REVIEW OF LITERATURE

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 CHAPTER II

REVIEW OF LITERATURE

2.1 Introduction

The review of literature forms the main platform for the dissertation as
the consequent analysis and future result is based on it. A detailed review of
literature has been made to find out the research gap and to identify the relevant
issues. It is essential for a researcher to review the related literature in order to
have a clear knowledge about the subject and understand the research gap in
order to draw the scope for the study. The review is done on the literature
available on financial management practices adhered to by the SMEs (Small
and Medium Scale Entrepreneurs) and opinions of earlier researchers in the
areas of financial management like inventories, receivables, payables and cash
conversion cycle management.

2.2 Review of Literature

A brief summary of available literature on the subject is presented in this

cross section.

A study by Fong (1990)1 found that most SMEs in Malaysia were

managed by the owners themselves. Therefore, the quality of management
depends on the education, experience, and training of the entrepreneurs
themselves. However, since many of them did not have a formal education in
business management, they usually operated their business as traditional
family-type businesses. Fong concluded that for the sector to remain dynamic,
SMEs must employ professional managers for the continued growth of the
firm. A professional financial manager will be able to manage the firm’s
financial affair so as to maximize the value of the firm for its owners.

According to Mohd Amy Azhar B. Hj. MohdHarif and Harizal B.

Osman (1990)2 the important contribution of small and medium-scaled
enterprises to Malaysia’s GDP, employment, and industrialization has been

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 well documented. Although their role in economy is substantial, many SMEs
are plagued by management problems (Hashim and Wafa, 2002). These
management problems include human resource management, marketing
management, operations management, financial management, and strategic
management. Given that financial management is one of the key aspects of the
well-being and survival of a business, it is important that this topic be explored
in depth.

Thus, the main purpose of the study is to investigate the financial

management components and techniques practiced by the SMEs in Malaysia.
This study comprises of two analyses. In the first analysis, six financial
management components were identified, namely, financial planning and
control, financial accounting, financial analysis, management accounting,
capital budgeting, and working capital management. Subsequently, in the
second analysis, various financial management techniques were identified
under each component stated earlier. Data for the study has been obtained by
conducting a face-to-face interview using structured questionnaire with
respondents from selected SMEs. The study sample comprised of 30 SMEs
operating in the Kota Setar and Kubang Pasu district of Kedah Darul Aman.

The findings of the study show that three components of financial

management to be categorized as core components practiced by the SMEs, are
financial planning and control, financial accounting, and working capital
management. Three other components which are financial analysis,
management accounting, and capital budgeting can be categorized as
supplementary components practiced by the SMEs due to the small percentage
of the SMEs using these components in the management of their business.

Chan and Kevin (1990)3 reported that computers are used to improve
efficiency and produce quality products or services at the lowest costs. But they
agree that small companies are reluctant to accept information technology ( IT)
because they find that it is difficult to use computers.

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 Ang (1991) 4 suggested that it may be appropriate to define a business as
small if it possesses most of the following characteristics: it has no publicly
traded securities; the owners have undiversified personal portfolios; limited
liability is absent or ineffective; first generation owners are entrepreneurial and
prone to risk taking; the management team is not complete; the business
experiences the high cost of market and institutional imperfections;
relationships with stakeholders are less formal; and it has a high degree of
flexibility in designing compensation schemes.

According to McMahon et.al (1991)5sound financial management is

crucial to the survival and well-being of small enterprises of all types. Studies
of reasons for small business failure inevitably show poor or careless financial
management to be the most important cause. The author mentions that
recognition of such findings in the recent years have seen increased attention
towards financial management in small business training and educational
programs and books and articles written for small business. He also says that it
is not unreasonable to ponder whether this attention has had a visible impact on
the way in which small businesses are operated. It seems appropriate to review,
and attempts have been made to integrate available empirical research findings
concerning the financial management practices of small business in North
America. Such a review can lead to improved understanding of both the
research conducted till date and the financial management practices under
scrutiny. Furthermore, it can act as a stimulus for future research.

A similar view was taken by Osteryoung and Newman (1993)6who

suggested that a small business be defined as a business in which there is no
public negotiability of common stock and the owners must personally
guarantee any existing or planned financing.

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 Keasey and Watson (1993)7however, have hypothesized that the
factors which influence capital budgeting decisions differ significantly in
relation to small and large firms.

Gaskill, and Van Auken (1993)8have reported that the greatest internal
problems identified by small US firms relate to inadequate capital, cash flow
management, and inventory control.

