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RR64 - The financial management of the small enterprise
ACCA Research Report No. 64
Small and micro firms are important for future economic development and for the continued evolution of a modern, knowledge-based economy. An important key to the successful development and survival of small and micro firms is the role of financial management, which has been recognised by the Bank of England in its annual reports on the Finance of Small Firms (Bank of England, 1997; 1998; 1999a; and 1999b). Our report, however, diverge from most previous studies in taking a dynamic, process-based view of financial management. It is important to understand how changes in financial management practices in small firms occur. We argue that it is only through the qualitative methods adopted in the report that such understanding is possible. Policy interventions and the role of professionals can then be better informed: an issue on which we comment. The dynamics of financial management processes and decision making are influenced by many factors, including both internal management issues and external environmental issues. This summary is based upon the findings from a case-based study on financial management practice by owner-managers in small firms; our main conclusions reflect the importance of process issues.
The study involved four main case studies with owner-managers in small firms. In addition, we have completed a programme of 30 face-to-face interviews with firms that were not investigated in full case study detail. In the case study firms, additional information was collected through financial accounts and several interviews in each business have been completed over the time period. The study was undertaken over a period of 12 months, although for the case study firms we have retrospective information that covers a longer time period. The research centre, Paisley Enterprise Research Centre (PERC), had maintained contact with three of the four case study firms over a number of years, enabling a rich source of data to be established. This methodology has allowed us to examine process and dynamic issues in financial management. It is arguable that previous research into financial management practices in small firms has been static and survey-based. In this report we provide evidence on change over time and process issues in financial management practices by owner-managers in small firms.
We suggest that the management decisions of the small firm owner-managers are based on a rationality that is grounded in the particular contextual environment in which they operate. Change makes an evolutionary modelling approach suitable for financial management in small firms. Entrepreneurial learning is an important part of this process, with experiential learning being critical, but there is also considerable scope for intervention to ensure that such learning is efficient. The importance of learning and innovation in small firms’ financial management leads us to suggest that the concept of the Balanced Scorecard approach is appropriate to understanding financial management practices in small firms. In our report we suggest that the adoption of this concept, in the context of small firms, would be beneficial.
We found that financial management practices of small firm owners described in previous literature have often been characterised as fire-fighting; dealing with problems as they arise on a day-to-day basis. Consideration of these owner-managers’ practices over a prolonged period, however, would reveal that behaviour occurs in a more evolutionary fashion, with the role of critical events in small firms being important for determining the learning of owner-managers. This gives rise to an evolutionary approach to decision making. Critical events could change behaviour leading to (less) gradual change in management practices. Again, the holistic approach suggested by the Balanced Scorecard method, we suggest, has benefits in terms of producing a closer model of what actually happens in small firms in practice. Financial management practices in small firms are far from static; the owner-manager learns to alter behaviour and change practice with experience. Our case study evidence shows that strategies alter and change with learning, innovation and experience; this supports a Balanced Scorecard approach.
We argue that evolutionary change and learning are interlinked and this in turn has an important effect on the dynamics of financial management. Our evidence suggests that the learning process in small firms is a crucial part of their evolution. The entrepreneur learns through experience. Rarely is this learning process planned, but is in fact the result of a series of reactions to events and opportunities in which the entrepreneur learns to process information, adjust strategy and take financial management decisions.
In terms of decisions concerning capital structure, our evidence suggests that process and behaviour of owner-managers in this area is more complex than theories such as the Pecking Order Hypothesis (POH) might suggest. The POH suggests that owner-managers in small firms have a preference for sources of capital that lead to a distinct and characteristic capital structure, with the major proportion as personal equity, followed by debt and then, lastly, venture finance. The argument is based on the premise that owner-managers will be reluctant to cede control. Some willingness to take venture capital (equity) was expressed by most of the owner-managers interviewed, but a more important constraint (than owner-managers’ attitude) was locating suitable equity investors. This finding adds to the complexity and variety of practice in financial management that exist in small firms.
