THE INFLUENCE OF FINANCIAL MANAGEMENT ON THE GROWTH OF SMALL AND MEDIUM SCALE INDUSTRIES
CHAPTER TWO
LITERATURE REVIEW
Theoretical Framework
The study is based on the Pecking Order Theory. Pecking order theory of capital structure states that firms have a preferred hierarchy for financing decisions. The highest preference is to use internal financing (retained earnings and the effects of depreciation) before resorting to any form of external funds. Internal funds incur no flotation costs and require no additional disclosure of proprietary financial information that could lead to more severe market discipline and a possible loss of competitive advantage. If a firm must use external funds, the preference is to use the following order of financing sources: debt, convertible securities, preferred stock, and common stock. (Myers, 1984) This order reflects the motivations of the financial manager to retain control of the firm (since only common stock has a “voice” in management), reduce the agency costs of equity, and avoid the seemingly inevitable negative market reaction to an announcement of a new equity issue. (Hawawini and Viallet, 1999).
Implicit in pecking order theory are two key assumptions about financial managers. The first of these is asymmetric information, or the likelihood that a firm‟s managers know more about the company‟s current earnings and future growth opportunities than do outside investors. There is a strong desire to keep such information proprietary. The use of internal funds precludes managers from having to make public disclosures about the company‟s investment opportunities and potential profits to be realized from investing in them. The second assumption is that managers will act in the best interests of the company‟s existing shareholders. The managers may even forgo a positive-NPV project if it would require the issue of new equity, since this would give much of the project‟s value to new shareholders at the expense of the old (Myers and Majluf, 1984).
Pecking order theory is important for explaining capital structure changes. By including a discussion of pecking order theory in the capital structure unit financial managers are exposed to a broad base of both theory and practice that will enable them to better understand how important financing decisions are made. In addition to the traditional discussion of the impact of taxes, financial distress, and agency costs upon capital structure decisions, Pecking order theory help financial managers to gain insight to how management motivations and market perceptions also impact these decisions. Furthermore, the addition of pecking order theory into the basic discussion of capital structure provides one more opportunity for critical thinking to occur. For example, a financial manager can show how the debt ratios of leading companies in particular industries differ from the industry averages to which most companies are usually compared during a cross-sectional financial analysis.
Conceptual Framework
Mugenda (2008) defines conceptual framework as a concise description of the phenomenon under study accompanied by a graphical or visual depiction of the major variables of the study. According to Young (2009) conceptual framework is a diagrammatical representation that shows the relationship between dependent variable and independent variables. In the study, the conceptual framework will look at the relationship between financial management practices employed by the SME‟s and their effect on growth. The dependent variable is growth of SMEs while independent variables are working capital management practices, investment practices, financial planning practices, accounting information systems and financial reporting and analysis.
Working Capital Management
Previous researchers emphasized specific aspects of working capital management. Burns and Walker (2001) 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 without clearly handling other aspects of business efficiency.
Wanjohi (2009) conducted a study to elucidate the working capital practices of SMEs in Kenya using a sample of 113 SMEs. They concluded that working capital practices are low amongst SMEs as majority had not adopted formal working capital routines. Agyei-Mensah (2010) also conducted a research into the working capital practices of SMEs in the Ashanti region of Ghana. Using a sample of 800 randomly selected firms the study revealed weak working skils within the sector. Despite the importance of working capital management to SMEs, a research by Burns and Walker (1991) and Peel and Wilson (1994) show that only 24 per cent and 20 per cent respectively of the financial manager‟s time is spent on working capital. Harif et al. (2010) did a research on the financial management practices of SMEs in Malaysia, with the results indicating that lack of working capital which accounted for 93.6 per cent is the most common weakness in the area of financial management.
Cash management practices among SMEs were found to be inadequate in the study done by Grablowsky (2008). Grablowsky and Lowell (2008) 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 percent 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 percent of enterprises reported using any type of quantitative technique. Additionally, seventy-one percent of business in the Virginia survey reported that they had no short-term surpluses of cash in their recent history. Only 23 percent had a long-term surplus. Nearly 30 percent 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.
