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CAN THE ENTERPRISE ACHIEVE BOTH SUSTAINED PROFITABILITY AND ECONOMIC GROWTH?

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CAN THE ENTERPRISE ACHIEVE BOTH SUSTAINED

PROFITABILITY AND ECONOMIC GROWTH?

Dorin Cosma*, Anca-Ramona Botezat**

*University of Timisoara, +4 0722 348 039, dorin@cosma.ro **S.D.N. Arad, +4 0742 207 015, ancu0312@yahoo.com

Abstract

This paper focuses on the presentation, at the enterprises level of two primary objectives: its profitability and economic growth, on the grounds that everyone can choose one or the other. Achieving a sustained profitability and growth is difficult, but possible for enterprises that take account of continuous renewal. Achieving one or more goals means for the enterprise implementation of financing decisions that require a financing plan. In order to emphasize the importance of establishing long term business objectives referring to profitability or growth, that would give financial autonomy; we built a regression model using Pooled Least Squares method.

Key Words:profitability, economic growth, maximization, financing policy

Introduction

In classical theory, the enterprise had a single objective: to maximize profits, that search to obtain at the enterprise level the equal between marginal revenue - marginal cost, without specifying if it relates to maximizing profit on short term or long term. The one that proposed the objective of maximizing was the French economist Cournot (1938) and was provided only to a monopoly situation. Later, Anglo-Saxon economists considered the objective of maximizing profits for the situation of perfect competition and imperfect competition, not operational in the latter case, and disregarding the uncertainty and risk. This is because the enterprises` shares are influenced by the actions of other enterprises (Brezeanu P., 1997).

Because of the shortcoming regarding the operational objective of profit maximization, it was necessary to set other goals, such as: pursuing to achieve a

profit rate that will be enable to maintain the enterprise’s control, maximizing

turnover, maximizing the utility function of the enterprise, or others that maximizes a variable if there is a certain constraint.

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allows comparison of productive investment with the benefits of financial investment (Dobrotă N., 1999). Regarding the other important and current objective, the one that can be pursued by publicly traded enterprises and that maximize their value, in other words economic growth objective, referring to enterprise` activities from financial markets that take into account cost and risk. They prefer to adopt this objective because the enterprise` owners have an incentive to increase its value, the distribution of shares motivating managers to increase enterprise` value.

Section 1

Anywhere in the world, the enterprise is led by two goals: first there is wanted the enterprise to be profitable, to record income from invested capital that exceeds the cost of capital, and secondly there is wanted to grow revenue. Although the merits of sustained profitability and economic growth are evident, their achievement is elusive reached. Accounting records have repeatedly suggested that only a few enterprises have been able to obtain sustained profitability and growth, much less both.

According to some surveys made on enterprises for a period of time, it was observed that even in the best period of economic boom, namely the 90 years, nine out of ten enterprises have failed to achieve sustained economic growth; even more, they failed to reach their targets in terms of growth. According to other studies, 10% of the traded enterprises in the U.S. have gone through the experience of eight or more years of growth, measured by a number with two-digits. If achieving sustained economic growth is difficult, as we have seen, sustained profitability seems to be just as difficult. Thus, as a result of a survey on 6772 enterprises have been obtained that 5% of them have been registered year after year a return on assets above the average of their industry. Only some of those enterprises have been recorded over 10 years of profitability and economic growth measured by a two-digit number. Moreover, only a part of the sub sectors, as the medical device, pharmaceutical, oil and gas, semiconductor and software have been recorded a sustained profitability and economic growth over the 10 year period represented by a two-digit number. Most enterprises have not obtained that, because both profitability and economic growth depend on a way or another by the industry performance to which the enterprise belongs. Another approach considers the profitability and economic growth of the enterprise being relevant to the average considered for that industry (Chakravarthy B., Lorange P., 2008). Comparing the two situations, we think the latter one is worthy being followed.

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that the most important conclusion is that enterprises which have also paid attention to both, profitability and economic growth, have managed to achieve both of them.

In order to obtain the profitability or economic growth they hoped for, enterprises only have the choice to conduct their activities taking into account the opportunities that they have exploited until then, and capabilities they have. Because those are affected by aging time, and work even if is very seriously done is not sufficient to obtain sustained profitability or economic growth, the managers of the enterprises have only the choice to ensure that they have been engaged in a continual renewal process, seeking new opportunities and adding new and distinct capacities (Chakravarthy B., Lorange P., 2008).

We appreciate that achieving sustainable profitability means achieving continuous renewal process. Moreover, looking to reach sustained profitability starts getting a redesign process developed and continually updated portfolio. Going further, achieving sustained profitability is possible only if the enterprise has distinct capabilities and they remain higher than those of competitors. Renewal process provides the achievement of profitability and growth on short term and regarding the strategies of renewal we have traditional strategies: protection and extension, conversion and two others which connect the other two: leverage and build.

