The previous section provides a review of SME and financial management. This section reviews SME financial management practices in the developed economies such as the USA, Canada, the UK and Australia.
The context of financial management practices
Financial management practices in the SME sector have long attracted the attention of researchers. Depending on different objectives, researchers emphasize different aspects of financial management practices. McMahon, Holmes, Hutchinson and Forsaith (1993) and McMahon (1998) summarize their review of financial management practices in Australia, the UK and the USA. In their review the context of financial management practices includes the following areas:
Financial reporting and analysis – the nature, frequency and purpose of financial reporting, auditing, analysis and interpretation of financial performance
Working capital management – non-financial and financial considerations in asset acquisition, quantitative techniques for capital project evaluation, investment hurdle rate determination and handling risk an uncertainty in this context
Financial structure management – financial leverage or gearing, accounting to lenders, knowledge of sources and uses of finance, non-financial and financial considerations in financial structure decisions and non-financial and financial considerations in profit distribution decisions
Financial planning and control – financial objectives and targets, cost-volume-profit analysis, pricing, financial budgeting and control, and management responsibility centers
However, the purpose of this study is not to cover all the contexts of financial management practices as indicated above but to review selected financial management practices that affect on or are related to SME profitability. These include accounting information systems, financial reporting and analysis, working capital management, fixed asset management, and capital structure management.
2.3.1 Financial reporting and analysis
Recording and organizing the accounting information systems will not meet objectives unless reports from systems are analyzed and used for making managerial decisions. This section provides a review of financial reporting and analysis of SMEs.
Louma (1967) conducted a survey of 62 manufacturing SMEs on the use of accounting information in managerial decision-making. 86% of respondents reported that they used some form of financial statement analysis and interpretation. Of these, 40% indicated that the founder of the businesses was actively involved.
In their survey, DeThomas and Fredenberger (1985) found that 81 percent of the small enterprises regularly obtained summary financial information. Ninety-one percent of the summary information was in the form of traditional financial statements (balance sheets, profit and loss statements, fund statements), the remainder being bank reconciliation and operating summaries whereas no business was regularly receiving cash-flow information.
DeThomas and Fredenberger also found that 61 percent of respondents felt the financial statements provided the information they required for planning and decision-making. Nevertheless, only 11 percent of respondents reported that they had used financial statement information formally as part of managerial evaluation, planning and decision-making, 2 percent of businesses utilized financial ratio analysis, and few made even simple historical comparisons.
Thomas and Evanson (1987) studied 398 small pharmacies (in Michigan, North Carolina, Nebraska, Rhode Island and Washington) to examine the extent to which financial ratios were used in a specific line of small retail business and tested for a relationship between use of financial ratios and business success. They used regression analysis to examine the relationship between financial ratio usage and SME profitability. However, they could not demonstrate any significant relationship between earnings-to-sales and the number of financial ratios used by the owner in operational decision-making. When efforts were made to include the effects of other managerial practices and variations in business environments, no association between use of individual ratios and total earnings or totalto-sales was found. They explained the lack of association between financial ratio usage and either survival or profitability, may also indicate that the level of sophistication in use of ratios has not reached a high enough level among pharmacies to make a discernible difference between those which use and those which do not use financial ratios. However, Thomas and Evanson (1987)’s study only examined the association between SME profitability and the number of financial ratios, while the relationship between SME profitability and the efficiency as the result of using the financial ratios was not studied.
McMahon (1998) examined which enterprises and financial management characteristics seem to most influence financial reporting practices adopted in small and medium-sized manufacturing enterprises in Australia and what impact these financial reporting practices appear to have on achieved business growth and performance. The research results showed that development orientation, extent of owner-management, technological complexity, degree of reliance upon external financial advice, and financial reporting climate significantly influence on the comprehensiveness of financial reporting practices in Australian small manufacturing enterprises. According to McMahon (1998) the relationship between financial reporting practices and business growth and performance is difficult to identify, describe and explain. The reason explained for this is that management is a complex activity affected by a myriad of interacting internal and external factors. Recently, McMahon (1999) reported new empirical evidence on financial reporting to financiers by small and medium-sized enterprises and found a significant relationship exists in the study sample between enterprise size in employment terms and provision to financiers of a business plan or future-oriented financial statements or annual historical financial statements or periodic historical financial statement. However, no statistically significant relationship exists in the study sample between enterprise size in employment terms and the likelihood of being asked to provide financial information by potential financiers.