Relationships established between owner-managers and external advisers, whether accountants, bank managers or other professionals were very important. Our evidence suggests that these relationships are crucial during the early stage of development of a business, especially in reducing the isolation and self-dependency of the owner-manager, which is particularly high during the early years of trading. The embeddedness of the owner-manager in networks involving advisers, we conclude, is an important factor that influences financial management practices. Policy makers have a role in facilitating such networks. The role of accountants could be particularly important in these networks and in ensuring that the transfer of knowledge and learning takes place.
The issue of late payment was highly variable in importance both between small firms and in the same same firm at different times. In terms of process, however, it was clear that owner-managers adjust behaviour through their experience in dealing with customers and in dealing with late payers. The related issues of invoice discounting and factoring also vary considerably from one small firm to another. The evidence from interviews regarding the importance of factoring was variable, although there was some evidence to support the increasing importance of factoring to some small firms. We suggest that for many small firms, however, factoring will only have a minor importance. Thus, like late payment this is an issue that varies, reflecting the diversity of small firms and the different practices in financial management.
Other issues considered included leasing, hire-purchase and business planning. Leasing was only used by a small minority of our respondents. In terms of business planning, again, evidence of practices was mixed. Issues discussed above in terms of evolutionary learning were also important for planning procedures. Some owner-managers could be considered to have sophisticated approaches, whereas others had a more ad hoc approach. Planning was used and was important in those firms undergoing growth and periods of rapid change.
In terms of policy, our study suggests that short-term episodic solutions are inappropriate. It is important to build long-term relationships so that advice can match evolutionary change and behaviour of small firms in the UK. Despite the inconsistency of approach to the small firms sector, the current review of business support in England, Scotland and Wales gives an opportunity to review the role of advisers and professionals such as accountants. An opportunity exists to recognise the role of accountants, who can help to support bodies that enhance evolutionary change in small firms. Indeed, the accountant performs two basic functions: that of an agent in the preparation and audit of external reports; and that of a business consultant advising on the internal management planning, decision making and control reports that will assist the owner-manager in the management of the small firm. The accountant hired to perform one of these functions will not necessarily be able, or be needed, to perform the other. Unless the owner-manager understands the difference between the two basic functions he or she may not even be able to identify the necessity for both.
Deakins, Logan and Steele, 2001
Executive summary
Small and micro firms are important for future economic development and for the continued evolution of a modern, knowledge-based economy. An important key to the successful development and survival of small and micro firms is the role of financial management, which has been recognised by the Bank of England in its annual reports on the Finance of Small Firms (Bank of England, 1997; 1998; 1999a; and 1999b). Our report, however, diverge from most previous studies in taking a dynamic, process-based view of financial management. It is important to understand how changes in financial management practices in small firms occur. We argue that it is only through the qualitative methods adopted in the report that such understanding is possible. Policy interventions and the role of professionals can then be better informed: an issue on which we comment. The dynamics of financial management processes and decision making are influenced by many factors, including both internal management issues and external environmental issues. This summary is based upon the findings from a case-based study on financial management practice by owner-managers in small firms; our main conclusions reflect the importance of process issues.
The study involved four main case studies with owner-managers in small firms. In addition, we have completed a programme of 30 face-to-face interviews with firms that were not investigated in full case study detail. In the case study firms, additional information was collected through financial accounts and several interviews in each business have been completed over the time period. The study was undertaken over a period of 12 months, although for the case study firms we have retrospective information that covers a longer time period. The research centre, Paisley Enterprise Research Centre (PERC), had maintained contact with three of the four case study firms over a number of years, enabling a rich source of data to be established. This methodology has allowed us to examine process and dynamic issues in financial management. It is arguable that previous research into financial management practices in small firms has been static and survey-based. In this report we provide evidence on change over time and process issues in financial management practices by owner-managers in small firms.
We suggest that the management decisions of the small firm owner-managers are based on a rationality that is grounded in the particular contextual environment in which they operate. Change makes an evolutionary modelling approach suitable for financial management in small firms. Entrepreneurial learning is an important part of this process, with experiential learning being critical, but there is also considerable scope for intervention to ensure that such learning is efficient. The importance of learning and innovation in small firms’ financial management leads us to suggest that the concept of the Balanced Scorecard approach is appropriate to understanding financial management practices in small firms. In our report we suggest that the adoption of this concept, in the context of small firms, would be beneficial.
