Predicting entrepreneurship from financial statements

Transcription

1 Predicting entrepreneurship from financial statements Three draft criteria Bernardo Bertoldi Assistant Professor University of Turin Turin, Italy Affiliate Professor ESCP Europe Turin, Italy Roberta Delmastro and Giulio Pattanaro Research Associates ESCP Europe Turin, Italy Abstract At the end of a three-step approach combining both quantitative and qualitative analysis, the authors of this study suggest to recur to these three criteria in order to at least partially predict the entrepreneurial posture of a company on the basis of its financial statements: turnover s growth and assets renewal of at least 33% over the past three years and a threeyear EBIT sum at least equal to 0. Further testing of the three criteria is finally suggested. can be considered as the core of entrepreneurship, both individual and corporate [12, pp ]. In the case of corporate entrepreneurship, some management practices and attitudes appear to be facilitating the formation and implementation of an entrepreneurial behaviour. In Table I, the ones suggested by three key articles on the subjects [1; 2; 3] are reported. Keywords- corporate entrepreneurship; financial criteria TABLE I. ENTREPRENEURIAL PRACTICES AND ATTITUDES I. INTRODUCTION Although corporate entrepreneurship has become a very relevant issue in management literature and many authors have explored the features and traits of entrepreneurial companies [e.g., 1; 2; 3; 4; 5], to the authors knowledge no study has ever tried to identify some purely financial criteria that may help predict the entrepreneurial posture of a company. This is why the following study aims at testing the validity of three financial criteria that the authors have identified as possible tools to help both the business and the academic community distinguish between entrepreneurial and non-entrepreneurial companies. II. LITERATURE REVIEW Since the XVII and the XVIII century, many definitions of entrepreneur and enterprise have been provided [6; 7]. Among these definitions, the one elaborated by Schumpeter in 1934 is generally recognised to constitute the foundation of the theory of entrepreneurship: The carrying out of new combinations we call enterprise ; the individuals whose function it is to carry them out we call entrepreneurs [8, p. 74]. If a look is given to the most recent definitions, a shift from an individual-oriented conception of entrepreneurship to a more extended corporate-oriented one has emerged in literature [see 5; 9; 10; 11]. In other words, the qualities that characterise the entrepreneurial attitude of the entrepreneur as a single person have now been analysed and detected in the case of organisations/companies as well. Three key adjectives - risk-taking, innovative and proactive - appear to clearly synthesise an entrepreneurial behaviour [1; 2; 3; 4] and the willingness to pursue new market opportunities Management attitudes and practices Covin and Slevin (1991) [2]: 1. Strategic level: - Adoption of an ambitious growth strategy - Emphasis on the prediction of industry and market trends; high advertising and promotion efforts; focus on product quality and relatively high product prices 2. Internal level: - High value placed on market share and on being perceived as an industry leader - Being quick to introduce new products; devoting a high percentage of financial resources towards R&D; being proficient at identifying opportunities for product-market development and at creating new product application from generic technologies - Empowerment of middle and lower-level employees and teamwork are valued and supported; high advertising and promotion efforts - Low level of structural formalisation, centralisation and complexity; organic rather than mechanistic structures. Barringer and Bluedorn (1999); Entrialgo et al. (1998) [1; 3]: 1. Scanning intensity or Analysis: learning about events and trends characterising the sector a company operates in 2. Planning flexibility or Flexibility: changing corporate strategic plans as environmental opportunities and/or threats emerge 3. Locus of planning: involving all hierarchical levels of employees in strategic planning activities 4. Strategic controls: rewarding employees creativity and pursuit of opportunity through innovation 5. Competitive strategy: pursuing an innovation-based differentiation strategy 1

2 If these attitudes and practices are adopted and implemented, an increase in corporate performance seems to be almost guaranteed. In fact, as many authors underline [e.g., see 2; 13; 14; 15], the reason which stands behind the search and analysis of the most entrepreneurial practices and strategies is the widespread belief that entrepreneurial activity stimulates general economic development as well as the economic performance of individual firms [2; p. 9]. III. METHODOLOGY In order to identify and design a set of financial criteria that may help detecting the degree of corporate entrepreneurship of a company right from the analysis of its financial statements, a three-step approach was adopted. First, the authors identified three financial criteria that seemed to constitute three valid proxies to predict the characteristics of entrepreneurial companies as summarised by literature. These financial