2.3.2 Working capital management
This subsection reviews the literature on working capital management practices of SMEs.The context of working capital management includes cash management, receivables and payables management, and inventory management.
Regarding cash management practices, Grablowsky (1978) and Grablowsky and Rowell (1980) conducted a questionnaire survey concerned with the cash management practices of 66 small enterprises from a number of industries located in and around Norfolk, Virginia. The results showed that 67% of respondents replied they did not do forecasting of cash flows. When asked how they determined the level of cash to be held by the business, less than 10% of enterprises reported using any type of quantitative technique. The method most often employed was to hold cash as a fixed ratio of projected expenses, forecasted sales or anticipated purchases. Non-quantitative methods used consisted of meeting compensating balance requirements, maintaining the level considered safe by management or achieving a level recommended by outside advisers.
Additionally, 71% of business in the Virginia survey reported that they had no short-term surpluses of cash in their recent history. Only 23% had a long-term surplus. Nearly 30% of respondents had invested excess cash in earnings securities or accounts. The most common investments were savings accounts, certificates of deposit, treasury bills, repurchase agreements, commercial papers, shares, bonds and other investments.
Regarding accounts receivable management practices, Grablowsky (1976) and Grablowsky and Rowell (1980) found generally low standards. Approximately 95% of businesses that sold on credit tended to sell to anyone who wished to buy. Only 30% of respondents subscribed to a regular credit reporting service. Most had no credit checking procedures and guidelines, and only 52% enforced a late-payment charge. 34% of businesses had no formal procedure for aging accounts receivable. Bad debts averaged 1.75% of sales, with a high of 10% in some concerns. Murphy (1978) revealed a very high level of awareness and utilization of credit control systems in the UK, even in the smallest businesses.
On inventory management practices, Grablowsky and Rowell (1980) found that most of the respondents had in excess of 30% of their capital invested in inventory, the general standard of inventory management was poor. Only 6% of businesses in their survey used a quantitative technique such as economic order quantity for optimizing inventory and 54% had systems which were unable to provide information on inventory turnover, reorder points, ordering costs or carrying costs.
In general, depending upon their objectives, in examining working capital management practices, the previous researchers emphasized specific aspects of working capital management. Burns and Walker (1991) examined working capital management as a whole. In their survey of working capital policy among small manufacturing firms in the USA, the following aspects of working capital were considered:
working capital policy,
managing working capital components, including cash, receivable, payable and inventory management, and
relationships between working capital management practices and profitability
Probably this survey was one of the most comprehensive surveys of working capital management practices where almost all aspects of working capital management were examined. Burns and Walker’s (1991) findings can be summarized into some main points as follows:
Overall, companies had an informal procedure or no written policy for working capital management. However, those that did have a written policy were probably more profitable than others.
For cash management, the typical company used cash budgeting on a weekly basis mainly to plan for shortages and surpluses of cash. Company would determine target cash balances based on needs for transaction balances, and put its idle cash in cash management accounts or certificates of deposit.
For accounts receivable, the typical company used both the collection period and aging schedule to monitor the payment behavior of credit customers.
With regard to inventory policy, the typical firm used computerized inventory control systems to decide on the appropriate amount to replenish its storage points by using ad hoc decisions. Company mainly considered the availability of parts and materials in deciding on reorder quantities for inventory purchased.
As for accounts payable, the typical firm became a net supplier of credit believing that the cost of foregoing trade discounts was only about 13%, yet it always or sometimes took the discounts.
In summary, working capital management practices have long attracted the attention of previous researchers. The main research areas related to these practices included cash, receivable and inventory management. However, relationships between working capital management practices and SMEs’ survival and growth have not been investigated.
2.3.3 Fixed Assets Management
This subsection reviews the previous researches on fixed asset management practices of SMEs.