Herbert E. Olivera and Charles Martin (1993)9examined the

accountant's role as a financial advisor and partial decision maker to small
business managers. Accountants cannot forget basics. All statements should be
prepared in a timely manner and should be available soon enough to assist
management in effective decision making. However, management must be
knowledgeable as to what the statements are portraying in order to make
decisions. Accountants must remember that often management does not have
the skill to interpret the statements, the records and the findings. Accountants
must therefore educate them. Financial information should not be just handed
over to the management by accountants. In fact, both must expend time and
effort to enable management to understand what is presented and the impact it
will have on the operation of the organization and its decision making.

The author mentions that it is inexcusable for skilled external

accountants to permit clients to fail because of indifference. Small business
owners have enough problems with which to contend without having to
consider the competency and motivation of an accountant. The role of the
accountant is to represent the financial team for the small business owner and
to reduce the pressures, problems and hurdles facing small business owners in
this difficult competitive U.S. economy. Basic accounting principles practiced
by competent and caring professionals can be the main source of strength
which can ensure success for small business.

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 Dodge et al. (1994) 10 reported that the most important internal problems
identified by small US firms relate to inadequate capital, cash flow
management and inventory control.

Kargar and Blumenthal (1994)11state that while the performance

levels of small businesses have traditionally been attributed to general
managerial factors such as manufacturing, marketing and operations, working
capital management may have a consequent impact on small business survival
and growth. 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.
Presuming that many small businesses suffer under capitalization, the
importance of exerting tight control over working capital investment is difficult
to overstate.

A firm can be very profitable, but if this is not translated into cash from
operations within the same operating cycle, the firm would need to borrow
support from its continued working capital needs. Thus, the twin objectives of
profitability and liquidity must be synchronized and one should not impinge on
the other for long. Investments in current assets are inevitable to ensure
delivery of goods or services to the customers and a proper management of the
same should give the desired impact on either profitability or liquidity. If
resources are blocked due to different stages of the supply chain, this will
prolong the cash operating cycle. Although this might increase profitability
(due to increase of sales), it may also adversely affect the profitability if the
costs tied up in working capital exceed the benefits of holding more inventory
and/or granting more trade credit to customers. Another component of working
capital is accounts payable, but it is different in the sense that it does not
consume resources; instead it is often used as a short term source of finance.

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 Thus it helps firms to reduce its cash operating cycle, but it has an implicit cost
where discount is offered for early settlement of invoices.

McMahon and Davies(1994)12in their empirical work had commented

that running a business effectively require an awareness and good or proper
knowledge of how the business is doing by the owner-manager of a small
business on a day to day basis. Apart from legal requirements, there is a
practical necessity to keep sufficient records to ensure that business activities
can continue without problem and in proper direction. However, the fields of
accounting and finance have yet to provide an accepted normative theory
indicating which financial reports are most valuable in financial management
and how often they should be used.

According to Peel, M. J., and Wilson, N. (1994)13if the financial or

working capital management practices in the small firm sector could be
improved significantly, then fewer firms would fail, and economic welfare
would improve substantially. The control of working capital can be subdivided
into areas dealing with stocks, debtors, creditors and cash. Considering the
importance of efficient management of cash by small firms, it is not surprising
that only 10percent of respondents claimed that they never used cash
budgeting, whereas 33percent used cash budgeting very often.

An examination of the bank statements of the respondent firms revealed

large credit balances at the end of the month. This is a sign of inefficient cash
management which should be discouraged. Surplus cash which could have
been invested in short term instruments like “call accounts" which yield good
returns are left in non interest yielding bank accounts.

Storey (1994)14 notes that small firms, constitute the bulk of enterprises
in all economies in the world. However, given their reliance on short-term
funds, it has long been recognized that the efficient management of working
capital is crucial for the survival and growth of small firms.

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 Jarvis et al, (1996)15 says that the working capital meets the short-term
financial requirements of a business enterprise. It is a trading capital, not
retained in the business in a particular form for longer than a year. The money
invested in it changes form and substance during the normal course of business
operations. The need for maintaining an adequate working capital can hardly be
questioned. Just as circulation of blood is very necessary to the human body to
maintain life, the flow of funds is very necessary to maintain business. If it
becomes weak, business can hardly prosper and survive. Working capital
starvation is generally credited as a major cause for business failure in many
developed and developing countries. The success of a firm depends ultimately,
on its ability to generate cash receipts in excess of disbursements. The cash
flow problems of many small businesses are exacerbated by poor financial
management and, in particular, the lack of planning cash requirements.

A study by LeCornuet.al(1996)16 has thrown light on the financial

objective of small business units. They found that financial management of
small enterprise is or should be qualitatively as well as quantitatively different
from that of large enterprises. It also appears that behaviour and decision
making in small enterprises are unequivocally attached to the personal
motivations of the owner managers.