Regarding the first strategy, namely, the protection and expansion, it relates to improving the place, keeping distinct capabilities, expanding product lines and services, and their continuous innovation, segmentation. This strategy is applied to register its level of profitability and economic growth, by increasing its market value. This objective is very important for achieving economic growth, particularly for enterprises which are on mature markets. In current markets, the objective of achieving a high market value can be an advantage for achieving the desired economic growth and profitability. Of course, this involves for the enterprise taking into account some risks: the risk of being imitated by competitors, because the technology can be deciphered and trade ideas can be copied, the risk of substitution the capabilities by the competitors (financial policies at its disposal and which can be used, more exactly the available financing policies); risk of complacency, to ignore market entry of competitors, risk of market saturation.

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core activity. Without achieving a synergy between the core activity and the new capacities, the enterprise is subject to one or more of the mentioned risks, and thus its value may decrease as a result of financial innovation that have been made. To avoid this, the enterprise must build on core activity and then to apply the strategies of leverage and building.

The third strategy, the leverage is entering on an important new market segment, which is accomplished by adding new capabilities in terms of product design and its distribution or geographical diversification, both nationally and internationally. The fourth strategy is to build new assets, distinctive knowledge and skills. Not all the capabilities of an enterprise are distinctive, but only those that are difficult to acquire, imitated or substituted, and this distinction may not last on long term, because competitors will try to copy or substitute distinctive competencies. Where enterprise can build up additional capacities, different from the ones of the competitors in order to defend the initiative to use the leverage, would introduce a new opportunity to make money for the following ones. Through the strategy to build, the enterprise adds new skills, both to defend existing market franchise and to record growth on new markets. Unlike the strategy to protect and extend, in this case is not the intention to strengthen the existing competence, but to build another different one. As the strategy used by leverage follows the strategy of building different skills, there may be the vice versa case. As regarding strategy implementation risks due to construction, they appear as a result of difficulties in developing the capacities, new skills platform is difficult later or more costly, exceeding the budget allowed for it. In the worst case, the anticipated uses for new capacity may not materialize.

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Generally speaking, we believe that when profitability is below the base interest rate on long-term, the enterprise management should analyze the situation, so as to direct assets in a different direction or even to proceed to its liquidation or other reorganization proceeding, where profitability can be improved.

Achieving one or more of the enterprise goals means, from its part, implementing financing decisions that refers to asset financing decisions and decisions about the nature of resources. Financing decision at the micro-economic level is significantly influenced by the way the micro-economic mechanisms functions at regional, national and even global level. (Dragotă V., et al., 2003) The enterprise develops into a complex environment, regarding the following aspects: economic, financial, social and political environment and the state universe. In terms of economic and financial environment, it also influences the financing decision by the influence of inflation, exchange rate (depreciation), interest rate developments in the economy.

The financing decision is the option of the enterprise to cover the financing needs of projects under consideration, either by equity, loans or holding. (Toma M., 1994) Regarding financing, we appreciate that there is not an optimal decision for all enterprises that disregard place and time. To choose from the financing resources at their disposal for the one or the most advantageous combination that brings a better situation for the enterprise depend in particular on it through its financial managers, but also on the supply and demand from capital market, whether or not there is free capitals that are possible to be attracted, the conditions and facilities for obtaining credits, the willingness of shareholders to make capital contributions.

We believe that the choice of financing resources must be based on opportunity (the opportunity cost), because the cost of financing of any kind tends to a unit cost, if we take into account the risk-factor. The most important thing is not to stop lending through which it could achieve economic growth and getting more profits in the future.

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relationship between financial resources, meaning that the size of each of their way of financing from all of them, near the recalled factors, even of the external constraints and major objectives of the enterprise.

Regarding the financing of the enterprise, it must be based on a financing plan. Financing Plan aims at a horizon of higher dimension (generally 5-7 years) for the financing needs of enterprise and resources that it could and should have to meet these needs. (Manolescu Gh., 1995) Financing Plan aims to ensure consistency of financial flows resulted from decisions taken at the level of financial strategy or for a many-year horizon. (Herbei M., 1999) Any enterprise must first determine which type of financing needs, depending on their situation at that time, but also on the business situation, which can provide favorable and unfavorable aspects for a particular financing resource. Then it is necessary to determine whether the need to be financed is permanent or temporary, and will be pursued to determine the level of profitability willing to be achieved. Each resource of financing has a cost, but we believe that in addition to this, the enterprise must establish its own attitude towards risk, in order to determine the level of risk that is willing to assume regarding the decisions that is going to take. Also, another aspect that the enterprise should have to take into account is the cost and the financial structure that would be adopted by competitors, the trends of the interest rate and the factors that are influencing it.