Brigham (1992) suggested that capital budgeting might be more important to asmaller firm than its larger counterparts because of the lack of access to the publicmarkets for funding. Capital budgeting has attracted researchers over the past severaldecades. McMahon et al. (1993) claimed the earliest study of capital budgeting of SMEswas reported by Soldofsky (1964). During 1961, Soldofsky interviewed 126 owners ofsmall manufacturing businesses in Iowa and the results were published in 1964. Soldofsky (1964) found there was considerable variation in the methods of calculating payback period and in determining payback standards. In many businesses, required payback periods were flexible according to circumstances such as the variability of cash, planned product changes and business outlook. In the smaller enterprises, approvals for capital outlays tended to be given as required, whereas larger concerns were more likely to have annual capital budgets. Only four firms attempted to calculate some variation of the average cost of capital for use as a hurdle rate for capital projects. Most businesses seemed unaware of the link between their financing and investment decisions. On the positive side, it was quite clear that the evaluation of capital projects was heavily cash flow oriented.
Regarding capital project selection techniques, there were several surveysconducted by previous researchers such as Soldofsky (1964), Luoma (1967), Grablowsky and Burns (1980), Proctor and Canada (1992), and Block (1997). Soldofsky (1964) found that around 58 percent of respondents used payback period methods whereas only 4.1 percent employed accounting rate of return technique.
Block’s (1997) survey of 232 small businesses in the USA indicated payback method remains the dominant method of investment selection for small businesses, whereas large corporations widely incorporate discounted cash flow models in financial analysis of capital investment proposals (Proctor and Canada, 1992). This is not evidence of a lack of sophistication as much as it is a reflection of financial pressures put on the small business owner by financial institutions. The question to be answered is not always how profitable the project is, but how quickly a loan can be paid back. Nevertheless, more sophisticated methods using discounted cash flow (IRR and NPV) have increased in use over time.
Scott et al. (1972) examined the capital investment evaluation procedures of 135 small manufacturing enterprises in the USA and the following are some principal findings:
84% of respondents indicated that some investments were necessary in the short-run, regardless of their profitability.
Payback period was used to evaluate capital projects by 51% of respondents, while 30% reported use of some variation of accounting rate of return. Only 10% reported use of discount cash flow methods such as net present value (5%) and internal rate of return (2 percent). This finding is consistent with the Louma (1967), Grablowsky and Burns (1980) findings of a tendency in using simple and complicated methods of capital investment project evaluation.
61% of respondents indicated that they screened capital expenditures by comparing the expected rate of return on investment with the cost of capital or some cost of financing.
In summary, the previous findings related to fixed asset management practices reveal that Payback period method continues keeping its dominant position in evaluating capital investment projects of SMEs.
2.3.4 Capital structure management
This current subsection reviews capital structure management or financial management practices related to the decisions of sources of financing. It includes examining what factors affect capital structure decisions and how capital structure impact on SME growth and survival.
Small companies frequently suffer from a particular financial problem – lack of a capital base. Small businesses are usually managed by their owners and available capital is limited to access to equity markets, and in the early stages of their existence owners find it difficult in building up revenue reserves if the owner-managers are to survive. A question concerns how small businesses determine sources of finance in such difficult circumstance. According to Brigham (1995, p. 447), modern capital structure theory began in 1958, Since that point of time, researchers have attempted to explain how firms choose their capital structure.
Literature of the 1980’s has attempted to explain small firm financing decisions by using modern financial theories. McConnell and Pettit (1984) suggested that small businesses generally have proportionally less debt than large firms because: (1) small firms generally have lower marginal tax rates than larger firms, thereby, less tax deduction benefit of debt, (2) small firms may have higher bankruptcy costs than large firms, and (3) small firms may find it more difficult to express their business health to creditors.
Another attempt to explain small firm financing behaviour relied on agency theory. Agency theory holds that investors who have equity or debt in a firm require costs to monitor the investment of their funds by management or the small business owner (agency costs). This view suggests that financing is based on the owner-manager being able to assess these agency costs for each type of financing, and then select the lowest cost method of financing the firm’s activities. One weakness of this explanation is that no one has yet been able to measure agency costs, even in large firms (Myers, 1984).
