The importance of financial management to SMEs

Good financial management is critical to the success of any business, but it is particularly important in small to medium enterprises (SMEs) where the risk of insolvency is often little more than an unpaid invoice away. A key concern for small business owner-managers is cash flow management, or more specifically the cash conversion cycle. This is the firm’s ability to generate cash from its customers’ invoices, and the time it takes to collect these accounts receivable.

Closely related to the cash conversion cycle is the working capital cycle, which is the movement of cash and other liquid assets through the business as a process of regular trading. How efficiently a business manages its working capital, and speed of its cash conversion cycle will impact on firm’s overall profitability.

These issues were highlighted in a review of recent literature into the financial management of SMEs that I published in the journal Small Enterprise Research in August 2014. A total of 18 papers published in the previous 12 months were reviewed. Drawn from a wide cross-section of journals and countries of origin they reveal an interesting set of findings. These are summarised below.

The relationship between working capital management and profitability

In relation to the linkage between working capital management and profitability within the firm, the review found several things that are worth summarising.

The research shows that there is a significant relationship between the firm’s profitability and its cash conversion cycle, although this is influenced by firm size, age and the industry within which it operates. Small business owner-managers can enhance their firm’s profitability through the improvement of how efficiently they manage their working capital, as this frees up the amount of liquidity in the business.

The faster a business can turn around its cash conversion cycle the more efficient it will manage its working capital. This can be driven by more effective management of inventory and attention to the turnover of stock within the business. Inventory management is likely to be more important in periods of economic downturn than during boom times, due to the fluctuations that occur in customer demand.

In addition to the efficient management of inventory and working capital, SMEs can also boost their profitability through the effective management of accounts payable and receivable. Good management of the accounts receivable helps the business bring in its customer payments faster thereby speeding up the cash conversion cycle. However, prompt payment of accounts payable also avoids late payment costs, interest charges or the loss of supplier discounts. In fact the efficient management of accounts payable and receivable might be more important than inventory management.

Working capital management by SME owner-managers is not good

An overall message from the research is that SME owner-managers can enhance their firm’s profitability through more efficient management of accounts receivable and payable, plus the monitoring of inventory. However, the review also found that many owner-managers are poor at managing these things. This was particularly the case for SMEs in developing economies.

For example, in the Czech Republic SME owner-managers were found to devote a lot of attention to monitoring accounts receivable, but were less effective at speeding up their cash conversion cycle through incentives or penalties. By comparison owner-managers in Uganda were found to use only informal methods of financial record keeping and relied largely upon their memories when tracking accounts receivable and inventory. There was also little formal cash flow forecasting and poor credit management.

A similar pattern was found in Ghana where the majority of owner-managers surveyed did not keep formal financial records. This was due in part because there was no requirement for them to do so, but also as a consequence of them fearing that to do so would disclose how much money they were making and the risk that this would incur tax penalties.

Financial management education and support of owner-managers is important

Education is the key to enhancing SME owner-manager financial management skills and performance. In South Africa owner-managers who had more knowledge of cash flow management and formal record keeping and their importance, were more likely to keep good financial records. This was also found in Greece where owner-managers with higher levels of education were more likely to have superior financial knowledge and to manage their finances better. Within the United States owner-managers who had a good understanding of financial statements were more likely to regularly use them to make decisions.

Coupled with management education the review of these research papers also highlighted the importance of outsider support to SME owner-managers. While most small firms rely on Accountants for their financial advice, many turn to family, friends, banks and local business associations, as well as the internet. As firms grow larger the need for outsider support increases, but the type of counselling rather than the amount of counselling that is important.

Not surprisingly the research found that younger firms require a much closer attention to cash flow and working capital than their older counterparts, particularly if they are experiencing growth. Growth in SMEs is associated with investment in R&D, employee productivity, debt leverage and the effective management of cash flow.

Get organised and get help

The overall message from this research is that owner-managers of SMEs, particularly firms engaged in growth, need to learn how to maintain financial records and use financial reports to make business decisions. Properly structured accounts that can generate timely reports on cash flow, liquidity and other key performance indicators (KPI) remain essential to the firm’s survival and success.

Firms in their early years from start-up will often experience a lack of working capital particularly if growth is strong. The efficient management of cash flow and working capital are therefore critical to survival. They also help to boost profitability and this can in turn facilitate growth. Owner-managers who are experiencing growth or financial stress need to seek outsider assistance. However, they also need to invest in learning more about financial management and systems they require to effectively operate their business.

Further reading