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ARCHIVED—Financing Profile: High-growth SMEs

May 2006

Report Summary:
This profile on HGSMEs presents key characteristics, financing patterns and potential financial barriers for these high-performing firms.

Patrick Huot, Industry Canada
Christine Carrington, Industry Canada

Small businesses are key to economic growth. Recent studies by Industry Canada (Parsley and Dreessen, 2004) and other organizations have identified a small group of small and medium-sized enterprises (SMEs) that contributed disproportionately to the growth in Canadian employment. These high performers, often referred to as high-growth small and medium-sized enterprises (HGSMEs), were responsible for creating nearly 1 million net jobs out of a total of nearly 1.8 million net jobs in Canada between 1985 and 1999.

Other recent research (Fischer and Reuber, 2002) indicates that HGSMEs have great profit potential, but also potentially represent great financial risks. If HGSMEs are to continue as a principal engine of growth, it is important from a public policy perspective to understand the challenges and barriers they face in maintaining their growth. Using the most comprehensive database on small business financing, this profile on HGSMEs presents key characteristics, financing patterns and potential financial barriers for these high-performing firms.

Summary of Key Findings

• In 2001, 17 percent of all Canadian SMEs were considered HGSMEs; between 1985 and 1999, HGSMEs created roughly one out of two net jobs in Canada.
• In 2001, HGSMEs were
  • located in every region of the country, with a slightly higher concentration in Ontario (38 percent) and Quebec (24 percent);
  • found in all sectors of the Canadian economy, but were more concentrated in the manufacturing sector, professional services and knowledge-based industries; and
  • more likely to invest in research and development (R&D) than other SMEs (34 percent of HGSMEs invested in R&D activities compared with 25 percent for other SMEs).
  • HGSMEs were more likely to request debt financing (21 percent versus 17 percent) and leasing (11 percent versus 6 percent) than other SMEs.
• In 2000, HGSMEs were more likely to use risk capital from angel investors or venture capitalists. They were nearly three times more likely to be financed by angel investors and over 22 times more likely to be financed by venture capitalists than other SMEs.
• After commercial loans and lines of credit (48 percent usage), HGSMEs were more likely to use trade credit from suppliers (45 percent) and the owner's personal credit (38 percent), compared with other SMEs (49 percent, 38 percent and 33 percent, respectively).

Small Number but Large Economic Contribution

In 2001, 17 percent of all Canadian SMEs (over 305 000 firms) were considered high growth, up from 12 percent in 2000. An earlier Industry Canada study (Parsley and Dreessen, 2004) found that hyper- and strong-growth firms^{Footnote 1} (7 percent of all firms) were responsible for nearly 1 million of the nearly 1.8 million net jobs created between 1985 and 1999. While accounting for a small proportion of the SME population, HGSMEs make a considerable contribution to the Canadian economy.

Located in Every Region of the Country

The regional distribution of HGSMEs reflects the regional economic structure of Canada. Although HGSMEs were located in every region of the country (see Figure 1), they were more concentrated in Ontario and Quebec. The combined share of HGSMEs in these provinces (62 percent) was slightly higher than other SMEs' share (57 percent). An earlier report (Industry Canada, 2003) indicated that HGSMEs were more likely to be found in the manufacturing sector and knowledge-based industries than in other sectors of the economy in 2000. The concentration of manufacturing firms (67 percent of all manufacturing SMEs in Canada) and knowledge-based industries (65 percent of all knowledge-based SMEs in Canada) in Ontario and Quebec could help explain the higher concentration of HGSMEs in central Canada.

Figure 1
Regional Distribution of HGSMEs in 2001

Source: Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2001.

Present in All Sectors but Concentrated in Manufacturing and Knowledge-Based Industries

HGSMEs were found in every sector of the Canadian economy in 2001. As seen in Figure 2, however, HGSMEs tended to be somewhat more concentrated in manufacturing, professional services and knowledge-based industries, accounting for 24 percent of firms in both manufacturing and professional services and 19 percent of all knowledge-based firms. This may, in part, explain the higher expenditures in R&D among HGSMEs, as these three sectors have the highest percentage of SMEs engaged in R&D. In 2001, 43 percent of manufacturing firms, 37 percent of professional service firms and 47 percent of knowledge-based businesses invested in R&D.

