Financial Management Impact on SME Survival
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After twenty-four years of reforming policy, along with the development of the national economy, Small and Medium Enterprises (SMEs) in Vietnam have remarked contributions in creating employment, increasing GDP, and raising the nation's volume of exports. However, SMEs have been restricted development by lack of management experience and financial resources, and due to uncertainty within the business environment. As a result, SMEs often faced obstacles during their operations. This research examines the relationship between financial management and probability to grow and survive of SMEs to determine whether financial management practices impact on SMEs' growth and survival.
In terms of structure, the report has two chapters.
Chapter one: Introduction: It reviews the research background, presents definitions of terms and scope of the study.
Chapter two: Literature Review: This chapter also reviews previous research related to financial management for SMEs in Vietnam and for SMEs worldwide.
Chapter One: Introduction
In 1986, Vietnam shifted from a centrally planned and controlled economy to a market oriented economy. It is apparent that since the government introduced the series of economic reforms known as “doi moi” (renovation), the SMEs have rapidly grown in terms of the number of businesses, capital and employees. According Ministry of Planning and Investment, in 2009, the number of enterprises in Vietnam was nearly 420,000 and among of this, SMEs was account of 97%. SMEs have contributed considerably to growing GDP with occupation of 26% of GDP and creating more job opportunities for 50% of labour-age people, especially in rural areas.
In addition to achievements and contributions as mentioned above, SMEs in Vietnam are currently being faced with many serious difficulties such as shortage of capital for expanding and renovating equipment and technology, low productivity and competitiveness, lack of experience in terms of marketing, production management, and financial management. Of these difficulties, lack of financing resources and experience of financial management is currently one of the most serious issues (Ebashi, Sakai and Takada, 1997). Inefficient financial management may damage SME profitability and, as a result, the difficulties of SMEs will become greater. Conversely, efficient financial management will help SMEs to strengthen their profitability and, as a result, these difficulties can partly be overcome. Most commercial banks refuse to offer loans for SMEs because the banks have doubt about SMEs' growth and survival. However, to date there has not been any research on SME growth and survival conducted in Vietnam. Conducting such research will enable commercial banks to evaluate SME profitability and make decisions on granting loans for SMEs. In addition, when the stock exchange is established in Vietnam, conducting research on SME profitability will help SMEs to improve their performances and reinforce financial management as a preparation to participate in stock exchange listing.
Originating from recognition of the increasingly important role and contribution of SMEs as well as the recent promotion and supporting policy on developing SMEs, this research study is considered a contribution to improvement of financial management practices to ensure for the growth and survival of SMEs in Vietnam.
1.2. Statement of Problem
In Vietnam, defining the research problem of SMEs may begin with a consideration of the typical characteristics of management. In operation of most SMEs, the position of financial manager who would be in charge of financial management of the company is empty. Usually, the owner-managers with the assistance of the chief-accountant control financial matters of the company. However, most owner-managers have no formal training in management skills, especially financial management. Moreover, the concepts of financial management have also only been recognized in Vietnam since the beginning of the 1990s when the economy was converted into a market economy. Currently, financial management is one of the challenges of SMEs. Lack of knowledge of financial management combined with the uncertainty of the business environment often leads SMEs to serious problems regarding financial performances.
Consequently, the growth and survival of SME could be restricted by inefficient financial management. SMEs have often failed due to lack of knowledge of efficient financial management. Moreover, undercapitalization and uncertainty of the business environment cause SMEs to rely excessively on equity and maintain high liquidity and these financial characteristics probably affect SME profitability (Vuong, 1998).
In summary, the problem that SMEs in Vietnam face appears to be that inefficient financial management practices have adversely affected their profitability. Therefore, the problem to be addressed in this research is to investigate the simultaneous effects of financial management practices and financial characteristics on SME growth and survival, and then, to determine the best measures for improving SME profitability in Vietnam by using efficient financial management tools.
