Modern Financial Management Theories & Small Businesses

The following are some examples of modern financial				money is like losing one's own reputation which is
management theories formulated on principles				considered very serious customarily in Ghana.
considered as 'a set of fundamental tenets that form				Access to capital
the basis for financial theory and decision-making in				The 1971 Bolton report on small firms outlined issues
finance' (Emery et al.1991). An attempt would be				underlying the concept of 'finance gap' (this has two
made to relate the principles behind these concepts				components-knowledge gap-debt is restricted due to
to small businesses' financial management.				lack of awareness of appropriate sources,
Agency Theory				advantages and disadvantages of finance; and supply
Agency theory deals with the people who own a				gap-unavailability of funds or cost of debt to small
business enterprise and all others who have interests				enterprises exceeds the cost of debt for larger
in it, for example managers, banks, creditors, family				enterprises.) that: there are a set of difficulties which
members, and employees. The agency theory				face a small company. Small companies are hit harder
postulates that the day to day running of a business				by taxation, face higher investigation costs for loans,
enterprise is carried out by managers as agents who				are generally less well informed of sources of finance
have been engaged by the owners of the business				and are less able to satisfy loan requirements. Small
as principals who are also known as shareholders. The				firms have limited access to the capital and money
theory is on the notion of the principle of 'two-sided				markets and therefore suffer from chronic
transactions' which holds that any financial				undercapitalization. As a result; they are likely to have
transactions involve two parties, both acting in their				excessive recourse to expensive funds which act as
own best interests, but with different expectations.				a brake on their economic development.
Problems usually identified with agency theory may				Leverage
include:i. Information asymmetry- a situation in which				This is the term used to describe the converse of
agents have information on the financial				gearing which is the proportion of total assets
circumstances and prospects of the enterprise that is				financed by equity and may be called equity to
not known to principals (Emery et al.1991). For				assets ratio. The studies under review in this section
example 'The Business Roundtable' emphasised that in				on leverage are focused on total debt as a
planning communications with shareholders and				percentage of equity or total assets. There are
investors, companies should consider never misleading				however, some studies on the relative proportions of
or misinforming stockholders about the corporation's				different types of debt held by small and large
operations or financial condition. In spite of this				enterprises.
principle, there was lack of transparency from Enron's				Equity Funds
management leading to its collapse;ii. Moral hazard-a				Equity is also known as owners' equity, capital, or net
situation in which agents deliberately take advantage				worth.
of information asymmetry to redistribute wealth to				Costand et al (1990) suggests that 'larger firms will
themselves in an unseen manner which is ultimately				use greater levels of debt financing than small firms.
to the detriment of principals. A case in point is the				This implies that larger firms will rely relatively less on
failure of the Board of directors of Enron's				equity financing than do smaller firms.' According to
compensation committee to ask any question about				the pecking order framework, the small enterprises
the award of salaries, perks, annuities, life insurance				have two problems when it comes to equity funding
and rewards to the executive members at a critical				[McMahon et al. (1993, pp153)]:
point in the life of Enron; with one executive on				1) Small enterprises usually do not have the option of
record to have received a share of ownership of a				issuing additional equity to the public.
corporate jet as a reward and also a loan of $77m				2) Owner-managers are strongly averse to any
to the CEO even though the Sarbanes-Oxley Act in				dilution of their ownership interest and control. This
the US bans loans by companies to their executives;				way they are unlike the managers of large concerns
andiii. Adverse selection-this concerns a situation in				who usually have only a limited degree of control and
which agents misrepresent the skills or abilities they				limited, if any, ownership interest, and are therefore
bring to an enterprise. As a result of that the				prepared to recognise a broader range of funding
principal's wealth is not maximised (Emery et al.1991).				options.
In response to the inherent risk posed by agents'				Financial Management in SME
quest to make the most of their interests to the				With high spate of financial problems contributing to
disadvantage of principals (i.e. all stakeholders), each				the high rate of failures in small medium enterprises,
stakeholder tries to increase the reward expected in				what do the literature on small business say on
return for participation in the enterprise. Creditors				financial management in small businesses to combat
may increase the interest rates they get from the				such failures?
enterprise. Other responses are monitoring and				Osteryoung et al (1997) writes that "while financial
bonding to improve principal's access to reliable				management is a critical element of the management
information and devising means to find a common				of a business as a whole, within this function the
ground for agents and principals respectively.				management of its assets is perhaps the most
Emanating from the risks faced in agency theory,				important. In the long term, the purchase of assets
researchers on small business financial management				directs the course that the business will take during
contend that in many small enterprises the agency				the life of these assets, but the business will never
relationship between owners and managers may be				see the long term if it cannot plan an appropriate
absent because the owners are also managers; and				policy to effectively manage its working capital." In
that the predominantly nature of SMEs make the				effect the poor financial management of
usual solutions to agency problems such as monitoring				owner-managers or lack of financial management
and bonding costly thereby increasing the cost of				altogether is the main cause underlying the problems
transactions between various stakeholders (Emery et				in SME financial management.
