SME Financial Management

Posted by: whonderjohn in General

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Financial Management in SME

 With high spate of financial problems contributing to the high rate of failures in small medium enterprises, what do the literature on small business say on financial management in small businesses to combat such failures?

Osteryoung et al (1997) writes that  "while financial management is a critical element of the management of a business as a whole, within this function the management of its assets is perhaps the most important. In the long term, the purchase of assets directs the course that the business will take during the life of these assets, but the business will never see the long term if it cannot plan an appropriate policy to effectively manage its working capital". In effect the poor financial management of owner-managers or lack of financial management altogether is the main cause underlying the problems in SME financial management.

Hall and Young(1991) in a study in the UK of 3 samples of 100 small enterprises that were subject to involuntary liquidation in 1973,1978,and 1983 found out that the reasons given for failure,49.8% were of financial nature. On the perceptions of official receivers interviewed for the same small enterprises, 86.6% of the 247 reasons given were of a financial nature. The positive correlation between poor or nil financial management (including basic accounting) and business failure has well been documented in western countries according to Peacock (1985a).

It is gainsaying the fact that despite the need to manage every aspect of their small enterprises with very little internal and external support, it is often the case that owner-managers only have experience or training in some functional areas. This is also not always or usually applied because they might be doing everything from abusing telephone calls to ordering products.

There is a school of thought that believes  "a well-run business enterprise should be as conscious of its finances as healthy a fit person is of his or her breathing".It must be possible to undertake production, marketing, distribution and the like, without repeatedly causing, or being hindered by, financial pressures and strains. It does not mean, however, that financial management can be ignored by a small enterprise owner-manager; or as is often done, given to an accountant to take care of. Whether it is obvious or not to the casual observer, in prosperous small enterprises the owner-managers themselves have a firm grasp of the principles of financial management and are actively involved in applying them to their own situation. McMahon et al. (1993).

Some researchers tried to predict small enterprise failure to mitigate the collapse of small businesses. McNamara et al (1988) developed a model to predict small enterprise failures giving the following four reasons:

·            To enable management to respond quickly to changing conditions

·            To train lenders in recognising the important factors involved in determining an enterprise's likelihood of failing

·            To assist lending organisations in their marketing by identifying their customer's financial needs more effectively

·            To act as a filter in the credit evaluation process.

They went on to argue that small enterprises are very different from large ones in the area of borrowing by small enterprises, lack of long-term debt finance and different taxation provisions.


1.1 Financial Management of SMEs

It is important to make this observation that firms have stated or unstated objectives. Corporate finance theory assumes that the objective of the firm is to maximise shareholder's wealth by either maintaining net income and reduce risk, increasing net income while keeping risk constant or increasing net income to such an extent that it more than offsets any inherent risks available. This is, however, usually not the case with the small medium enterprises. Apart from other objectives, the small enterprise has at least dual objectives (Osteryoung, et al 1997):

I.    to provide income to the owner-manager; and

ii.    to grow the business in terms of earnings through sales.

If this is the case then the owner-manager needs to not just work very hard literally but also to do anything possible to keep the business. This is what the study is about. To sustain the growth in a small business by applying an effective financial management strategy.

As a matter of fact, Osteryoung, et al (1997), on small business enterprise agrees to the fact that the day to day dealings of small business enterprises show differences in their objectives for running their businesses well away from the traditional shareholder profit maximisation concept. From just having a job, to reasons for enjoying a particular lifestyle associated with getting involved in a particular business. Regardless of the goals and objectives that a small business may have, it is significant that there is an identification and implementation of the firm's (each one under discussion) objectives in order to make financial management of the small business relevant. (Osteryoung et al., 1997).

1.2  Financial Management Practices

Financial management can be defined as the management of the finances of an organisation in order to achieve the financial objectives of the organisation. It broadly embraces two aspects, namely

·            Financial planning which is a plan to ensure that enough funding is available at the right time to meet the needs of the organisation for short, medium or long-term capital.  For example how much money is needed to smooth out changes in debtors, creditors and other cash requirements, should a new asset be bought or leased; and

·            Financial control -which seeks to assess whether the plan put forward meets the objectives of the organisation in question.  For example, are assets being used effectively? Are past performance changes affecting the organisation? A financial manager in a big and well-established organisation normally carries out these functions.  However, in SME's where this might also be needful, the owner-manager carries it out.