We found that financial management practices of small firm owners described in previous literature have often been characterised as fire-fighting; dealing with problems as they arise on a day-to-day basis. Consideration of these owner-managers’ practices over a prolonged period, however, would reveal that behaviour occurs in a more evolutionary fashion, with the role of critical events in small firms being important for determining the learning of owner-managers. This gives rise to an evolutionary approach to decision making. Critical events could change behaviour leading to (less) gradual change in management practices. Again, the holistic approach suggested by the Balanced Scorecard method, we suggest, has benefits in terms of producing a closer model of what actually happens in small firms in practice. Financial management practices in small firms are far from static; the owner-manager learns to alter behaviour and change practice with experience. Our case study evidence shows that strategies alter and change with learning, innovation and experience; this supports a Balanced Scorecard approach.
We argue that evolutionary change and learning are interlinked and this in turn has an important effect on the dynamics of financial management. Our evidence suggests that the learning process in small firms is a crucial part of their evolution. The entrepreneur learns through experience. Rarely is this learning process planned, but is in fact the result of a series of reactions to events and opportunities in which the entrepreneur learns to process information, adjust strategy and take financial management decisions.
In terms of decisions concerning capital structure, our evidence suggests that process and behaviour of owner-managers in this area is more complex than theories such as the Pecking Order Hypothesis (POH) might suggest. The POH suggests that owner-managers in small firms have a preference for sources of capital that lead to a distinct and characteristic capital structure, with the major proportion as personal equity, followed by debt and then, lastly, venture finance. The argument is based on the premise that owner-managers will be reluctant to cede control. Some willingness to take venture capital (equity) was expressed by most of the owner-managers interviewed, but a more important constraint (than owner-managers’ attitude) was locating suitable equity investors. This finding adds to the complexity and variety of practice in financial management that exist in small firms.
Relationships established between owner-managers and external advisers, whether accountants, bank managers or other professionals were very important. Our evidence suggests that these relationships are crucial during the early stage of development of a business, especially in reducing the isolation and self-dependency of the owner-manager, which is particularly high during the early years of trading. The embeddedness of the owner-manager in networks involving advisers, we conclude, is an important factor that influences financial management practices. Policy makers have a role in facilitating such networks. The role of accountants could be particularly important in these networks and in ensuring that the transfer of knowledge and learning takes place.
The issue of late payment was highly variable in importance both between small firms and in the same same firm at different times. In terms of process, however, it was clear that owner-managers adjust behaviour through their experience in dealing with customers and in dealing with late payers. The related issues of invoice discounting and factoring also vary considerably from one small firm to another. The evidence from interviews regarding the importance of factoring was variable, although there was some evidence to support the increasing importance of factoring to some small firms. We suggest that for many small firms, however, factoring will only have a minor importance. Thus, like late payment this is an issue that varies, reflecting the diversity of small firms and the different practices in financial management.
Other issues considered included leasing, hire-purchase and business planning. Leasing was only used by a small minority of our respondents. In terms of business planning, again, evidence of practices was mixed. Issues discussed above in terms of evolutionary learning were also important for planning procedures. Some owner-managers could be considered to have sophisticated approaches, whereas others had a more ad hoc approach. Planning was used and was important in those firms undergoing growth and periods of rapid change.
In terms of policy, our study suggests that short-term episodic solutions are inappropriate. It is important to build long-term relationships so that advice can match evolutionary change and behaviour of small firms in the UK. Despite the inconsistency of approach to the small firms sector, the current review of business support in England, Scotland and Wales gives an opportunity to review the role of advisers and professionals such as accountants. An opportunity exists to recognise the role of accountants, who can help to support bodies that enhance evolutionary change in small firms. Indeed, the accountant performs two basic functions: that of an agent in the preparation and audit of external reports; and that of a business consultant advising on the internal management planning, decision making and control reports that will assist the owner-manager in the management of the small firm. The accountant hired to perform one of these functions will not necessarily be able, or be needed, to perform the other. Unless the owner-manager understands the difference between the two basic functions he or she may not even be able to identify the necessity for both.