Schilling (1996)17in his writing mentions optimum liquidity position,

which is a minimum level of liquidity necessary to support a given level of
business activity. Briefly, he says that it is critical to deploy resources between
working capital and capital investment, because the return on investment is
usually less than the return on capital investment. Therefore, deploying
resources on working capital as much as to maintain optimum liquidity position
is necessary. Then he sets up the relationship between CCC and minimum
liquidity required to state that if the CCC lengthens, the minimum liquidity
required increases; conversely, that if the CCC shortens, the minimum liquidity
required decreases.

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 Peel and Wilson (1996)18 have stressed the efficient management of
working capital, and more recently good credit management practice as being
pivotal to the health and performance of the small firm sector. The postal
questionnaire responses of 84 small firms conclude that a relatively high
proportion of small firms in their sample use quantitative capital budgeting
techniques, and review various aspects of the companies’ working capital.

According to Berger and Udell (1998)19 small and medium-sized

enterprises have greater informational opacity than larger firms, which worsens
information asymmetry problems. On the other hand, the coincidence of
ownership and control and the greater operational flexibility of these
companies also make the agency problems associated with debt, more serious.

20
A study by Holmes and Nicholls (1998) concluded that the amount
and nature of accounting information prepared or acquired is dependent on
number of operating and environmental variables like, business size, age,
industrial grouping, owner-managers education etc. The study also shows that
there is a big gap between the owner-manager, awareness, and the uses of
financial management techniques. They (owner-managers of small business
units) are venturing into business without proper accounting and financial
(control) ‘know-how’.

El Luodi (1998)21 on the other hand, explained that the unstable market
conditions require small companies to have readily available information to
face the oncoming problems. Because of that, these companies have to plan
carefully and find appropriate way to have good financial management to be
able to use the information accurately.

Collins (1999)22 concluded that one of the factors that influence the
companies not to implement IT in their business is the additional cost factor

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 incurred for acquiring hardware and to set aside the payment for the consultant
fees which are much higher than just to purchase the software.

Michaelaset al.(1999)23 argue that small businesses carry less debt than
the larger firms due to generally i) lower marginal corporate tax rates for very
small firms, ii) higher bankruptcy costs, iii) greater agency costs, and iv)
greater costs of resolving the larger informational asymmetries.

As examined by Peter (1999)24small companies are avoiding the

technology, as they are doubtful and unwilling to have IT to assist their
business operations.

This is agreed by Smallbone, Supri and Baldock (2000)25who found

that the adoption of IT in SMEs slower than larger firms. However, SMEs are
still trying hard to resort to IT because communication becomes so important
these days.

Peel et al.(2000)26 suggested that small firms are generally associated

with a higher proportion of current assets when compared to large firms, and
that the small firms also have less liquidity, more volatile cash flows and a
reliance on short-term debt.

Mitchell et al. (2000)27argued that accounting information is important

because it can help companies solve short term problems and assist in decision
making. Further, recent empirical evidence suggests that effective financial
management may contribute to the success of companies in future.

Abdullah, Ismail and Tayib(2001)28 found that companies are not

maximizing the use of accounting system software. Most companies prefer to
use accounting modules like general ledger, accounts payable and receivables
and payroll just to support operational tasks rather than for decision making
purposes. Additionally, it is believed that accounting information is easily
produced by the adoption of IT because nowadays there are many types of

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accounting software provided in the markets to help the management to make
decisions faster. This is agreed by Cragg and Zinatelli and Thong who show
that IT adoption in small firms are growing.

Humpreys, McCurry and McAleer (2001)29 believe that SMEs are

not free from the demand of being competitive in the business environment.
Therefore, it is an advantage for SMEs that adopt IT because they are able to
give more valuable services to their customers and can stay competitive in the
challenging business environment.

According to Sen.et. al (2001)30 efficient and scientific management of

finance in an enterprise is of prime importance for achieving the ultimate goal
i.e. profit maximization. In practice, ultimately the matter of production or
materials quality or marketing, relates to financial issues. Therefore, all efforts
are needed for applying the tools of financial management to the enterprises in
a scientific manner with an aim to restore fresh confidence and financial health
of the organization.