In contrast, more recent theoretical and empirical work suggests that a strategic perspective may have promise in explaining the financing decisions. Barton and Gordon (1988) suggest that the following characteristics must be accounted for in any explanation of firm financing decisions:
behavior at the firm level
fact that the capital structure decision is made in an open systems context by top management, and
decisions reflects multiple objectives and environmental factors, not all of which are financial in nature
The arguments of Barton and Gordon (1988) for the management choice perspective on large-firm financing decisions may have even more relevance and validity for small firms. First of all, because most small firms are not actively traded on a financial market as large, public firms are, they are unconcerned with the financial market’s assessment of their capital structure. As a result, modern financial leverage theory, which is based on the market’s assessment of total stock valuation, does not always apply. Second, as Levin and Travis (1987) pointed out the owners’ attitudes toward personal risk – not the capital structuring policies public companies use – determine what amounts of debt and equity are acceptable. In effect, the authors argue that small firms choose debt based on personal, managerial preference.
Conversely, Norton (1991) provided empirical evidence on capital structure selection by conducting a survey of 400 small, high-growth corporations. In his survey, respondents were asked to describe the underlying firm philosophy in making debt and equity decisions. There were 261 respondents answering this question and the results are shown in Table 2.3.
Other empirical evidence on capital structure was provided by Peterson and Shulman (1987). Peterson and Shulman (1987) analyzed the empirical data collected for 1984 International Small Business Congress. Approximately 130 questions were asked in 4,000 interviews conducted in 12 countries including Brazil, Colombia, Spain, Kenya, Cameroon, Indonesia, USA, Canada, West Germany, United Kingdom, Netherlands, and Japan. The survey questionnaire contains information regarding the source of funds, including traditional debt, internal equity, friends/relatives, and trade suppliers. The actual percentage of each source that a firm employs varies depending on such factors as (1) age of firm, (2) location of the firm, (3) cost of the source, (4) availability of the source, (5) profitability of the firm, (6) growth level of the firm, and (7) information flows.
The results of the study show that a life cycle of capital structure among small growing firms depend on age, size, and economic development. Most firms appear to be initially dependent on relatives/friends and personal equity for expansion/working capital needs and over time are able to rely on more heavily on traditional source of bank debt for financial support. Since firm managers/owners will attempt to minimize the overall cost of capital, the firm is seen as having a rising level of debt as it becomes available.
This section reviewed the literature of financial management practices of SMEs in the developed countries. Most previous researchers in the literature concentrated on examining, investigating and describing the behavior of SMEs in implementing financial management. Specific areas of financial management practices including accounting information system, financial reporting and analysis, working capital management, fixed asset management and capital structure management, have attracted the attention of many researchers. However, their findings are mainly related to exploring and describing behavior of SMEs in financial management practices. As a result, they provided many descriptive findings but seem to lack the associative findings of the relationship between financial management practices and financial performance of SMEs.
2.4 Research Model
Based on the literature, this research chapter was seeking to provide an overview of the findings of financial management practices, financial characteristics and SME growth and survival.
Related to financial management practices, most previous researchers from the literature concentrated on examining, investigating and describing the behaviour of SMEs in implementing financial management. The specific areas of financial management practices including financial reporting and analysis, working capital management, fixed asset management and capital structure management have attracted the attention of many researchers. Their findings are mainly related to exploring and describing behaviour of SMEs in financial management practices.
Although they provided much descriptive statistical data and empirical evidence on SME financial management practices, it appears that there are some limitations in past research, which need to be addressed.
Firstly, most empirical evidence comes from developed economies such as the USA, UK, Canada and Australia. Evidence seems to lack evidence from emerging economies, especially from the transiting economies such as Vietnam and China.
Secondly, most researchers in the literature only focus on investigating and describing financial management practices, whereas few examine the impact of financial management practices on SME profitability.
It will be difficult to convince financial management practitioners of the importance of financial management until evidence on the impact of financial management practices on SME profitability is provided and the relationship between the two variables are discovered.
In addition to financial management practices, the literature also provided the valuable findings related to financial characteristics of SMEs. Four variables including liquidity, financial leverage, activity and profitability are popularly used by previous researchers to identify and measure financial characteristics of SMEs.
Based on these findings provided by previous researchers and these gaps, a model of the impact of financial management on SME is developed. Such a model is presented in Figures 2.7.
Figure 2.7 describes the detailed model of the impact of financial management practices on SMEs’ growth and survival in which the components measuring financial management practices such as financial reporting and analysis, working capital management, fixed asset management, capital structure management and financial planning, and components measuring financial characteristics such as liquidity, financial leverage, and business activity are identified.