criteria were then applied to a specific population of European companies. A mail survey and some personal interviews were then conducted on a sub-portion of these European companies, a sub-portion which, according to the three criteria, seemed to have an entrepreneurial posture. This final step aimed at proving the validity of the three financial criteria which were selected, through a set of qualitative questions investigating the entrepreneurial posture of the sub-portion of companies. A. Three draft criteria According to the main characteristics of entrepreneurial companies that were outlined at the end of the literature review (see Table 1), the three criteria that follow - subjectively elaborated by the researchers themselves - were chosen in order to roughly distinguish, on the basis of financial figures only, between entrepreneurial and non-entrepreneurial companies. 1) Operating turnover grown of at least 33% over the last three years. The 33% ratio was selected after a comparison with Gazelles, which are defined as small businesses growing of 100% in 3 years [for an overview on Gazelles, see 16]. Since already-established companies are expected to grow at a slower path in comparison to Gazelles, a 33% growth rate over three years should be a valid indicator of a company which has been successful in seizing new opportunity to growth and expand. 2) Assets renewal of at least 33% over the last three years. Since literature suggests that entrepreneurial companies grow thanks to an ongoing investing and re-investing process, this criterion should exclude companies whose growth is not accompanied by an increase in investments. Asset renewal is calculated as follows: {[(EBITDAy0+EBITDAy-1+EBITDAy-2)- (EBITy0+EBITy-1+EBITy-2)]-(FIXEDASSETSy0- FIXEDASSETSy-2)}/FIXEDASSETSy0 with y standing for year 3) EBIT at least equal to 0 over the last 3 years. Since literature indicates that in the case of entrepreneurial companies the pursuit of new opportunities does not jeopardise the corporate financial stability, this criterion should exclude companies which keep on investing to the detriment of their financial situation. B. The application of the three criteria The financial figures concerning companies with a number of employees going from 250 to 999 and operating in France, Germany, Italy, Spain and the United Kingdom were extracted from the European database Amadeus [17] and were used as the sample on which to test the validity of the three criteria which had been previously identified. These particular companies were selected for the purpose of this analysis since they had already been the object of a research project commissioned to the academic institution the authors are affiliate to. The application of the three criteria elaborated by the authors on the sample was implemented by considering as the last 3 years the period going from 2004 to 2006 (2006 was the last year available for the sample companies at the time in which the database was consulted). Following the application of the three criteria, entrepreneurial companies - hereinafter called EEEs, i.e. European Entrepreneurial Enterprises were identified. C. A qualitative assessment In order to qualitatively verify whether the EEEs were actually characterised by an entrepreneurial posture, two instruments were used: face-to-face interviews as first option and mail questionnaires to enlarge the sample. In both cases, the companies CEOs were identified as the most appropriate people to address to, due to the knowledge they have of the managerial and strategic attitude of their company. In order to double-check the results, the questionnaire and the interviews involved some non-eees as well: out of the 200 copies that had been sent out (150 for EEEs and 50 for non-eees), 20 questionnaires were finally collected (14 for EEEs and 6 for non-eees) and a total number of 42 personal interviews were conducted (41 with EEEs and 1 with a non-eee). Questions were the same for both the personal interviews and the mail questionnaires and were designed to access the following set of nine hypothetical patterns of behaviour grouped in 4 different areas - which are believed to synthesise the most relevant traits of an entrepreneurial company according to the authors mentioned at the end of the literature review [1; 2; 3]: 1) Structure and organisation H1. Entrepreneurial companies are characterised by a flat structure, with no rigid hierarchy. 2) Market, products and innovation H2. Thanks to their dynamism and proactiveness, entrepreneurial companies are the leaders or among the leaders in the industry sector they operate in; H3. Entrepreneurial companies succeed because they are highly innovative: they constantly develop new technologies and new products but also new distribution channels and services 2

