Strategic Direction: Growth and Profitability of the Financial Sector in Ethiopia

Running a business, in most, is about making a profit, so it makes sense that one of the best measures of a company’s performance is its profit margins. Strong profit margins may mean a company is well-run, stable, and making money. A company with healthy profit margins might indicate it is efficient at allocating capital and controlling costs, so it can deliver more revenue to the bottom line. Decelerating earnings growth and contracting profit margins don’t sound like a good performance of financial firms, and they’re not. However, it has been argued that “profit” does not always give a useful or meaningful picture of a company’s operations. Readers of a company’s financial statements could even be misled by a reported profit figure. For instance, shareholders may believe that if a company makes a profit after tax of a certain lump sum then this is the amount it could afford to pay in dividends. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders expectations would be wrong. Survival of a business depends not just on its profit-generating ability but on the ability to pay debts when they fall due.

When one looks at the financial statements of financial companies in Ethiopia, the growth trend shows that the sector’s growth and profitability is booming, dividends soaring, and this in turn has resulted in greater investor confidence. However, the analysis and interpretation of a company’s financial statements requires an understanding of the basis on which they are prepared, the underlying objectives of their preparation and the purpose of financial reporting generally.

As per the financial reports of firms, there are strong reasons to believe that firm growth is conducive to firm profitability, although due to empirical and theoretical objections, this statement should be taken as a falsifiable clause rather than a confirmed fact. The underlying logic behind those supporting that profitability leads to firm growth rest basically on the recognition that most firms – especially the youngest – usually tend to finance their expansion with retained profits. In this context, however, it may be not clear enough, where this initial profitability of the new entrants to the Ethiopian financial sector comes from.

Where one looks deep in to the matter, the companies are securing greater profit margin, with exception of the few, which sometimes equivalent to their capital. This could mean a capacity to build public houses in every two or three year’s interval. But one may pose a question here. Can this profitability be sustained? Would it continue this way?

To find a feasible answer for this question many issues need to be investigated and the relationship of growth to profitability scrutinized in detail since the financial sector is the backbone of the economy and the sector’s growth would sparkle at the growth of other sectors.

Although the players in the sector are increasing from year to year and the financial sector is undergoing regulatory changes, companies have not only seen growth, but also posted profits. However, Ethiopian financial sector needs to focus on a sustainable, profitable model of growth since for a financial company; profitability is more the result of the health of existing business than new business and futurity.

It is meant that the firms have enjoyed profit subsequent to reducing operational costs and maintain a healthy expense ratio amid more business. This might hinder service expansion and broadening financial inclusion since the companies are enjoying profit amidst low financial density and penetration. In other words, it seems that the companies are working, every stone unturned, to increase their profitability instead of increasing the penetration and density of insurance and increasing financial service accessibility for most uninsured and unbanked society.

With the industry entering a new phase due to the expected fierce competition, experts believe the key to growth and sustainable profitable journey would be sticking to long-term business. The direction profit margins take from current levels will have a powerful effect on future growth. It will also determine whether or not the financial companies’ recent highs will be seen as reasonable, in hindsight. Analysts, who assume that profit margins will remain high and expand further, view current market levels as a success spring board for the future growth.

On the other hand, analysts who are increasingly uncomfortable with those assumptions view the sector as unusually overvalued and state that this is the result of an unusual widening in profit margins sending-off innovation.

Apart from this, companies should prudently make sure that factors playing a role in record elevated profit margins are well treated and all the required legal reserves and liabilities are met.

Moreover, the decision makers in the respective companies should be concerned about their decisions to allocate profits toward reinvestment and more likely consider the outlook and impact for the overall economy. The investment spending as a percent of corporate profits should also be separately treated since lower reinvestment rates aren’t a good strategy for boosting long-term earnings growth.

As figures indicate, in a little more than a decade, net margins for the financial sector have climbed high. It’s been a favorable environment for most companies. There’s been a bubble in both the banks and insurers side and a trend of increasing leverage on the balance sheets of individual companies. But the ability of companies in this sector to sustain such favorable profit margins is open to query. Not only is the environment for financials unclear, but competition will probably continue to increase in the crowd due to growing investor confidence.

Many perpetuate the myth that focusing on profits is ALWAYS the right answer and many managers repeat the same old mantra. However, the financial companies should understand as there is a healthy tension between profits & growth. To grow faster businesses need to fund growth. Although the improved profitability is impressive, considering their life span, firms in the financial sector should focus on profitable growth which stresses that profitability and growth should be jointly achieved. Firms’ working for increasing profitability should understand the “Profitable growth paradox”. And the only way out of this paradox is innovation. At most, Sustainable growth and profitability should be an inherent part of their strategic direction.

Moreover, there needs to be call for socialization of the financial service provider companies in order to make them serve “societal” rather than merely “profit oriented” goals. The players in the Ethiopian financial sector should also focus on delivering value adding financial products and basic financial services through financing community based development initiatives thereby fostering sustainable development including poverty alleviation along with generating Profit.

2nd Year • December 2013 • No 10