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by Peter Atrill 27 Jul 2001 Diploma in Financial Management Relevant to Paper D3

Introduction
Small businesses are an essential element of a healthy and vibrant economy. They are seen as vital to the promotion of an enterprise culture and to the creation of jobs within the economy. However, the failure rate among small businesses is very high compared to that of large businesses. Studies in the UK and the US have shown that weak financial management - particularly poor working capital management and inadequate long-term financing - is a primary cause of failure among small businesses. In this article we will consider these financial management issues relating to small businesses.

The management of working capital
The management of working capital is important to the financial health of businesses of all sizes. The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way. However, there is evidence that small businesses are not very good at managing their working capital. Given that many small businesses suffer from undercapitalisation, the importance of exerting tight control over working capital investment is difficult to overstate.

Credit customers
Credit management is a particular problem among small businesses. Although approximately one third of total assets employed within small businesses consist of trade debtors, there is often a lack of expertise and insufficient resources allocated within the business to manage the trade debts. There is often no dedicated credit control department within the business and so there may be no proper scrutiny of credit applications or efficient monitoring and collecting of debts. The results are borne out in a survey of small businesses by Manchester Business School (MBS) which indicated that 25 per cent of those businesses replying face either serious or very serious late payment problems.1 The slow payments or defaults arising can have very damaging effects on the cash flows of the business.

The problem of late payment may be exacerbated by the enthusiasm of the owners to increase sales in order to encourage business growth. This can result in providing credit to high-risk customers and undue reliance on a small number of customers. In addition, where a small business is selling to a large business, the difference in market power can make it difficult to impose strict credit terms. The government is aware of this latter problem and has introduced legislation to allow small firms to charge interest on overdue accounts. However, the evidence suggests that few firms take advantage of the legislation - probably because such action could threaten future sales. What is really needed is a change in the payment culture among large businesses. To help bring about this change the government has introduced a code of practice concerning the payment of trade debts that is aimed at large businesses and public sector organisations.

One way of dealing with the credit management problem is to factor the outstanding debts. Under this kind of arrangement, the factor will take over the sales ledger of the business and will take responsibility for the prompt collection of debts. However, some businesses are too small to take advantage of this facility. The set-up costs of a factoring arrangement will make businesses with a small turnover (say £100,000 per annum or less) an uneconomic proposition for the factor.

Credit suppliers
In practice, small businesses often try to cope with the late payment of credit customers by delaying payments to their credit suppliers. However, such a tactic can be very expensive. To illustrate this point, let us assume that a supplier offers a 2 per cent discount if the amount due is paid within 30 days and the business decides to delay payment until 50 days after the invoice date. The cost of this extra 20 (i.e. 50 - 30) days credit will be the 2 per cent discount foregone. If we annualise this cost, we have 365/20 x 2% = 36.5% (approximate). This annual cost compares unfavourably with most other forms of short-term financing. However, the MBS survey indicates that the vast majority of small businesses are unaware of the very high cost of delaying payment.1

Stock management
The management of stocks suffers from the lack of financial management skills within small businesses. The owners of small businesses are not always aware that there are costs involved in holding too much stock (e.g. additional, storage and handling costs, risks of obsolescence and opportunities foregone in tying up funds) and that there are also costs involved in holding too little stock (e.g. loss of sales and goodwill, lost production, higher purchase and transportation costs to replenish stocks quickly). These costs may be very high as stocks in some industries such as manufacturing and wholesaling, where stocks account for a significant proportion of the total assets held.

The starting point for an effective stock management system is good planning and budgeting systems. In particular, there should be reliable sales budgets available for stock ordering purposes. However, it seems that not all small businesses prepare budgets. The MBS survey indicated that only 78 per cent of those replying prepare a sales budget. Stock management can also benefit from good reporting systems and the application of quantitative techniques (e.g. the Economic Order Quantity model) to optimise stock levels. However, the MBS survey found that more than one third of small businesses rely on manual methods of stock control and the majority do not use stock optimisation techniques.1

Cash management
The management of cash raises similar issues to those raised in relation to the management of stocks. There are costs involved in holding too much cash (e.g. investment opportunities foregone, loss of purchasing power during a period of rising prices etc) and also costs in holding too little cash (e.g. interest costs, lost goodwill etc). Thus, there is a need for careful planning and monitoring of cash flows over time. However, the MBS survey found that only 63 per cent of those replying prepared a cash budget. It was also found that cash balances are generally higher for small businesses than for larger businesses with more than half of those in the survey holding surplus cash balances on a regular basis.1 Although this may reflect a more conservative approach to liquidity among small business owners, it may reflect a failure to recognise the opportunity costs of cash balances.