Figure 2
Proportion of High-Growth SMEs by Industry Sector in 2001

Source: Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2001.

Represented in All Business Size Segments

Although HGSMEs were represented in businesses of all sizes (defined by number of employees) (see Figure 3), the majority (74 percent) had fewer than five employees in 2001. This finding is similar to the finding for other SMEs (80 percent of which had fewer than five employees).

Figure 3
Distribution of Firms by Business Size in 2001

Source: Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2001.

Firms with more than five employees represented a higher proportion (26 percent) of HGSMEs compared with other SMEs (20 percent) in 2001. It might be assumed that these HGSMEs have higher revenues, assets and profits and a more extensive track record as larger firms tend to produce more in absolute terms and tend to be in operation for a longer period of time than smaller firms. However, this assumption is not supported by the data, which show the age distribution for HGSMEs was the same as for other SMEs in 2001 (78 percent having been in operation for more than five years). However, the combination of these factors (higher revenues, assets and profits) may mitigate lenders' perceptions of risk: as will be seen below, HGSMEs appear to have no more difficulty accessing financing than other SMEs.

Propensity to Export Underestimated Because Contribution to the Global Supply Chain is Unknown

Although a recent study (Industry Canada, 2005) on small business goods exporters^{Footnote 2} established that fewer than 2 percent of SMEs exported their goods in 2000, the Survey on Financing of Small and Medium Enterprises found that 18 percent of HGSMEs in all sectors (products and services) exported, compared with 9 percent for other SMEs during that year. The higher propensity of HGSMEs to focus on external markets may actually be underestimated because the survey did not test the extent to which these firms are integrated into larger firms' supply chains (e.g. Bombardier and its suppliers or the automobile industry and its suppliers) that would then export worldwide. Additional research is required to fully understand the contribution of HGSMEs to the export market through larger firms' supply chains.

Higher Propensity to Invest in Research and Development Activities

Although more HGSMEs (34 percent) invested in research and development (R&D) activities in 2001 than other SMEs (25 percent), only a small proportion of them (2 percent in 2001 and 6 percent in 2000) were considered innovative firms,^{Footnote 3} which was similar to the finding for other SMEs (2 percent in 2001).

Stronger Financial Performance

Table 1 presents key financial amounts for the average HGSME in 2000, compared with averages for other SMEs. In 2000, HGSMEs demonstrated stronger financial performance than other SMEs in terms of size and profitability.

In 2000, the average HGSME was better positioned financially, with 18 percent greater assets than other SMEs, 72 percent greater revenues, 45 percent greater profits and 11 percent greater equity holdings.

Examining common profitability measures,^{Footnote 4} HGSMEs again outperform other SMEs:

• Slightly higher rate of return on assets (13 percent versus 10 percent among other SMEs);
• Higher rate of return on equity (33 percent versus 24 percent); and
• Similar profit margins (8 percent versus 9 percent).

In terms of liquidity and debt management, the average HGSME had a similar debt-to-equity ratio as other SMEs (1.5 for HGSMEs and 1.4 for other SMEs). In the short term, HGSMEs have the same level of liquidity as other firms, with a ratio of current assets to short-term debt of 1.5.^{Footnote 5}

^{Footnote 1} Although the Growth Firms Project: Key Findings study measured firms' growth based on employment growth, SME FDI uses sales growth as the determining factor. This difference in growth criteria may lead to some conceptual differences in the findings of both studies.

^{Footnote 2} This estimate, produced from the Statistics Canada Exporter Registry, covers only small business goods exporters, whereas the Survey on Financing of Small and Medium Enterprises, 2000, 2001 covers all sectors (services and goods).

^{Footnote 3} Innovative firms are firms that invest more than 20 percent of their total investment expenditures in R&D.

^{Footnote 4} The rate of return on assets measures a firm's performance in using assets to generate earnings independent of the financing of those assets, whereas the rate of return on equity measures a firm's performance in using assets to generate earnings but also considers the financing of those assets using the DuPont method of calculation (Gaber, Davidson, Stickney and Weil. Financial Accounting, Dryden).

^{Footnote 5} Current ratio is a measure of a company's current assets to its short-term debt. A current ratio of 1.0 means that a company could survive for one year, even if it made no sales. Overall, the higher the ratio, the more liquid the company is.