In the study conducted by Cooley and Pullen (1979), cash management was seen as the process of planning and controlling cash flows. It consisted of three basic components: cash forecasting practices, cash surplus investment practices and cash control practices. Cooley and Pullen (1979) examined cash management practices of 122 small businesses engaged in petroleum marketing and reported that 73 percent of respondents had experienced a cash surplus. In a divergent view to Grablowsky and Rowell‟s (1978) and Cooley and Pullen‟s (1979) survey, Murphy‟s (1979) study indicated that active cash management in small enterprises in the UK was unusual, and that there was little inclination to invest surplus cash on a short-term basis.
Regarding accounts receivable management practices, Grablowsky (1976) and Rablowsky and Lowell (1980) found generally low standards. Approximately 95 percent of businesses that sold on credit tended to sell to anyone who wished to buy. Only 30 percent of respondents subscribed to a regular credit reporting service. Most had no credit checking procedures and guidelines, and only 52 percent enforced a late-payment charge. Thirty-four percent of businesses had no formal procedure for aging accounts receivable. Bad debts averaged 1.75 percent of sales, with a high of 10 percent 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.
The previous studies done on inventory management practices, D‟Amboise and Gasse (1980) studied the utilization of management techniques in small shoe and plastic manufacturing industries in Canada and found 64 percent of shoe and 65.4 percent of plastic businesses employed formal inventory control systems. While Grablowsky and Rowell (1980) found that most of the respondents had in excess of 30 percent of their capital invested in inventory, the general standard of inventory management was poor. Only six percent of businesses in their survey used a quantitative technique such as economic order quantity for optimizing inventory and 54 percent had systems which were unable to provide information on inventory turnover, reorder points, ordering costs or carrying costs. Related to the methods used to determine inventory level, Grablowsky (1984) compared methods used by a sample of 94 small enterprises with those used by large enterprises and found that large enterprises used methods to determine inventory levels far more than small enterprises.
Investment
Brigham (1995) suggested that capital budgeting might be more important to a smaller firm than its larger counterparts because of the lack of access to the public markets for funding. Capital budgeting has attracted researchers over the past several decades. McMahon et al. (1993) claimed the earliest study of capital budgeting of SMEs was reported by Soldofsky (1964). During 1961, Soldofsky interviewed 126 owners of small manufacturing businesses in Iowa and the results were published in 1964. Regarding capital project selection techniques, there were several surveys conducted by previous researchers such as Soldofsky (1964), Luoma (1967), Taylor Nelson Investment Services (1970), Hankinson (1979), Grablowsky and Burns (1980), Proctor and Canada (1992), and Block (1997). Soldofsky‟s (1964) study results shows 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. Payback period was used to evaluate capital projects by 51 percent of respondents, while 30 percent reported use of some variation of accounting rate of return. Only 10 percent reported use of discount cash flow methods such as net present value (5 percent) and internal rate of return (2 percent). This finding is consistent with the Soldofsky (1964), Louma (1967), Corner (1967), and Grablowsky and Burns (1980) findings of a tendency in using simple and complicated methods of capital investment project evaluation.
Financing
Small companies frequently suffer from a particular financial problem of 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), modern capital structure theory began in 1958, when Modigliani and Miller‟s (1958) seminal article on capital structure was published. Since that point of time, researchers have attempted to explain how firms choose their capital structure. Myers (1984) stated: How do firms choose their capital structure? The answer is we don‟t know… we do not know how firms choose the debt, equity, or hybrid securities they issue. This study was based on capital structure theory and Myers‟ Pecking Order Theory (1984). According to Myers (2004), the Pecking Order Theory (POT) suggests that there is no well-defined optimal capital structure; instead the debt ratio is the result of hierarchical financing over time. The foundation of POT is that firms have no defined debt-to-value ratio. Management has a preference to choose internal financing before external financing.