Nguyen. KM (2001)31in his thesis, provides descriptive findings of

financial management practices and financial characteristics and demonstrates
the simultaneous impact of financial management practices and financial
characteristics on SME profitability. In addition, the research study provides a
model of SME profitability, in which profitability was found to be related to
financial management practices and financial characteristics. With the
exception of debt ratios, all other variables including current ratio, total asset
turnover, working capital management and short-term planning practices, fixed
asset management and long-term planning practices, and financial and
accounting information systems were found to be significantly related to SME
profitability. With the findings as presented above, this study provides many
implications for financial management practices and contributes to the
knowled0PaY.314W68U6PnY31Q84.314W68UW08P-Y31PfY.0140878PoY31Q8114W68U
 KessevenPadachi (2006)48states that a well designed and implemented
working capital management is expected to contribute positively to the creation
of a firm’s value. The purpose of this paper is to examine the trends in working
capital management and its impact on a firm’s performance. The trend in
working capital needs and profitability of firms are examined to identify the
causes for any significant differences between the industries. The dependent
variable, return on total assets is used as a measure of profitability and the
relation between working capital management and corporate profitability is
investigated from a sample of 58 small manufacturing firms, using panel data
analysis for the period 1998 – 2003. The regression results show that high
investment in inventories and receivables is associated with lower profitability.
The key variables used in the analysis are inventories days, accounts receivable
days, accounts payable days and cash conversion cycle. A strong significant
relationship between working capital management and profitability has been
found in previous empirical work. An analysis of the liquidity, profitability and
operational efficiency of the five industries shows significant changes and how
best practices in the paper industry have contributed to performance. The
findings also reveal an increasing trend in the short-term component of
working capital financing.

Martínez-Solano, Pedro and García-Teruel, Pedro J. (2006)49

provided empirical evidence about the effects of working capital management
on the profitability of a sample of small and medium-sized Spanish firms. With
this in mind, was collected a panel of 8,872 SMEs covering the period 1996-
2002. The results, which are robust to the presence of endogeneity, demonstrate
that managers can create value by reducing their firm's number of day’s
accounts receivable and inventories. Equally, shortening the cash conversion
cycle also improves the firm's profitability.

Rehman (2006)50 studied the impact of the different variables of

working capital management including Average Collection Period, Inventory
Turnover in Days, Average Payment Period and Cash Conversion Cycle on the

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 Net Operating Profitability of firms and concluded that there was a strong
negative relationship between the above working capital ratios and profitability
of firms. Furthermore the study stated that managers can create a positive value
for the shareholders by reducing the cash conversion cycle up to an optimal
level.

Charles J. Mambula I (2007)51in his paper presents the results of a study

conducted among 36 owners of small manufacturing businesses in Senegal.
Although most of these firms show promising potential for success they are
threatened with some operational problems that constrain their ability to attain
more rewarding results. In order for these mostly stagnated small firms to
graduate into higher levels of development, the need for adequate management
training and relevant supporting infrastructures are essential. This research
identified the biggest single impediment facing most Senegalese small
businesses as that of acute shortage to sources of capital, in addition to external
conditions affecting the productive management of funds. It is therefore
recommended that the government machinery, relevant establishments and
business communities combine efforts to create effective structures that will
help ameliorate the capabilities for effective capital formation processes and
enhance better management know-how for entrepreneurs in order to encourage
the progressive development of small businesses in Senegal.

Samiloglu and Demiraunes (2008)52 analyzed the effect of working

capital management on the profitability of the firms. Their study depicted the
accounts receivable period, inventory period and leverage which affect the
profitability of the firm negatively while growth affects a firm's profitability
positively.

Shahwan and Al-Ain (2008)53 argued that users of financial report

should be able to make decisions about resource allocation and are capable of
managing the resources. Business decision relies on relevant information
produced. Information should be of high quality. Besides, the information can

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 be viewed in different dimensions to monitor performance, to investigate
relationship and to take advantage of trends.
This is agreed by Sian and Roberts (2009)54who found that the main
users of the financial statements were the owners themselves. However, they
indicate that the use of financial reporting and other information by owner-
managers are not useful. According to Nobanee and Haitham (2009)55 the
traditional link between the cash conversion cycle and the firm's profitability is
that shortening the cash conversion cycle increases a firm's profitability. On the
other hand, shortening cash conversion cycle could harm the firm’s operations
and reduce profitability. However, identifying optimal levels of inventory,
receivables, and payables where total holding and opportunities cost are
minimized and recalculating the cash conversion cycle according to these
optimal points provides more complete and accurate insights into the efficiency
of working capital management. In this regard, an optimal cash conversion
cycle seems to be a more accurate and comprehensive measure of working
capital management.