1.3 Research questions
Research questions involve the research translation of “problem” into the need for inquiry (Zikmund, 1997, p.88). The research problem defined above leads to the following research questions:
- How important are SMEs' growth in Vietnam?
- How have researchers in the literature review, identified the context of financial management practices and financial characteristics, and how have they proposed to support SME growth and survival?
- How important are financial management practices and financial characteristics to SME growth and survival?
- What are the relationships between financial management practices, financial characteristics and SME growth?
- How do financial management practices and financial characteristics affect SME growth and survival?
- What action can improve financial management of SMEs in Vietnam?
1.4 Research objectives
A research objective is the researcher's version of a business problem. Objectives explain the purpose of the research in measurable terms and define standards of what the research should accomplish (Zikmund 1997, p. 89). In solving the research problem and answering the research questions mentioned previously, this study has the following objectives:
- To collect descriptive evidence on financial management practices, financial characteristics and the growth and survival of SMEs in Vietnam
- To develop a model of the impacts of financial management practices and financial characteristics on SMEs' growth and survival
- To contribute to knowledge of the relationships of financial management practices, financial characteristics and SMEs' growth and survival.
1.5 Justification for the Study
In terms of financial management practices, most previous researchers have focused on examining, investigating and describing the behaviour of SMEs in practising 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 long attracted the attention of researchers (McMahon, et al. 1993). Their findings are mainly related to exploring and describing the behaviour of SMEs towards financial management practices. Although they provided such descriptive statistical data and empirical evidence on SME financial management practices, it appears that there still are some gaps in the literature, which need to be addressed.
Firstly, most empirical evidence comes from the developed economies such as the United States of America (USA), the United Kingdom (UK), Canada and Australia (McMahon et al. 1993). There seems to be a lack of evidence from emerging economies, especially from transiting economies such as Vietnam and China.
Secondly, most previous researchers focus on investigating and describing financial management practices whereas there has been little research examining the impact of financial management practices on the ability to grow and survive (McMahon et al. 1993).
These are major gaps and it is difficult to convince business financial management practitioners of the need for changes in practices until evidence of the effects of financial management practices on the ability to grow and survive of SME is provided and the relationship between the two variables are discovered.
Based on previous research findings and recognition of these gaps, a study of the impact of financial management on SME profitability is justified and a model of the impacts of financial management practices and the financial characteristics should be developed and tested by using the empirical data from emerging economies. Vietnam is one of many appropriate countries to provide such data. Therefore, this study will extend previous studies by focusing on examining the simultaneous impacts of financial management practices and financial characteristics on SMEs' growth and survival using the empirical evidence from Vietnam.
1.6 Significancy and Scope of Research
Completing this study brings together aspects of theory and practice. For theory, this study is an expansion of previous studies on financial management practices and financial characteristics of SMEs by focussing on examining the simultaneous impacts of financial management practices and financial characteristics on SME growth and survival. In addition, utilizing data from Vietnam, one of the emerging economies, contributes to the literature of SME financial management, which traditionally concentrates on SMEs of developed economies rather than SMEs in other economies. Using data from Vietnam to test theories of financial management helps to confirm and expand the scope of theoretical applications.
In practice, this study is significant for financial management practices in Vietnam. Results will indicate relationships between financial management practices, financial characteristics and SME growth and survival, and will assist owner-managers and financial managers to improve performance and profitability of their businesses by managing financial matters efficiently and effectively.
Chapter Two: Literature Review
2.1 Defination of Small and Medium Enterprises
This section reviews the definitions of small and medium enterprises (SMEs) from the literature. Obtaining a definition is the starting point for reviewing literature on the aspects of SME financial management. There is no universal definition of small enterprise (Back, 1985 and Meredith, 1993). In theory and practice, there are many terms used to refer to SME including “small business”, “small enterprise”, “small firm”, “small company”, “small and medium enterprise”, and “small and medium-sized enterprise”. They all are somewhat different in meaning but distinguishing differences among these terms is not the purpose of this study. In this study all these terms are used as if having the same meaning.