Section 2 - Case Study

Further, we made a practical study, in order to highlight the importance of establishing long term objectives for profitability or economic growth that would give financial autonomy to the enterprise. To this end we built a regression model that shows exactly those influences and from whose use is provided a flexible framework for analysis. The regression model is used according to the type Least Squares Pool, with corresponding data from 21 enterprises for which we have information on the value of considered variables for the period 2004-2009.

The dependent variable that we considered is the rate of global autonomy and independent variables are the financing rate of the tangible assets, the financing rate of stocks, the rate of financing stability, the overall borrowing rate, the correlation between financial structure and borrowed capital, equity profitability, business profitability, assets profitability and revenues profitability. The rate of overall autonomy is an indicator that reflects the amount of their own

sources used in financing the enterprise’s economic needs, which vary depending

on the financial policy of the enterprise and its profitability. Formulas for calculating the variables used there are:

•for the rate of global autonomy we have:

100

s liabilitie total

equity

,(1)

•for the financing rate of tangible assets we have:

100 tangible assets

equity

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•for the financing rate of stocks we have: 100 ⋅ stocks total capital working (3)

•for the rate of financing stability we have:

100 ⋅ s liabilitie total capital permanent (4)

•for the overall borrowing rate we have:

100 ⋅ equity debts total (5)

•for the correlation between financial structure and borrowed capital we have:

100 ⋅ equity assets total (6)

•for equity profitability we have:

100 ⋅ equity profit net (7)

•for business profitability we have:

100 ⋅ turnover profit net (8)

•for assets profitability we have:

100 ⋅ assets total profit net (9)

•for revenues profitability we have:

100 ⋅ revenues total profit net (10)

It is necessary to present the linear function which connects the mentioned variables, so that the formal representation of this model is:

it it it it it it it it it it

it C X X X X X X X X X

Y = +

+

+

+

+

+

+

+

+

+

9 8 7 6 6 5 5 4 4 3 3 2 2 1 1 ,(11) where,

Yit - The dependent variable, so that the rate of global autonomy;

it

X

1 - vector of independent variables the financing rate of tangible

assets;

it X2

- vector of independent variables the financing rate of stocks;

it X3

-vector of independent variables the rate of financing stability;

it X4

- vector of independent variables the overall borrowing rate;

it X5

- vector of independent variables , the correlation between financial structure and borrowed capital;

it X6

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it X7

- vector of independent variables business profitability;

it X8

- vector of independent variables assets profitability;

it X9

- vector of independent variables revenues profitability;

α- independent variable coefficient, which explains the relative change in the dependent variable Y as a consequence of the explanatory variable X changes, in the hypothesis that the other explanatory variables remain constant;

εit - regression residual term, which quantifies the influence of random action, characterized by zero mean and constant dispersion;

i -number of "sections" after which the regression is made = 21;

t– period of time = 1,2,3,4,5,6 years. Normal form of the econometric model is:

= AutGl R

C+

1

TangAssets Eq

+

2

TStk WK

+

3⋅ TLiab PermK

+

4

Eq TDebt

+

5⋅ Eq TAssets

+

6⋅ Eq net

+

7⋅Turnover net

++

8⋅TAssets net

+

9⋅ T venue net

Re

+εit, (12)

Where,

i=1,21, t=1,6

This model was determined using the EVIEWS program, obtaining the results that are shown in Table 1. Given the presentation of data and the size of the used sample, we chose to achieve cross-section regressions, where the group factor was time, in order to capture the individual and as a temporary change the interaction between the analyzed variables. In the idea of highlighting the influence of independent variables on the dependent variable we look over the sign of T-statistic, and thus we observe that the financing rate of tangible assets, the rate of financing stability, the correlation between financial structure and borrowed capital, business profitability and revenue profitability has a positive influence on the rate of overall autonomy, while the financing rate of stocks, the overall borrowing rate and the assets profitability have a negative influence. Among the independent variables which have the highest positive influence is the rate of financing stability, with an amount of T-statistic of 26.792, while the biggest negative influence on the rate of global autonomy has the overall borrowing rate for 3.057.

Thus, the normal form of the econometric model is: =

GlAut R

(-25,46)+0.145⋅TangAssets Eq

+(−0.421)⋅ TStk WK

+0.797⋅ TLiab PermK

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+15.217⋅ Eq TAssets

+(−0.061)⋅ Eq net

+0.062⋅Turnover net

+(−1.702)⋅TAssets

net

+

799 .

