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Firm Size and Profitability [Economics
Posted on November 13, 2014 @ 01:10:00 PM by Paul Meagher

What is the relationship between the size of a firm and the amount of profit, on average, it generates? The question is fairly important because if smaller firms are more profitable than larger firms, it might tell you something about where you should invest your money.

In order to compare profitability of smaller firms to larger firms you need to come up with a ratio that allows you to compare them. A commonly used ratio is the Return on Assets which can be defined as:

ROA = Net Income/Total Assets

Where the Total Assets are comprised of both debt and equity financing. So if a company has total assets of 1 million and generates a net income of 100,000 then the ROA is a 10% return. If a larger company has total assets of 10 million and generates a net income of 1 million, then again the ROA is a 10% return. So the ROA ratio allows us to compare larger and smaller firms in terms of their relative profitability.

A 2012 bulletin by Statistic Canada called Are Small Firms More Profitable than Large Firms? reported the following result:

What this graph shows is that firms with between 5 and 20 employees had the highest return on assets and that the largest firms are quite a bit less profitable. Similar results can be found for US companies but you have to wade through more literature to find a graph that expresses the relationship this simply.

So why might the curves look like this? There are many possible reasons cited in the article Employees, firm size, and profitability in US manufacturing. Some of them include:

  • Some notion of optimal firm size
  • Dis-economies of scale may be more the rule than the exception in many industries
  • Organization overhead drains profit as as you get bigger
  • Loss of unique competencies/secrets as you get bigger and cannot contain them
  • More competition as you get bigger
  • Market saturation
  • Etc...

The Fortune 500 worldview would have us believe that we should be investing our money in the large companies of the world. They certainly generate huge amounts of revenue, and therefore media buzz, but we might ask how profitable they are from an ROA perspective (the organization drain on these companies due to high executive salaries can make them considerably less profitable). We might not hear as much buzz around the companies with between 5 and 20 employees because they don't generate amounts of revenue that generate media buzz, but if measured by ROA they might be more profitable than many of the large companies touted as "leaders" in the business world.

The purpose of this blog is simply to question the notion that larger firms are more profitable and point out some data that suggests otherwise. The data is not as simple or as clear in some cases as the data I report here so do you own research if you want a more nuanced understanding of this relationship. I've also not addressed issues of relative risk in investing in small and large firms and that always has to be taken into account when investing. The Statistic Canada report also has a chart showing the volatility of ROA as a function of firm size.

The author of the report summarizes the volatility data in this way:

These results provide evidence that, as small firms grow, their financial performance becomes more homogeneous—though this trend reverses itself for very large firms.

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