There are half a dozen or so key financial metrics that analysts and investors home in on to determine the health and performance of a company. They tend to focus on things like gross profit margin, revenue growth, free cash flow, operating expenses, return on equity, cost of capital, sales and the like.

But in the small-to-medium enterprise (SME) space, there is another critical, often overlooked, metric that is just as important and arguably more telling.

This metric – the wage bill of the firm – provides an insight into the level of complexity and efficiency inside a business, and when making an investment decision, it’s the number that I focus on the most.

The most beautiful curve

Over the past five years, AZ NGA has gained an interest in around 60 SMEs, primarily in the accounting and financial advisory space. We work closely with these firms, intimately understand their P&L and balance sheets, and benchmark their performance.

Each business is unique. They are all different sizes; some employ three staff, others have 20 plus. Some are mature and established, others are relatively young.

Unsurprisingly, when I look at their data altogether, it’s a scrambled mess. Some patterns are starting to emerge but, by and large, it’s all over the place.

However, there is one line of data that stands out.

When we plot the net profit after tax (NPAT) of our underlying firms against their wages bill, it creates the most ‘normal’ beautiful symmetrical distribution.

The data reveals three key insights about our network:

• Firms with a wages bill under $500,000 are underperforming their peers;
• Firms with a wages bill over $1.7 million are underperforming their peers; and
• Firms with a wages bill between $500,000 and $1.7 million are out-performing their peers.

There isn’t an obvious reason why businesses paying between $500,000 and $1.7 million in wages are outperforming, so we’ve spent a lot of time trying to understand the results.

What does the data mean?

Wages are a proxy for size and at the smaller end of the scale, businesses struggle to leverage their fixed cost base effectively.

Every business has a minimum fixed cost base to maintain operations, and successful businesses are able to leverage their cost base to build their revenue and derive benefits.

Firms with a wage bill under $500,000 typically have low margins, which makes them extremely vulnerable to external factors such as regulation, interest rates, volatile markets, poor consumer sentiment and an unhappy client. Over the business cycle, these firms are likely to under-perform.

However, big is not always beautiful.

There’s an assumption that bigger businesses are more profitable but, based on our benchmarking analysis, large practices grow at around 13 per cent per annum; a much slower rate than medium-sized practices which clock in at 26 per cent.

As businesses get bigger, headline revenue typically creeps up but they tend to become more complex. Complexity demands more investment, more highly-skilled staff and better systems and processes. The associated costs impact on profitability.

Furthermore, average people can, and often do, hide in big businesses because there’s so much going on and plenty of distraction. Accountability can be lax. Ironically, more staff rarely equates to better service and more engaged clients.

A close examination of large businesses reveals they often end up operating like a collection of small businesses. By employing pod structures and adviser-centric teams they become more and more inefficient and complex.

This is why an important metric when evaluating a business is its wage bill; a high wage bill often signals unnecessary complexity, and larger businesses are often just as bad as small businesses at leveraging their cost base.

Generally, as medium enterprises grow and transition into a larger organisation they stop being a unified firm with a strong culture and a single way of doing things.

As a result, there’s usually a lot of duplication, inconsistency and poor communication inside these businesses. Ironically, they end up grappling with the same issues as much smaller firms because of the decentralised, pod-like nature of their business structure.

In our experience, the tipping point is the $1.7 million wages mark.

In a bid to stop the downward efficiency spiral, the knee-jerk reaction is to hire more people but that often only adds even greater complexity.

We don’t just observe these trends inside our network, we see them across the industry.

The purpose of benchmarking isn’t to encourage or discourage principals to act a certain way but to make us more aware of the pitfalls. Our analysis simply tells us that if a business is not properly geared up for growth, profitability will take a hit. My next column will look at how businesses can expand without experiencing a decline in efficiency and margin.

To find out more contact Paul Barrett at paul.barrett@aznga.com