3 H4. In order to detect and anticipate more easily market and consumer trends, entrepreneurial companies prefer to implement a process consisting of small-sized but very frequent experiments rather than a long-term large-sized innovation plan. H5. Internal resources who are constantly in contact with customers are entrepreneurial companies main source of information with regard to market and consumer trends. H6. As part of their proactiveness, entrepreneurial companies are always ready to understand and anticipate consumer needs, so as to quickly provide what customers are looking for and therefore enlarge their market size. 3) Human resources H7. In entrepreneurial companies, thanks to a personal and appropriate budget, managers at all levels are key players in the pursuit of new market opportunities; H8. Being the willingness to constantly pursue new market opportunities a key feature of entrepreneurial companies, managers are evaluated above all according to their ability to seize new opportunities. 4) Internationalisation H9. International markets are considered by entrepreneurial companies as a place where to further expand their business and attract new customers. IV. RESEARCH FINDINGS A. A first quantitative validation A first validation of the three criteria s ability to set a distinction among entrepreneurial and non-entrepreneurial companies emerges from the analysis of some financial variables the authors looked at (for further details on Amadeus indicators, see Appendix, Table I). In particular, it is worth underlining the strong positive correlation between Delta cash flow (Delta stands for a particular variable s variation in the period ) and Delta number of employees (+0,750 vs. +0,245 in the case of the whole segment) and between Delta cash flow and Delta total assets (+0,850 vs. +0,266 for the whole segment). These correlations seem to prove the pro-activeness of EEEs: they seem to constantly re-invest the cash flow they generate in order to increase the number of employees and augment their assets. The correlations between Delta added value and Delta cash flow (+0,852 for EEEs vs. +0,136 for the whole segment), on the one hand, and the one between Delta cash flow and Delta operating turnover (+0,942 for EEEs vs. -0,18 for the whole segment), on the other hand, seem to further highlight the entrepreneurial mindset of the companies which were selected. Actually, EEEs seem to internally develop the competences they need so as to make their growth happen in an organic way: they are the only companies to both increase assets and number of employees when turnover grows and to increase their added value by augmenting cash flow. B. Six validated hypotheses Six hypotheses out of a total number of 9 proved to be valid in the EEE sample: 1) Structure and organisation: H1. Validated. EEEs appear to have a flat structure: 60,4% of them declared that there are 4 or less organisational layers between the CEO and a newly-employed person, in comparison to a percentage of 41,7% in the case of non-eees. 2) Market, products and innovation: H2. Validated: 40,6% of EEEs declared they are leaders in the industry sector they operate in (16,7% in the case of non-eees). Another 34,4% of the EEEs which have been contacted are among the most important players. H3. Validated. The ongoing search for innovation in terms of both new technologies/products and new distribution channels/service proves to be the main strength of EEEs. New technologies are considered to be the main strength by 46,8% of EEEs; innovative marketing and customer-service practices are the main strength for 35,6% of them. Very similar is the case of non-eees: innovative technologies are seen as the main strength for 45,5% of them and innovative marketing and customer-service practices for 36,4% of non-eees. H4. Not validated. When they were asked to evaluate their internal innovation process in a scale from 1 to 5, with 1 meaning a large number of small-sized experiments taking place and 5 meaning focus on few large-sized projects, CEOs gave a 2,9 mark on average for both EEEs and non- EEEs (standard deviation of 1,3 for EEEss and of 1,4 for non- EEEs). H5. Validated. Asked to evaluate their market research process in a scale from 1 to 5, with 1 meaning market research outsourced to specialised agencies and 5 meaning managers spending time among selling people or directly dealing with customers, CEOs gave a 4 average mark in the case of EEEs (standard deviation of 1,0) and 3,1 in the case of non-eees (standard deviation of 0,9). H6. Validated. Asked about the approach which has been followed in the planning process of their company s future growth in a scale from 1 to 5, with 1 meaning particular attention to customers needs and 5 meaning particular focus on the internal skills you can leverage to provide a better product/service, EEE s CEOs gave a 2,3 average mark (standard deviation of 1,1), in comparison to a 2,7 in the case of non-eeess (standard deviation of 1,4). 3) Human resources: H7. Not validated. EEEs (and the same is true for non- EEEs) appear to be quite centralised and rigid as to managers budget autonomy and freedom of spending. Asked about the way in which the launch of new products/initiatives is decided in a scale from 1 to 5, with 1 meaning a pluri-annual plan is in place and it is run by a dedicated officer within the company and 5 meaning product line managers or equivalent officers have their own budget and can decide the launch of a new product/initiative, EEE s CEOs gave a 2,9 3