Although there are several definitions of small and medium enterprises, definitions are basically classified into two types: those based on qualitative characteristics and those based on quantitative characteristics of small and medium enterprises (Back, 1985).
2.1.1 Qualitative definitions
Qualitative definitions define small and medium enterprises based on their qualitative characteristics. The great advantage of these definitions is that they attempt to capture the essential nature of small business. However, the problem is that they vary from country to country and from industry to industry.
The Small Business Act of 1953 of USA defines a small business as “one which is independently owned and operated and not dominant in its field of operation”. The act also empowers the Small Business Administration (SBA) to identify standards of size for “number of employees” and “sales volume” that small business must meet. When reviewing the quantitative definitions, these standards will be examined in more detail.
In the UK, the qualitative definitions adopted by the Bolton Committee (1971) identified three major characteristics of small business:
- Firstly, in economic terms, a small firm is one that has a relatively small share of the market, and is unable to influence the price or quantity of goods or servicing.
- Secondly, an essential characteristic of a small firm is that it is managed by its owner or part owner in a personalized way, and not through the medium of a formal management structure.
- Thirdly, it is also independent in the sense that it does not form part of a larger enterprise and that the owner-managers should be free from outside control in making their principal decisions.
In Australia, the annual report of small business released by the Department of Industry, Technology and Commerce (1992, p.5) employs a definition of a small enterprise that is based on the following characteristics:
- independently owned
- closely controlled by owner-managers who have responsibility for principal decisions
- owner-managers contribute most, if not all, of the capital
Operations are locally based, although its market might not be.
In addition to the definitions of small business stated by the organizations mentioned above, there are many other different definitions of small business put forward by many authors and researchers. Meredith (1986, p.3) defines small enterprises as enterprises where one or two owners are required to make all critical decisions, and these owners, therefore, rely on specialist advice multiplier agents. McMahon (1995, p. 3) confirmed that many people think small business should be defined as:
A business in which one or two persons are required to make all the critical management decisions: finance, accounting, personnel, processing or servicing, marketing, selling, etc. without the aid of internal specialists and with specific knowledge in only one or two functional areas.
Although qualitative definitions have the great advantage of attempting to capture the essential nature of small business, they still have the disadvantage of being unworkable in carrying out research or in gathering statistical information. It is, therefore, useful to define small business from the quantitative characteristic perspective.
2.1.2 Quantitative definitions
Quantitative definitions define small and medium enterprises based on their quantitative characteristics. Unfortunately, quantitative characteristics may be difficult to measure. Firstly, there are a variety of ways in which enterprise size can be measured, including (1) number of employees, (2) sales revenue or turnover, (3) total assets, and (4) net worth. The first of these is the most widely used measure of size in qualitative definitions of small enterprise around the world, although the second and the third also find significant use (McMahon et al. 1993).
Secondly, the quantitative characteristics of small enterprises vary from industry to industry and from country to country. For example, an enterprise, which is small in one industry such as cement manufacture, may be regarded as large in another industry such as trading or tourism. Similarly, an enterprise, which is considered small by the USA standards, may be relatively large in other countries such as Thailand, Malaysia or Vietnam.
Regarding the number of employees, in the USA the government decided to use 500 employees as the general cut-off between small and other businesses (Back, 1985, p.4) while most studies in Australia have classified a firm is small, if it employs less than 100 employees (Back, 1985, p.3). In addition to the number of employees, some other countries such as the USA, Britain, and Japan define small business based on turnover and industry breakdown. Table 2.1 summarizes the quantitative definitions of SMEs in the developed countries.
According to the criteria of the World Bank and Decree No. 56/2009/ND-CP dated 30/6/2009 of Vietnam's government, SMEs are determined as Table 2.2 below:
The quantitative definitions of SMEs, especially their quantitative characteristics, are very important because they provide the bases for carrying out research and gathering statistical information. They also provide quantitative standards for the comparative studies between SMEs in one country and SMEs in another country.