Notwithstanding that, Ghanaian SMEs do not usually have formal plans as the study will show in subsequent paragraph 5.1.

1.3  Financial Planning and Forecasting In SMEs.

The problems of SMEs attributed to growth enterprises makes financial planning very important for the small enterprise in its quest to attain full growth potential and sustain that growth.

Financial planning is the process of analysing, projecting, formulation, and monitoring of short-term and long-term choices in financial terms for the purposes of unraveling any inconsistencies in order to arrive at a financial plan for the organisation.

All managerial decisions are based on forecasts. Forecasting is defined as the prediction of what will occur in the future, but it is an uncertain process. Financial forecasting is, therefore, the estimate of a financial trend for an organisation. The goal as it were is to minimise the error between planned requirements and actual requirements. Meyer and De Wits (1998) writes ..."plans require forecasts".  A Danish physicist, Niels Bohr also once joked, ..."Prediction is very difficult, especially about the future.  Even enthusiastic planners acknowledge that forecasts will be inaccurate".  And Makrid-akis, the most prolific writer on the topic 'forecasting', writes (1960-66), ..."the future can be predicted only by extrapolating from the past, yet it is fairly certain that the future will be different from the past". Because of the uncertainty of forecasting, the accuracy of a forecast is as important as the outcome predicted by the forecast.

An effective financial planning could thus be considered as a workable plan that could be translated into a financial forecast. The following are the features of effective financial planning:

§           Relevant choices

The ability of the optimal financial plan for the firm to determine the quality of the planning process.

§           Forecasting

It is said that firms will not have accurate forecasts that is why there is the need for planning. Forecasters should recognize that other competitors are also developing their own plans. In simplifying the forecasts, there is the need to focus on the long-term economics of the business, not just the individual line items of the forecast.

A competitive advantage must ultimately be expressed in terms of one or more of these characteristics like achieving lower costs than competitors; using capital more productively than competitors; and providing superior value to the customer through a combination of price and product attributes that cannot be copied by competitors. Describing competitive advantage this way helps to begin to shape the financial forecast. (Copeland, et al, 2000)

§           Flexibility in the plan

The other attribute of an effective financial planning is the ability to adapt to changing situations that might affect the financial forecast. This could be done by setting a benchmark to monitor the events as they happen.

§           Financial planning models

Financial planning models are often used by financial planners to help them explore the consequences of alternative financial strategies. The models support the financial planning process by making it easier and cheaper to construct financial forecast statements. The use of the relevant model for a particular financial planning will be a plus for the financial planning process.

This is not asking too much from SMEs (in Ghana and elsewhere).To illustrate this it is just as an inventor makes a model of a small truck and translates that into a big truck. The difference between the model and the actual truck would not be too big. It is the translation of the underlying vision which is central in such situation.

Copeland et al (2000), writes that the first step in valuing a business is analysing its historical performance; thus a sound understanding of the company's past performance provides an essential perspective for developing and evaluating forecasts of future performance. Ratio analysis is calculated from a firm's income and expenditure accounts and the Balance Sheet. The best way to develop a financial plan is to turn to the performance analysis of the company. Copeland et al (2000) argues that analysing a company's historical performance in order to arrive at an effective financial forecasting, is to reorganise the accounting statements to estimate ROIC, (free cash flow, and economic profit ;) and afterwards analyse the ROIC and other measures to derive an integrated perspective on the company's performance. They suggested a useful way to organize an analysis of rate of return by developing a return-on-invested-capital (ROIC) tree which disaggregates the ROIC into its key components to provide more insights into the drivers of ROIC. 

This is intended to be used as a model to analyse HV's financial performance later in the study (see; Appendix  X )

John Whonderr-Arthur