There is huge variance in businesses to measure performance and the selection of metrics they use. While almost all businesses focus on accounting profit, it isn't quite the same as Economic Profit (EP) – which can be defined as returns over and above the cost of capital the business requires to produce it.
While this concept is known and pursued by large enterprises, a new paper produced by Alpin Advisory’s Managing Partner, Andrew Murray and Strategic Consultant, Don Holdsworth, suggests mid-sized enterprise (MSEs) can greatly benefit by reviewing their strategic decisions through the lens of their EP.
Creating Profitability and Investor Return
MSEs are generally more dynamic, agile and entrepreneurial than their large counterparts and frequently have great quality products, excellent customer relationships and low defect rates. While they perform well with individual growth drivers, the overall objective of any business should be to deliver a return to its investors. This is where using EP becomes important as it allows businesses to create profitability over and above the baseline expectation.
The paper found that only a few of the MSEs that were delivering accounting profits were also providing an economic profit to their owners. While lack of awareness is one issue, Murray believes the issue is a capital one too. “It is not only due to a lack of awareness; often, Australian MSEs are not using the right type or quantum of capital in the most profitable way,” Murray said.
"In Australia, many MSEs don't have the same access to capital that is available to either larger enterprises or MSEs in more mature markets such as in the US. Funding in Australia is dominated by large banks, and many MSEs don't necessarily look at alternative sources of capital," says Murray.
Improve Performance and Use of Capital
The paper draws on research conducted by McKinsey into EP for large enterprises. Murray and Holdsworth have applied this to the MSE sector, the type of businesses that Alpin focuses on.
Alpin has found that increasing EP involves focusing on two elements of the business: operating performance and capital efficiency.
Driving operating performance requires a clear understanding of the drivers of value in a business such as focusing on industry & market share growth, and profitable customer prioritisation. Alpin works with clients to find early profit opportunities for MSEs by focusing on performance. This can be done through critiquing the product mix, understanding how different products might perform in certain markets, or addressing operational efficiency issues.
For capital efficiency and sourcing of capital, Alpin recommends looking at Shareholder Funds, Debt and two other important sources: Trade Credit and Latent Capital. Alpin has regularly found that the latter two levers (both internal sources of equity able to be controlled through business operations) are rarely considered. Companies who only rely on external capital (debt and shareholder equity) suffer from higher costs of funding, greater dilution of existing equity, increased leverage, transactions costs and potential dispersion of shareholder interests.
Owners and executives of MSEs need to identify all available sources of potential capital and then align their options to the needs of the business.
The paper will be released on June 20, along with a seminar held with our Managing Partners, our co-hosts Partners for Growth, and founders of two start-ups, GlamCorner and TOMORROW Super. To register, please follow the link, HERE.
To find out more, contact the specialist business consultants at Alpin Advisory today.