2.2 Financial Management for SMEs
This section provides a general framework of financial management for SMEs from the literature. At the same time, it points out the specific areas of financial management in the literature that will be reviewed.
2.2.1 Defining financial management
The main objective of this study is to review financial management and its impact on the growth and survival of small and medium enterprises. Before reviewing the relations between financial management and SME growth and survival, the concept of financial management needs to be clarified. According to Meredith (1986) financial management is one of several functional areas of management but it is the central to the success of any small business. This definition emphasizes the central role and position of financial management in relation to the other specific areas of business management. Figure 2.2 describes the central role and position of financial management in relation to specific areas of business management.
McMahon et al. (1993, p.3) defines financial management based on mobilizing and using sources of funds:
Financial management is related to raising the funds needed to finance the enterprise's assets and activities, the allocation of theses scare funds between competing uses, and with ensuring that the funds are used effectively and efficiently in achieving the enterprise's goal.
According to McMahon et al. (1993), modern financial management involves planning, controlling and decision making responsibilities embracing:
- Various types and sources of finance an enterprise may employ, but how these may be accessed, and how to choose among them.
- Alternative ways in which finance raised may be used in an enterprise and how to select those that are likely to prove most profitable.
- Different means of ensuring that finance entrusted to specific activities realizes the returns that were anticipated on its allocation to them.
However, according to Meredith (1986) financial management is concerned with all areas of management, which involve finance not only the sources, and uses of finance in the enterprises but also the financial implications of investment, production, marketing or personnel decisions and the total performance of the enterprise. English (1990) argues financial management is concerned with what is going to happen in the future. Its purpose is to look for ways to maximize the effectiveness of financial resources.
Definitions mentioned above only emphasize areas or scopes of financial management, which financial management is concerned with, but they do not emphasize the objectives of financial management. While English (1990) indicated financial management consists of working simultaneously toward three objectives: liquidity, profitability and growth.
2.2.2 Objectives of Financial Management
Like many other management sciences, financial management, firstly, establishes its goal and objectives. Objectives of financial management are foundations or bases for comparing and evaluating the efficiency and effectiveness of financial management. The final goal of financial management is to maximize the financial wealth of the business owner (McMahon, 1995). This general goal can be viewed in terms of two much more specific objectives: profitability and liquidity.
Profitability management is concerned with maintaining or increasing a business's earnings through attention to cost control, pricing policy, sales volume, stock management, and capital expenditures. This objective is also consistent with the goal of most businesses.
Liquidity management, on one hand, ensures that the business's obligations (wages, bills, loan repayments, tax payments, etc.) are paid. The owner wants to avoid any damage at all to a business's credit rating, due to a temporary inability to meet obligation by: anticipating cash shortages, maintaining the confidence of creditors, bank managers, pre-arranging finance to cover cash shortages. On the other hand, liquidity management minimizes idle cash balances, which could be profitable if they are invested (McMahon, 1995).
In addition to the two objectives mentioned by McMahon, English (1990) viewed growth as another objective of financial management. He also emphasizes the relationships between the three objectives by putting them on a triangle as illustrated in figure 2.3 as below:
While discussing the objective function of a privately held small firm, Ang (1992) indicated that its objective function is to maximize three components. The first is to maximize its current market price, to avoid unwanted mergers and to obtain outside financing in the securities market. The second is to maximize long term or intrinsic value, if the two values diverge. The last is to maximize non-owner manager's own pecuniary and non-pecuniary incomes by avoiding control rights. Whether the absence of marketable securities means that small firms need not be concerned with current performance and can concentrate on long-term values, depends on the organizational types and circumstances.
In making decisions related to financial management, the owner-manager or the financial manager should remember objectives of financial management and balance between liquidity and profitability objectives, and between current and long-term (growth) objectives.
