Inter-relationship Between Firm Growth And Profitability

There is a widespread presumption that there is a close link between firm growthand profitability, some classical theories, such as Peking Order Theory, ClassicalRecardian Hypothesis, Agency Theory and Kaldor-Verdoorm Law, have depicted theinter-relationship between firm growth and profitability to a certain extent. However,thus far, empirical studies on inter-relationship between firm growth and profitabilitywere very few and the results were inconsistent.In this paper, we investigate how firm growth and profitability simultaneouslyaffect each other using panel data on488China manufacturing firms for2001-2013. Atthe same time, we are also interested in examining the dynamics of firm growth andprofitability respectively. To be more specific, this study investigates interactionbetween firm growth and profitability employing the panel unit-root test and thedynamic panel system GMM estimator. And we will examine the extent to which theLPE and POP hold in relation to China manufacturing firms, which are an importantissue for industry practitioners as well as academic researchers.Through the empirical research, this paper draws three conclusions.Firstly, for Chinese manufacturing firms, the law of proportionate effect hypothesiswas rejected. The study found that the prior year’s firm size has a negatively significanteffect on current growth rates and growth rates are serially correlated. That is, firmgrowth rate is related to firm size and prior growth rate, not following random walk.Secondly, for Chinese manufacturing firms, the persistence of profit hypothesiswas validated in some extent. The study found that profit rate is stable and convergenton the whole, but long-run convergence of profit rate is imperfect. In this study, bothimperfect convergence and persistent differences in profit rate were observed. In otherwords, profits persist and that convergence is at work to some extent.Thirdly, previous years’ profit rates had a positive effect on current firm growthrate, and effect of the current and previous growth rates on current profit rate were alsopositive. But the link between prior growth and current profits is much stronger than thelink between previous profits and current growth. The effects of current and previousgrowth rates on current profit rate were significant, while the effect of previous profitrates on current growth rate were not significant. Therefore, current growth may be a pre-requisite for future profitabilityThis study may have following two innovation points.Firstly, this study explored the effects of firm growth and profitability time lagsbefore making a testable model for the dynamic panel system GMM estimator, andchose an appropriate lag length. In previous researches, the selection of lag length wasarbitrary, this paper employed IPS panel unit-toot test and the AIC criterion to choose anappropriate lag length and subsequently made a testable model for the dynamic panelsystem GMM estimator.Secondly, this paper conducted the research by using dynamic panel system GMMestimators. However, empirical studies investigated interaction between firm growthand profitability employing this theory were very rare in domestic at present.