17 T venue

net

Re

+εit, (13) where, i=1,21, t=1,6

Table1. The dependence of the variable rate of global autonomy by self-development of

the financing rate of tangible assets, the financing rate of stocks, the rate of financing stability, the overall borrowing rate, the correlation between financial structure and borrowed capital, equity, business, assets and revenues profitability

Dependent Variable: the rate of global autonomy Method: Pooled Least Squares

Sample: 2004 - 2009 Included observations: 6 Cross-sections included: 21

Total pool (balanced) observations: 126

Variable Coefficient

Standard

Error t-Statistic Probability

C -25.460 7.838 -3.247 0.001

the financing rate of tangible assets 0.145 0.020 6.975 0.000 the financing rate of stocks -0.421 0.190 -2.213 0.028 the rate of financing stability 0.797 0.029 26.792 0.000 the overall borrowing rate -0.167 0.054 -3.057 0.002 the correlation between financial

structure and borrowed capital 15.217 5.592 2.721 0.007 equity profitability -0.061 0.027 -2.219 0.028 business profitability 0.062 0.191 0.325 0.745 assets profitability -1.702 17.263 -0.098 0.921 revenues profitability 17.799 20.006 0.889 0.375

R-squared 0.934 Mean dependent var 63.909

Adjusted R-squared 0.929 S.D. dependent var 48.317 S.E. of regression 12.811 Akaike info criterion 8.014 Sum squared resid 19039.77 Schwarz criterion 8.239

Log likelihood -494.920 F-statistic 184.656

Durbin-Watson stat 0.920 Prob(F-statistic) 0.000

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Because the Durbin-Watson statistics value is 0.920 in this case, we can say that there is a strong positive correlation in the series of errors. Regarding the value of R, it is 0.934, which means the existence of a connection between variables with high intensity, being a relation of dependence on 93.40% of the variable rate of global autonomy towards the independent variables that we considered. It follows that the autonomy of the enterprises is influenced by the financing policies that enterprises implement and the level of achieved profitability.

Conclusions

We believe that each enterprise can choose to pursue obtaining sustained profitability or sustained growth over time. There is important to set clear objectives and try to coordinate their activities towards their goals. Any enterprise is driven by two objectives: first, there is wanted it to be profitable, to record income from invested capital that exceeds the cost of capital, and secondly there is wanted to grow revenue. In an ideal world there can be achieved both, profitability and economic growth for long periods of time, because once with increasing profitability there is achieved too the economic growth ofenterprise’s

value for its shareholders. All thought the merits of sustained profitability and economic growth are evident, their achievement is elusive obtained. We believe that one of the major objectives of an enterprise is ensuring the necessary capital at the lowest costs and so to obtain the highest level of profitability.

From the study that we have made results that the sample of considered enterprises is representative in order to highlight the importance of setting enterprises` objectives, namely the importance of implementing financing policies that are able to achieve financial autonomy. We considered this indicator on the grounds that whether one chooses to obtain sustained profitability or sustained economic growth matter if the enterprise has financial autonomy. Regarding the quality of the used model, we believe that it is satisfactory, and overall, we can say that the presented empirical evidence is supporting the idea we presented above.

As a possible direction of study, it would be interesting to know the managers opinion regarding their choice of the desired long-term objectives to be achieved, whether they prefer for sustained profitability and sustained economic growth over time. Even more, beside the simple preference, it would matter the reasons for which they would choose one of two objects. Even if not always the practice follows the course offered by the theory, there is important to establish clearly and realistic the objectives of each enterprise, for the reason that further in its activity to do whatever it takes to achieve its best.

References

Brezeanu P., 1997, Gestiune financiara a intreprinderii, Editura Fundatiei Romania de maine, Bucuresti;

Chakravarthy B., Lorange P., 2008, Profit or Growth? Why You Don’t

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Dobrotă N., 1999, Dicţ ionar de economie, Editura Economică, Bucureşti;

Dragotă V., Ciobanu A., Obreja L., Dragotă M., 2003, Management financiar, Vol.II, Politici financiare de întreprindere, Editura Economică, Bucureşti;

Herbei M., 1999, Echilibrul financiar la nivel microeconomic, Editura

Mirton, Timişoara;

Manolescu Gh., 1995, Managementul financiar, Editura Economică, Bucureşti;

Rusu C., 1999, Management strategic, Editura Allbeck Bucureşti;

Ştefea P., 2002 Analiza rezultatelor întreprinderii, Editura Mirton, Timişoara;

Toma M., 1994, Finanţ e şi gestiune financiară, Editura Didactică şi Pedagogică, Bucureşti;

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