Australian business profitability is not world best practice

Australian companies must boost performance through upskilling and better strategies to stack up to global standard, says Phil Ruthven AM.

There is enormous confusion about business profitability in Australia. Ostensibly, our companies perform pretty well, their success celebrated in press headlines. Yet profits as a return on shareholder funds after tax (ROSF) have averaged just 3.7 per cent for the nation’s 2.3 million businesses during the past three decades — lower than the 5.5 per cent, risk-free, 10-year bond rate in that time.

Our largest 2000 companies have had an average return on shareholders’ funds during the past three years of just 6.9 per cent and our largest 100, just eight per cent. Perhaps worse, all these measures are little more than half the profitability of equivalent US businesses.

Yes, we have some high-flyers: more than one in 10 of our largest 200 businesses achieve, or better, world best practice of 22 per cent ROSF — a standard set by US best performance several decades ago. But our average is awful and nearly one in five (18 per cent) of our largest 2000 companies lost money during the past three years.

Part of the confusion or prejudice is cultural, with Australia having what is called an “envy” gene (tall poppy syndrome), in contrast to the US having an “aspirational” gene. One of the setbacks to modernisation of businesses in the 20th century was the adoption of protectionism in the first decade after Federation, leading to Australia having an economy with a jack-of-all-trades/master-of-none outcome. The 13-year Hawke and Keating Labor terms were a vital compass reset with their overdue economic reforms.

We still have a risk-averse mentality, backed by the stigmas of bankruptcy and insolvency, in contrast to the US second-chance Chapter 11 legislation — tolerance of first-time entrepreneurs who fail. Our venture capital sector continues to fail to adequately support our entrepreneurs with their unique technology or products. No wonder our All Ordinaries Index underperforms the US S&P 500 Index, let alone the NASDAQ.

A confusing factor about profitability is the practice of companies reporting profits in dollar terms. This leads to an impression the firms are successful. Using the proper measure of the return on shareholder funds after tax, it usually points to the majority of them being less than successful.

Another fallacy is that company profits go to often-vilified owners. In reality, most profits via dividends go to workers and retirees through superannuation funds that get the lion’s share from listed companies valued at well over $2 trillion. The moderate profits of the mixed-incomes (where it is impossible to clearly separate wages from profits to owners) are widely dispersed to more than 500,000 sole traders and partnerships, mainly small and medium-sized enterprises (SMEs).

Yes, some companies have sky-high profitability. Among the 2000 largest businesses, accounting for 46 per cent of the nation’s revenue, there are about three dozen with an average ROSF over a three-year period of 50-200 per cent a year. But companies such as Philip Morris (204 per cent), Bechtel Australia (143.4 per cent) and Sunstate Cement (102.8 per cent) are exceptions. More than 350 of the largest 2000 ran at a loss of up to 100 per cent a year. The top end is not the norm.

Lowering the corporate tax rate from 30 per cent to the OECD average of 25 per cent would raise our after-tax profits by seven per cent. But that won’t bridge the 45 per cent gap we have with the US; only equivalent performance in strategy and other managerial skills will do that.

The truth about profits

Leading and managing a business in the post-industrial age calls for higher returns to owners with their active assets such as intellectual property and organisational culture — as opposed to passive assets such as land, buildings and stock, with a low-risk return up to 11 per cent.

Passive assets no longer belong on a trading company’s balance sheet. However, with GAAP (generally accepted accounting principles) standards, intellectual property (IP) and other intangibles rarely put on a balance sheet, net assets values are artificially low.

However, investors on the share market return these missing assets through share prices that are about four times the balance sheet price. That means if a company had IP and other intangibles on its balance sheet, a reported 22 per cent ROSF would generally convert to just a quarter of that, being 5.5 per cent. Hardly excessive.

Achieving a return after tax of four times the normal 5.5 per cent bond rate is the new world best practice benchmark expected of owners. We have enough businesses achieving this. For example, Amcor (average 55.8 per cent ROSF over three years) is an international success story with revenue above $22b, and Blackmores (41.4 per cent ROSF over three years) is an Asia Pacific operator with revenue heading for $1b. This suggests others can do a lot better.

When we ask directors to manage investors’ money, the investors have a right to expect those managing their funds have adequate training. But Australia’s lack of adequate profitability for decades reveals how undertrained our business leaders are. Honesty and good governance are important, but competence and upskilling are paramount. They lead to better strategies, higher productivity and wages, higher profits and subsequent capital expenditure in the blast-furnace competitiveness of this “Asian century”. We need world best practice profitability.