2.2.3 Major Decisions of Financial Management
Generally, previous authors had no differences in opinions of major decisions in financial management. Ross, Westerfield and Jaffe (1999, p.1) indicated three kinds of decisions the financial manager of a firm must make in business: (1) the budgeting decision, (2) the financing decision, and (3) decisions involving short-term finance and concerned with the net working capital. Similarly, Ang (1992) also indicated three main financial decisions including the investment decisions, financing decisions and dividend decisions.
McMahon (1995) suggested another way of identifying the major decisions of financial management is to look at the balance sheet of a business. There are many decisions regarding items on the balance sheet. However, they are classified into three main types: investment decisions, financing decisions and profit distribution decisions (McMahon, 1995).
Investment decisions: (1) relate to the amount and composition of a business's investment in short-term assets (cash, stock, debtors, etc.) and fixed assets (equipment, premises, facilities, etc.), and (2) relate to the achievement of an appropriate balance between the two classes of assets.
Financing decisions: (1) relate to the types of finance used to acquire assets, and (2) relate to the achievement of an appropriate balance between short-term and long-term sources, and between debt and equity sources.
Profit distribution decisions: (1) relate to the proportion of profit earned that should be retained in a business to finance development and growth, (2) and the proportion, which may be distributed to the owner (McMahon, 1995).
These major decisions of financial management will be discussed in more detail in the next section where the specific areas of financial management are respectively clarified.
2.2.4 The specific areas of financial management
Most authors and researchers approach the specific areas of financial management in different ways depending upon their emphasis.
Walker and Petty (1978) define the main areas of financial management including planning (cash planning and control, asset-required forecasting, profit planning), financial leverage, investment decision-making, working capital management (cash, receivable and inventory management) and sources of financing (short-term and long-term financing, intermediate financing and going public). Barrow (1984) emphasizes a practical rather than theoretical perspective. Instead of identifying specific areas of financial management, he listed the tools of financial analysis, including business controls; measure of profitability; control of working capital (or liquidity); control of fixed assets, cost; volume; pricing and profit decisions, and business plans and budgets.
Meredith (1986) emphasizes information systems as a base for financial management including financial management records and reports. This is considered very important because the owner-managers or financial managers find it is difficult, if not impossible, to make decisions if they lack finance information. English (1990) emphasizes objectives of financial management including liquidity, profitability and growth. Therefore, the specific areas that financial management should be concerned with are liquidity management (cash flow budgeting, working capital management), profitability management (profit analysis, profit planning), and growth management (capital resource planning and decisions).
McMahon (1995) examines specific areas of financial management including all areas that relate to items on the balance sheet of the business. The specific areas financial management covers consist of managing working capital, managing long-lived assets, managing sources of finance, planning financial structure, and planning and evaluating profitability.
In summary, financial management is concerned with many specific areas. Probably the balance sheet of a business may demonstrate how to recognize these areas including:
- current asset or working capital management,
- fixed asset or long-lived asset management,
- funding management,
- financial budgeting and planning,
- leverage and capital structure,
- financial analysis and evaluating performance of the business, and
- Profit distribution (dividends and retained earnings policy).
Figure 2.4 below, adopted from financial management for small business (McMahon, 1995), illustrate a model of financial management, which covers most issues discussed earlier and shows relations between objectives and decisions of financial management.
This study examines financial management practices in relation with objectives, decisions and specific areas of financial management. Objectives, decisions and areas of financial management are relevant to financial management practices. The specific areas of financial management are viewed as a theoretical framework for financial management practices while objectives and decisions of financial management are viewed as factors influencing financial management practices. Figure 2.5 illustrates interaction between theoretical and practical aspects with influence of objectives and decisions of financial management.
Figure 2.5 presents the relationship between specific areas of financial management and financial management practices. However, the purpose of this study is not to cover all areas of financial management but only to examine the areas of financial management practices such financial reporting and analysis, working capital management practices, fixed asset management practices, capital structure management practices, financial planning and financial characteristics including liquidity, financial leverage, and activity.
2.3 Financial Management Practices
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.
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