The Canadian Economy in Transition
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Firm Dynamics: Variation in Profitability Across Canadian Firms of Different Sizes, 2000 to 2009
by Amélie Lafrance
Are small firms more profitable than large firms? This paper uses a longitudinal firm-level dataset to explore the financial performance of firms across size classes, and across industries and provinces during the 2000-to-2009 period. It also examines the volatility of profitability across firm size classes. The results show that the relationship between firm size and profitability follows an inverted u-shaped curve―profitability rises up to a relatively small firm size class and falls after that threshold has been reached. This relationship prevails across most industries and provinces and over most of the post-2000 period. Furthermore, on an intra-group basis, smaller firms tend to have much more variability in profit rates.
Small businesses continue to attract the attention of policy-makers, small business advocates, and the research community. The job growth, output growth and contribution to the economy of this group of firms are often compared with those of larger businesses. Missing from the debate in Canada has been the relationship between firm size and financial performance. The United States has an extensive literature on this subject, but little is known about whether the size of a business is positively or negatively related to profitability in Canada. As well, information about financial performance by firm size across industries and regions is lacking.
Theoretically, if economies of scale exist, so should a connection between firm size and profitability. As firms increase their workforce and reduce their operating costs, their profits are expected to follow, albeit to a certain threshold—the minimum efficient sized firm. Of course, a number of factors must be taken into account, including industry-specific effects, market size and regulations to account for industry differences in the relative performance of small and large firms. As a result, the evidence on the relationship between firm size and financial performance is mixed, with few agreeing that a relationship even exists. To a great extent, these differences arise from the use of different databases that are often less than representative of the universe of firms.
With information from a longitudinal dataset on the entire Canadian corporate universe, this study examines profitability rates across firm size classes, industries and regions over the 2000-to-2009 period. It may be that smaller firms have higher profit rates than larger firms, but their profits may be more variable on an intra-group basis and over time. Therefore, the volatility of profitability across firm size classes is also examined.
During the period, the relationship between firm size and profitability, as measured by the rate of return on assets, followed an inverted u-shaped curve. That is, for each year, the return on assets increased up to a relatively small firm size class, and fell at larger size classes. This pattern is consistent with other studies showing diminishing returns to firm size in terms of profitability. This relationship between firm size and profitability also held across most industries and provinces.
Intra-group variation in profitability in each year was inversely related to firm size, as measured by the coefficient of variation—smaller firms tended to have much more variability in profit rates. These results provide evidence that as small firms grow to become middle-sized firms, their financial performance becomes more homogeneous. Growth beyond the middle-size leads to greater intra-group variability, but it is still well below that of the smallest firms.
The intertemporal variability of profit rates of individual continuing firms, as measured by the standard deviation of rates of return, over the post-2000 period followed a u-shaped curve. As firms grew beyond the smaller size classes, their intertemporal variability decreased in the middle size class but then increased in the largest groups.
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