When a firm is forced to use external financing sources, managers select the least risky and demanding source first. When it is necessary to issue external sources, debt issuance is preferred to new equity. In an attempt to explain small firm financing behavior, other scholars have 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, 2004). 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 firm‟s financing decision, then, appears to be a product of many internal and external factors, as well as managerial values and goals.
Thevaruban (2009) examined small scale industries and its financial problems in Sri Lanka. He underscored that SMEs of small scale industries in Sri Lanka finds it extremely difficult to get outside credit because the cash inflow and savings of the SMEs in the small scale sector is significantly low (Ganesan, 1982; 2000). Hence, bank and non bank financial institutions do not emphasise much on credit lending for the development of the SMEs in the small scale sector in Sri Lanka. Pettit and Singer (1985) study underscored that financing is the most difficult problems of the SMEs in USA. External finance is more expensive than internal finance (Watson et al., 1998; Datta, 2010). Due to lack of access to external finance (private placements and initial public offerings of varying sizes), SMEs rely on bank loans as compared to their larger counterparts (Bracker et al., 2006).
Ssendaula (2002) lists factors that have discouraged banks from lending to SMEs. Among them are poorly compiled records and accounts; low levels of technical and management skills; outdated technologies; lack of professionalism and networking; lack of collateral; lack of market outlets due to poor quality and non - standardized products; poor linkages and limited knowledge of business opportunities. In addition, most businesses, such as those dealing in foodstuffs, have been affected by lack of proper storage facilities. This has been a major limitation on business success because most agricultural products require preservation and have an inelastic demand meaning that even if their prices are lowered, quantity demanded can increase in that same proportion to clear the market of surpluses.
Accounting Information Systems
D‟Amboise and Gasse (1980) studied the utilization of formal management techniques in 25 small shoe manufacturers and 26 small plastic manufacturers in Quebec, Canada and found that 88 percent of the businesses used a cost accounting system. Regarding accounting standards, DeThomas and Fredenberger (1985), in a survey of over 360 small enterprises in Georgia, found that the standard of financial record keeping was very high. In addition to cheque and deposit receipts, around 92 percent of respondents had some form of record keeping. Regarding the use of financial information, DeThomas and Fredenberger‟s (1985) study indicated that 96 percent of the respondents had financial statements prepared, the responsibility for evaluating and using the information was within the business itself and only four percent relied on an outside accountant services.
In the survey of 69 small enterprises across the USA, Farhoodman and Hryck (1985) reported on the most important applications of computers, and it was found out that accounting was rated as the highest percentage. Similarly, Palmer (1994) interviewed 36 small independent retail owner-managers and found that 33 percent of the sample businesses used computerized accounting systems. Reviewing previous research results shows accounting and financial management applications dominated the use of computers in small and medium enterprises in the North America in 1980‟s and 1990‟s.
Williams (1986) evaluated the adequacy of accounting records for 10,570 failed and surviving small enterprises operating throughout Australia. The findings are compatible with Peacock‟s (1986, 1987 and 1988) findings in that a significant proportion of owner-managers kept inadequate accounting records. Holmes (1987) conducted a survey of accounting information requirements of 928 small enterprises operating in Sydney, Melbourne and Brisbane. Fifty-seven percent of respondents indicated they used the journal/ledger (double entry) systems. This finding is rather in contrast to Peacock‟s (1987) findings of types of records maintained by failed enterprises, where only 2.1 percent of respondents were found to use double entry systems.
Financial reporting and analysis
Bookkeeping alone without preparing reports is likely not to be fundamental in aiding decision making unless proper reports are prepared and analyzed to attach a meaning so as to help decision makers. D‟Amboise and Gasse (1980) studied the use of financial statement analysis by small manufacturers in Quebec, Canada and found that small manufacturers in shoe and plastic industries formally undertook the analyses based on financial statements and the findings revealed that manufacturing firms managerial decisions were largely based on the financial reports prepared.
The research conducted by 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. The study further 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. The study used regression analysis to examine the relationship between financial ratio usage and SMEs 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 total to sales was found.