4 average mark with a standard deviation of 1,4 (average mark of 3,1 and standard deviation of 1,5 for non-eees). As to freedom of spending, 82% of EEE s CEOs (67% in the case of non-eees) declared that second levels are allowed to autonomously spend without a formal budget approval in order to pursue new opportunities and amount of money inferior to 100K Euros; in 5,3% of EEEs only this amount can go beyond 500K Euros (0% in the case of non-eees). H8. Not validated: for both EEEs and non-eees, ability to pursue opportunity ranked fourth among the most important variables that are taken into account in the evaluation process of managers. Making decisions and taking full responsibility ranked first, followed by ability to lead and motivate people and ability to cope with budget limitations. According to the authors, the result of this question may have been biased by the fact that making decision and taking full responsibility could be seen as a variable someway including the ability to pursue opportunity (opportunity in terms of key decisions). 4) Internationalisation: H9. Validated: foreign markets are seen by EEEs (35% of their turnover is generated abroad, as it is the case for non- EEEs) as a major opportunity to seize, above all in difficult economic periods for the domestic market; huge efforts have been made in order to access foreign consumers through the most effective marketing strategies. V. CONCLUSION As a result of the qualitative analysis, the EEEs which were selected on the basis of the three financial criteria identified by the authors appear to adopt 6 out the 9 entrepreneurial attitudes. This appears to prove the ability of the three criteria to predict, at least partially, the entrepreneurial posture of a company. In other words, the study appears to prove that, if a company over the last three years has seen its operating turnover grown of at least 33%, its assets renewed for at least 33% and its three-year EBIT at least equal to 0, it is very probable that this company is proactive, risk-taking and innovative. However, the authors recognise that the study constitutes just a first attempt to deal with the financial criteria identification issue and that it presents some limitations. The most relevant ones concern the qualitative assessment: some elements - like, for example, the number of interviews and questionnaires which were collected, the questions used to test the different hypotheses and the lack of a sample breakdown by industry sector may have affected the outcome of the qualitative validation process. Therefore, both the business and the academic community are invited to further test the three financial criteria that have been suggested. The authors are willing to share their results and experience in order to come to the identification of the most appropriate criteria to distinguish among entrepreneurial and non-entrepreneurial companies, starting from the analysis of corporate financial statements. REFERENCES [1] Barringer, B. R., & Bluedorn, A. C The relationship between corporate entrepreneurship and strategic management. Strategic Management Journal, 20: [2] Covin, J. G., & Slevin, D. P A conceptual model of entrepreneurship as firm behaviour. Entrepreneurship: Theory and Practice, 16: [3] Entrialgo, M, Fernandez, E., & Vazquez, C. V Linking entrepreneurship and strategic management: evidence from Spanish SMEs. Technovation, 20: [4] Stopford, J. M., & Baden-Fuller, C. W. F Creating Corporate Entrepreneurship. Strategic Management Journal, 15: [5] Wennekers, S. & Thurik, R Linking entrepreneurship and economic growth. Small Business Economics, 13: [6] Murphy, A. E Richard Cantillon: Entrepreneur and Economist. New York: Oxford University Press. [7] Palmer, R. R J.-B. Say: An Economist in Troubled Times. Princeton: Princeton University Press. [8] Schumpeter, J. A The theory of economic development. Cambridge: Harvard University Press. [9] Burgelman, R. A Designs for corporate entrepreneurship. California Management Review, 26(2): [10] Jennings, D. F., & Lumpkin, J. R Functionally modeling corporate entrepreneurship: An empirical integrative analysis. Journal of Management, 75(3): [11] Miller, D The correlates of entrepreneurship in three types of firms. Management Science, 29(7): [12] Stevenson, H. H., & Jarillo, J. C A Paradigm of Entrepreneurship: Entrepreneurial Management. Strategic Management Journal, 11: [13] Drucker, P. F Innovation and Entrepreneurship. New York: Harper & Row. [14] Lumpkin, G. T., & Dess, G. G Clarifying the entrepreneurial orientation construct and linking it to performance. Academy of Management Review, 21: [15] Zahra, S. A Environment, corporate entrepreneurship, and financial performance: A taxonomic approach. Journal of Business Venturing, 8: [16] Acs, Z. J, & Mueller, P Employment effects of business dynamics: Mice, Gazelles and Elephants. Small Business Economics, 30(1): [17] Bureau Van Dijk Electronic Publishing (BvDEP) (2008) Amadeus [Internet], BvDEP. Available from: < [Accessed 15 April 2008]. Indicator APPENDIX TABLE I. DEFINITIONS OF AMADEUS INDICATORS [17] Operating Turnover EBIT EBITDA Added Value Cash Flow Total Assets Definition Sales (+stock variations + other operating revenues). Does not include VAT Earning Before Interest and Taxes = Operating Profit (Loss) Earning Before Interest, Taxes, Depreciation and Amortization =EBIT+ Depreciation Taxation + Profit (Loss) + Cost of Employees + Depreciation + Interest paid Profit (Loss) + Depreciation Fixed Tangible and Intangible Assets + Current Assets (Stocks + Debtors) 4

5 5