An explanation of the process used is as follows:
1. We begin with the median net income per $100 in sales-$3.00
for the EOY firms and $2.50 for the industries, as determined by
the respective net profit margins.
2. Given the asset turnover ratios, we calculated the total
assets for every $100 in sales.
3. From the debt-equity ratios, we computed the amount of debt
used by the median firm and paired industry comparisonC57 percent
debt to assets for the EOY firm and 38 percent for the industry.
4. We assumed an interest rate on debt of 12 percent for the
entrepreneurial firms and 10 percent for the publicly-traded
firms.
5. We assumed a 34 percent effective tax rate to convert from
after-tax profits to before-tax profits.
6. We computed the earnings before interest and taxes as earnings
before taxes plus interest expense.
7. Using the 34 percent tax rate, we estimated the operating
profits after taxes-without including the tax benefit of the
interest expense since it is recognized in a firm's cost of
capital.
8. Finally, we calculated the operating return on total capital
as operating profits after taxes divided by the total assets.
TABLE 3
After-tax Operating Return on Total Capital
EOY Firms | Industries | |
Net income per $100 sales | $3.00 | $2.50 |
Total assets per $100 sales | $35.46 | $60.24 |
Total debt per $100 sales | $20.24 | $23.06 |
Assumed interest rate | 12% | 10% |
Implied interest expense | $2.43 | $2.31 |
Earnings before taxes | $4.55 | $3.79 |
Earnings before interest and taxes | $6.97 | $6.09 |
Operating profits after taxes | $4.60 | $4.02 |
After–tax operating return on capital | 13.00% | 6.70% |
The resulting after-tax operating return on capital provides a
crude estimate of what each group earns on a dollar of capital
after taxes without regard of the source of the financing. Based
on these results the EOY firms earn roughly twice as much on
their invested capital as the large publicly-traded firm.
Sustainable growth rate Across firms and years, the
entrepreneurial firms experienced sales growth averaging 30
percent per year, with a median of 19 percent. Since we did not
have access to sales growth rates for the matching industry data,
we were unable to compare these growth rates to those of their
publicly-traded counterparts. However, we do know that the median
growth rate for Fortune 500 companies is something less than nine
percent. Also, we were able to compare EOY firms and
publicly-traded firms based on their sustainable growth rates.
The sustainable rate of growth for a firm is the rate at which
its sales can grow without forcing the firm to alter its
financing mix or issue new common stock. The sustainable rate of
growth is calculated as the product of the firm's return on
equity and the earnings retention rate. The resulting average
sustainable rate of growth for the EOY sample is 29.5 percent,
compared to only 6.2 percent for the publicly-traded firms ( 17.6
percent and 8.5 percent for the respective medians). The
difference in these growth rates for the two groupings is
statistically significant in both the parametric and
non-parametric tests. The reason for this impressive difference
is twofold: As already noted, the entrepreneurial firms are twice
as profitable as their industry counterparts and, second, they
retain and reinvest a higher portion of their profits. As shown
in Table 1, the average earnings
retention rate for the EOY firms is 96 percent (100% median),
compared to 82 percent (79% median) across the paired industries.
With the foregoing comparison of the financial profiles of
entrepreneurial firms relative to large publicly-traded companies
within the same industries, we now turn to examining the NCER
survey results for any possible insights as to the reasons for
these differences.
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