The performance of young firms: patterns of evolution in the growth-profitability space

The aim of this paper is to provide a better understanding of the evolution of small firm performance. We do so by studying performance changes on a two dimensional "growth– profitability performance space". It is well established that both growth and profitability are important dimensions of SME performance. The majority of earlier studies tend to focus on the evolution of firm growth or profitability separately. Alternatively, they explore the impact of growth on profitability and vice versa. A primary difficulty is studying this phenomena is the complex inter-relationship between growth and profitability. There are sound theoretical arguments that growth affects future profitability, and that profitability allows future growth. Of course, industry conditions and economic cycles affect the competitiveness of the market environment, and in turn both growth and profitability of firms. Microeconomic perspectives argue that a trade-off often exists between short term growth and profitability. Many econometric studies have empirically established relationships between growth and profitability, but the exact nature of these relationships and causality remains unresolved. These considerations lead us to the central research question of this paper: How do young and small firms evolve on the dual performance dimensions of profitability and growth? The current paper adds to our knowledge of firm evolution by studying the dual performance measures of growth and profitability simultaneously. We examine the longitudinal behaviour of firms using the ABS BLS database of SME from 1995-1998. In our analysis we assign firms to initial performance positions (low, medium, high) along the two performance dimensions (growth and profitability), for a total of nine groups. Consistent with previous research that reveals younger firms have higher average growth rates, our results indicate young firms are most likely to be in the higher growth performance groups. Interestingly, they are most likely to have either relatively high profits (Star Group) or relative low profits (Growth Focus). Of these two groups, not surprisingly, firms in the Star group have much better future performance. However, the Growth Focus firms on average have poorer future performance than all other firms (other than low growth / low profit). In general, firms in the high profit groups had substantially better future prospects than firms in low performance groups. As firms age further, they are most likely to transition towards the Middle, Low Growth and Poor groups. Older firms are particularly unlikely to be in the high growth / low profit group.