al.1991).				Hall and Young(1991) in a study in the UK of 3
Nevertheless, the theory provides useful knowledge				samples of 100 small enterprises that were subject
into many matters in SMEs financial management and				to involuntary liquidation in 1973,1978,and 1983 found
shows considerable avenues as to how SMEs financial				out that the reasons given for failure,49.8% were of
management should be practiced and perceived. It				financial nature. On the perceptions of official
also enables academic and practitioners to pursue				receivers interviewed for the same small enterprises,
strategies that could help sustain the growth of				86.6% of the 247 reasons given were of a financial
SMEs.				nature. The positive correlation between poor or nil
Signaling Theory				financial management (including basic accounting) and
Signaling theory rests on the transfer and				business failure has well been documented in western
interpretation of information at hand about a business				countries according to Peacock (1985a).
enterprise to the capital market, and the impounding				It is gainsaying the fact that despite the need to
of the resulting perceptions into the terms on which				manage every aspect of their small enterprises with
finance is made available to the enterprise. In other				very little internal and external support, it is often the
words, flows of funds between an enterprise and				case that owner-managers only have experience or
the capital market are dependent on the flow of				training in some functional areas.
information between them. (Emery et al, 1991). For				There is a school of thought that believes "a well-run
example management's decision to make an				business enterprise should be as unconscious of its
acquisition or divest; repurchase outstanding shares;				finances as healthy a fit person is of his or her
as well as decisions by outsiders like for example an				breathing". It must be possible to undertake
institutional investor deciding to withhold a certain				production, marketing, distribution and the like,
amount of equity or debt finance. The emerging				without repeatedly causing, or being hindered by,
evidence on the relevance of signaling theory to small				financial pressures and strains. It does not mean,
enterprise financial management is mixed. Until				however, that financial management can be ignored
recently, there has been no substantial and reliable				by a small enterprise owner-manager; or as is often
empirical evidence that signaling theory accurately				done, given to an accountant to take care of.
represents particular situations in SME financial				Whether it is obvious or not to the casual observer,
management, or that it adds insights that are not				in prosperous small enterprises the owner-managers
provided by modern theory (Emery et al.1991).				themselves have a firm grasp of the principles of
Keasey et al(1992) writes that of the ability of small				financial management and are actively involved in
enterprises to signal their value to potential investors,				applying them to their own situation." McMahon et al.
only the signal of the disclosure of an earnings				(1993).
forecast were found to be positively and significantly				Some researchers tried to predict small enterprise
related to enterprise value amongst the following:				failure to mitigate the collapse of small businesses.
percentage of equity retained by owners, the net				McNamara et al (1988) developed a model to predict
proceeds raised by an equity issue, the choice of				small enterprise failures giving the following four
financial advisor to an issue (presuming that a more				reasons:
reputable accountant, banker or auditor may cause				- To enable management to respond quickly to
greater faith to be placed in the prospectus for the				changing conditions
float), and the level of under pricing of an issue.				- To train lenders in recognising the important factors
Signaling theory is now considered to be more				involved in determining an enterprise's likelihood of
insightful for some aspects of small enterprise				failing
financial management than others (Emery et al 1991).				- To assist lending organisations in their marketing by
The Pecking-Order Theory or Framework (POF)				identifying their customer's financial needs more
This is another financial theory, which is to be				effectively
considered in relation to SMEs financial management.				- To act as a filter in the credit evaluation process.
It is a finance theory which suggests that				They went on to argue that small enterprises are
management prefers to finance first from retained				very different from large ones in the area of
earnings, then with debt, followed by hybrid forms of				borrowing by small enterprises, lack of long-term
finance such as convertible loans, and last of all by				debt finance and different taxation provisions.
using externally issued equity; with bankruptcy costs,				For small private companies, these measures are
agency costs, and information asymmetries playing				unreliable and textbook methods for judging
little role in affecting the capital structure policy. A				investment opportunities are not always useful in
research study carried out by Norton (1991b) found				organisations that are privately owned to give a true
out that 75% of the small enterprises used seemed				and fair view of events taking place in the company.
to make financial structure decisions within a				Thus,modern financial management is not the ultimate
hierarchical or pecking order framework .Holmes et al.				answer to every business problem including both
(1991) admitted that POF is consistent with small				large and small businesses.However,it could be argued
business sectors because they are owner-managed				that there is some food for thought for SMEs
and do not want to dilute their ownership.				concerning every concept considered in this study.
Owner-managed businesses usually prefer retained				For example it could be seen (from the literature
profits because they want to maintain the control of				reviewed )that, financial records are meant to
assets and business operations.				examine and analyse corporate operations. Return on
This is not strange considering the fact that in Ghana,				equity, return on assets, return on investment, and
according to empirical evidence, SMEs funding is made				debt to equity ratios are useful yardsticks for
up of about 86% of own equity as well as loans				measuring the performance of big business and SMEs
from family and friends(See Table 1). Losing this				as well.

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Modern Financial Management Theories & Small Businesses