Financing the small business
The problem of small businesses not having ready access to sources of long-term finance was first identified 70 years ago.2 However, this problem still persists today and poses a major obstacle to growth. It seems that small businesses have to overcome a variety of difficulties when seeking to raise finance. These include:

• a lack of financial management skills (leading to difficulties in developing credible business plans that will satisfy lenders and investors);
• a lack of knowledge concerning the availability of sources of finance;
• high levels of security required by lenders;
• rigorous assessment criteria (for example, a good financial track record over five years);
• an excessively bureaucratic screening process for applications.3

One consequence of these difficulties can be an excessive reliance on short-term sources of finance, such as bank overdrafts to fund operations. In addition to the difficulties identified, it is also worth mentioning that the cost of finance is often higher for small businesses than for large businesses because of the higher risks involved. However, not all of the problems of raising long-term finance are imposed externally - some arise from the attitudes of the owners. It seems that many owners of small businesses are unwilling to consider raising new finance through the issue of equity shares to outsiders as it involves a dilution of control. It has also been claimed that some owners do not take out loans because they do not believe in borrowing.4 Although obtaining long-term finance is not always easy for small businesses, it is nevertheless true to say that things have improved over the years. Some of the more important sources of long-term finance now available are considered below.

Venture capital
Venture capitalists provide finance to small and medium-sized businesses that do not have access to stock markets. They are interested in businesses that require investments in excess of £100,000. In many cases, however, the amount invested is considerably above this figure. The British Venture Capital Association states that the average size of investment made by venture capitalists during 1999 was £5.6million.5

Venture capitalists provide equity and loan finance for different types of business situations including:

• Start-up capital to help provide the finance necessary to commence trading.
• Growth capital to help expanding businesses to fund growth plans.
• Buy-in and buy-out capital to help management teams acquire an existing business.
• Share purchase capital to help finance the acquisition of an existing ownership interest.
• Recovery capital to help turn around the fortunes of a business suffering from poor performance.

Venture capitalists display a clear preference for investing in growth businesses and management buy-ins/buy-outs rather than business start-ups. During 1999, £7.8 billion was invested by UK venture capitalists of which only £128 million was invested in start-up businesses.5 Although start-ups may be important to the health of the economy, they are very high risk - investing in existing businesses is usually a much safer bet. A further point that venture capitalists consider is that start-up businesses often require relatively small amounts of finance and so the high cost of investigating and monitoring investment opportunities can make them unattractive. It is interesting to note that where venture capitalists made investments in start-up businesses during 1999, the average size of investments was in excess of £1 million.5

Business angels
Business angels are wealthy individuals that are prepared to invest in small businesses with growth potential through an equity stake. They are often prepared to invest between £10,000 and £100,000 in start-up businesses or businesses at an early stage of development. Business angels have often been successful in business themselves and so, in addition to providing financial assistance, they are often able to draw on a wealth of business and management experience to help fledgling businesses. They fill an important gap in the market, as the size of investment required may be too small for a venture capitalist to consider.

Business angels are an informal source of equity finance and so matching small businesses that require funds with suitable investors can be a problem. However, to help the matching process, a number of business angel networks have been developed in recent years. One such network is the National Business Angels Network (NBAN), which is sponsored by various financial institutions and supported by the Department for Trade and Industry. The NBAN provides a variety of services to its members including:

• A monthly bulletin to all its investors which sets out available opportunities.
• Experienced associates to examine and develop funding proposals and to bring together investors and small business owners.
• An e-commerce service designed to match small businesses with appropriate investors.6

Government assistance
One of the most effective ways in which the government assist small businesses is through the Small Firms Loan Guarantee Scheme. This scheme is designed to help small firms that have viable business plans but which are prevented from obtaining a loan through lack of security. The scheme guarantees loans made over a 2 - 10 year period to small businesses from lending institutions for sums of £5,000 to £100,000 (increased to £250,000 for businesses that have been trading for at least two years). The government will guarantee up to 70 per cent (increased to 85 per cent for businesses that have been trading for at least two years) of the amount borrowed.

In addition to other forms of financial assistance such as government grants and improving tax incentives for equity investors to invest in small businesses (e.g. Enterprise Investment Schemes and Venture Capital Trusts), the government can help in providing information concerning the sources of finance available. It was mentioned earlier that lack of knowledge concerning funding sources can be a real problem for small businesses.

Conclusions
We have seen that there is clear evidence that small businesses suffer from a lack of financial management skills and this can have serious implications for the financial health of such businesses. The management of working capital within small businesses is a particular problem. Policies and techniques employed in this area often fall some way short of best practice and this can put at risk the survival of the business. We have also seen that small businesses encounter problems when seeking finance in order to expand. This has been a long-standing problem and various attempts to improve the access of small businesses to sources of finance have been introduced over the years. In this short article, we considered some of the main sources of finance for small businesses.

References

1. Financial Management and working capital practices in UK SME's, Chittenden F, Poutziouris P and Michaelas N., Manchester Business School 1998
2. Committee on Finance and Industry (Macmillan report) 1931 Cmnd 3897 HMSO
3. SME Finance and Regulation The Institute of Chartered Accountants in England and Wales 2000
4. Committee of Inquiry on Small Firms (the Bolton Committee) Report 1971 Cmnd 4811 HMSO
5. www.bvca.co.uk
6. www.bestmatch.co.uk/about/overview National Business Angels Network website

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