This chapter will consist of gathering enough research material and empirical evidence from previous studies to provide a foundation to the study. This chapter presents an overview of empirical literature on liquidity management of SMEs. It reviews findings
2.1 Introduction
The small and medium-sized enterprise sector is often viewed as the incubator of employment, innovation and growth (Craig et al., 2003). Jovanovski, klein and Mancini (2003) stated that the SME sector has emerged as the main driver of world economic growth. This particular sector has contributed a lot in the creation of employment, poverty alleviation, wealth creation, price stability, inflow of foreign exchange earnings, economic development and democratization. Such businesses are seen as vital to the promotion of an enterprise culture and to the creation of jobs within the economy (Bolton Report, 1971; Padachi, 2006). In many countries, such as Singapore and United States, they are the driving force of the economy. In Europe, two third of all new jobs created are from small enterprises (The Entrepreneur, 2004).
In Mauritius also the contribution of SMEs is widely acknowledge. The SME sector is mentioned each year in the Government's budget and it is demonstrating its endeavor to promote, consolidate and modernize the SME sector. Successive Governments have put in place a wide range of support institutions and continuously increasing its various incentives. An array of services ranging from training, business counseling services to financial assistance in the form of both loans and grants are being provided by various institutions to boost up SMEs development so as meet economic and social challenges of the country.
2.2 Definition of SME
Different countries use different criteria to determine their SMEs sector. The definition varies depending on the relative development of the country's economy. However, there are some parameters generally considered by most countries and the common ones are:
Number of employees employed
Amount of capital invested
Total assets
Turnover / Sales volume
Capacity of production
2.3 Importance of SMEs
SMEs play a significant role in the socio economic development of most countries around the world. The contribution of SMEs in the development of output, employment and economic growth is being acknowledged universally (Beyene, 2002). They constitute the majority of enterprises found even in all industrialized countries.
SMEs exist because of their inherent properties. Being small and less hierarchical, they are more flexible and decision making is faster, hence making them on a better edge than large firms. Nowadays, SMEs are increasing the level of output and employment by moving gradually from local operations to export-led firms.
Moreover, SMEs are an important job generator. This is because they are likely to be involved in more labour intensive businesses that require less capital spending on technology when compared to larger organizations (Storey, 2004). According to De Ferranti and Ody (2007), SMEs which employs between 10 and 250 persons, forms the backbone of modern economies and can be crucial engines of development through their roles as seedbeds of innovation.
2.4 Nature and Importance of Liquidity
Liquidity is considered 'king'; it keeps a company solvent and provides it with the flexibility to seize business opportunities. Liquidity is defined as a measure of the extent to which a person or company has (or has the ability to quickly put hands on) cash to meet immediate and short-term obligations. Therefore the liquidity position of a firm is about the degree in which it can dispose of money. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations and its continued flow can be guaranteed from a profitable venture (Padachi, 2006). Liquidity problems of many small businesses are mainly caused by poor financial management and in particular the lack of planning cash requirements (Jarvis, Kitching, Curran, and Lightfoot, 1996).
2.5 Liquidity Risk
Liquidity risk is the risk that a business will have insufficient funds to meet its financial commitments in a timely manner. In easier terms, liquidity risk can be defined as the risk of being unable to liquidate a position timely at a reasonable price (Muranaga and Ohsawa, 2002). This risk can adversely affect both earnings and capital. Therefore, it becomes the top priority of a firm to ensure the availability of sufficient funds to meet future day to day expenses. All businesses need to manage liquidity risk to ensure that they remain solvent. Liquidity risk has become a serious concern and challenge for SMEs.
2.6 Importance of Liquidity Management
Liquidity management refers to management of current assets and liabilities. It plays an important role in the successful management of a company and secures future growth. The liquidity position of a company is about the degree in which a company can dispose money. Liquidity management in small firms can be described as the planning and controlling of cash flow by owner-manager in order to meet their day to day commitments (Collis and Jarvis, 2000).