Negiet et.al (2010)56 aim to analyze the effect of the working capital
management on firm's performance. In accordance with this, the statistically
significant relationship between Operating Profit Margin and the component of
Working Capital Management of Indian Manufacturing companies for the
period of 2003 to 2008 has been analyzed under a multiple regression model.
The findings of the study indicate that current asset to total asset, total debtors
to total asset and inventory days are directly related variables with working
capital management, and have significantly negative effects on a firm’s
profitability while the other variables included in the regression model (Asset
Turnover, Gearing, Current liability to total asset, accounts payable and current
ratio) have no statistically significant effect on firms profitability.

57
Ben Kwame Agyei-Mensah (2011) comments that the contribution
of small firms to the employment of the youth in Ghana is highly recognized,
but their contribution towards revenue to the national budget seems to be

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 negligible. The reason for this situation is that these small firms do not have
sound financial management systems in place which will help them to prepare
financial reports. The end result is that it becomes very difficult for tax
authorities to compute their taxable incomes. The three most influential factors
that motivate the sample firms in pursuing sound financial management
practices are: (1) Pressure from bankers (90percent); (2) Pressure from external
accountants (80percent) (3); Pressure from providers of capital (70percent).
The three most influential factors that prevent them from practicing sound
financial management practices are: (1) Qualified accountants too expensive to
maintain (93percent); (2) Accounting records too difficult to understand (87per
cent); (3) Lack of internal accounting staff (73percent). In the light of their
findings, it has been recommended that they should avoid mixing business
transactions with non-business transactions. It was also recommended that
small firms should disclose fully their financial position by keeping a full set of
information on business transactions.

According to Fadhil and Fadhil (2011)58Small and Medium Enterprises

(SMEs) have been very important in many countries including Malaysia
because of its role in the country’s economic growth. This thesis explores the
level of awareness towards the importance of financial management from the
reparation of accounting reports and its information usage in the business. The
research focuses on small non-manufacturing companies because very few
studies have been conducted in this area. Besides, the findings will help to
reveal some of the key points that can contribute to decision-making and
growth especially in the case of small companies. The research is based on case
study, which is to concentrate more on a situation that is similar to the previous
research done. The situation considered is among small non-manufacturing
companies, which can provide useful tools to study the financial management
and the usage of accounting information in the companies. In addition, the level
of awareness on the importance of using information technology (IT) in
managing a company’s financial also has been identified.

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 A study made by Amarjit Singh Gill et.al (2012)59 aimed to examine
the factors that influence financial leverage of small business firms in India.
This study also seeks to extend the findings of Michaelas et al. (1999). Small
business owners from the Punjab area of India were surveyed in order to gather
information. Subjects were asked about their perceptions, beliefs, and feelings
regarding the factors that influence the financial leverage of their firms. This
study utilized survey research (a non-experimental field study design). The
findings show that small business growth, small business performance, total
assets, sales, tax, and family have positive influence on the financial leverage
of small business firms in India. This study also contributes to the literature on
the factors that influence financial leverage of small business firms. The
findings may be useful for the “financial managers, investors, and financial
management consultants.

Ashim Kumar Das and Nikhil Bhusan Dey(2012)60statement that

“Small is beautiful” is more relevant to the Indian scenario as small business
units contribute nearly 40 percent of gross industrial value and 7 percent of her
GDP. Small business is the only ray of hope for a large number of people to
survive as most of the states are industrially backward, having poor
infrastructure facilities and subsistence agriculture. Growing literature on
financial management supports the argument that in small business, financial
management is one of the key issues. It not only increases the success rate but
also affects the level of performance of a business. This research paper
undertakes an exploratory study by raising some queries on the financial
management practices of small businesses in India and attempts to find
empirical justification on the usual practices by small businessmen.

The research does prove that there is a wide gap between the theory of
financial management and actual practice to show that firms not doing well are
less likely to have knowledge of financial management and maintenance of
proper business records. While the exploratory nature of the study does not

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 allow its results to be generalized, it however, suggests the need for further
theory development in the field of financial management for small business and
formulation of hypotheses for wider empirical analysis in future.

2.3 Conclusion
From the detailed literature review, it is understood that many experts
have said that the business environment is different according to the style of
management as well as the culture that the family inherited from generation to
generation. Small companies have little management accounting information
and poor control, and decision making is mostly on informal basis. Thus, they
lack information on these key variables used in the analysis such as inventories
days, accounts receivable days, accounts payable days, and cash conversion
cycle. It is ironical that not much research study has been done in this area of
SMES’ and their financial management practices. No study is carried in
specific in Tamilnadu, as this has been considered to be a viable research area,
Thus, the researcher will attempt to make an in-depth study of the topic:
Financial Management Practices of Small Firms: An Empirical Study With
Special Reference to Coimbatore City.

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