If a company does not manage its liquidity position well, its current assets may not meet its current liabilities resulting in cash shortages and difficulty in paying obligations. Liquidity position of a firm is of major importance to both the internal and the external analysts because of its close relationship with day-to-day operations of a business (Bhunia, 2010). In short, liquidity management is necessary for securing the operational processes of a company and the continuity of the company.
A firm should be able to convert its profits into cash from operations within the same operating cycle, or else the firm would need to borrow from external sources to support its working capital needs. Smaller and medium sized enterprises (SMEs) are usually unable to find external financing easily because they are seen as less creditworthy than larger companies (Bernanke, 1991). On the other hand for those that are able to fine external financing, the cost of borrowing may be expensive (Jose et al., 1996).
Liquidity management takes the form of cash management and credit management. Whilst the most important aspect of cash flow management is avoiding extended cash shortages, credit management involves not only the giving and receiving of credit to customers and suppliers, but also involves the assessment of individual customers, the credit periods allowed and the steps taken to ensure that payments are made in time (Poutziouris et al., 1999).
2.7 Cash management
Cash is king but for SMEs, cash means flexibility, the ability to make acquisition, to invest in new plant and machinery and to innovate. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business and this requires that business must be run both efficiently and profitably (Padachi, 2006). Cash asset is also referred to as cash, cash equivalent or marketing securities on the statement of financial position of an organization. Keynes (1936) identified three reasons for holding cash:
Transactions motive
A business needs cash to meet payments arising in its ordinary course. Such payments include product purchases, administrative expenses and distribution costs.
Precautionary motive
A business needs cash to maintain a cushion or buffer to meet unexpected contingencies. The more predictable the cash flows, the fewer precautionary balances are needed.
Speculative motive
A business holds cash to take advantage of expected changes in security prices.
Fraser (1998) stated that there may be no more financial discipline that is more important, more misunderstood, and more often overlooked than cash management. In order to manage cash in an efficient manner, it is important that owner/manager prepare frequents reports on cash balances at bank as well as anticipated cash receipts and cash disbursement. Consequently, these will enable them to better plan and gain control over major inflows and outflows.
2.8 Cash Conversion Cycle
Besley and Brigham (2005) define cash conversion cycle as the average length of time from the payment for the purchase of raw materials to until the collection of receivables associated with the sale of the product. The cash conversion cycle is a traditional model introduced by Richards and Laughlin (1980). It is a powerful performance measure for determining the performance of a company in managing its working capital. According to Gentry, Vaidyanathan, Lee and Wai (1990), short cash conversion cycle is indirectly related to a firm's value. In other words, short cash conversion cycle indicates that the business is collecting the receivables as quickly as possible and delaying the payments to suppliers as much as possible. Consequently, this leads to relatively high net present value of cash flow and relatively high firm value.
Many businesses and particularly small businesses are faced with liquidity problems since most have to operate with fewer sources of both short and long term financing than larger firms. Given that less financing is available, more assets must be held in liquid form so as to meet daily transactions and emergency requirements. Larger firms, that have better access to both the money and capital markets, can afford to hold fewer current assets and meet cash requirements just as quickly and efficiently through borrowing.
The cash conversion cycle
2.9 Credit Management
Credit management is also known as account receivables, trade receivables or customer receivables and is an important element in the statement of financial position. It involves sales that have been made on credit which will be converted into cash at a later stage. Christie and Bachuti (1981) define credit as the ability of a business or individual to obtain economic value on faith, in return for an expected future payment. According to Ferris (1981), credit provision can also be viewed as an equivalent short term loan. Bad credit management can be devastating since it directly affects working capital of a business in the form of finance cost.
Allowing credit is common practice, especially for SMEs, as it allows them to take advantage of the credit term to settle their accounts. It is a kind of short term loan which will need to be settled according to the terms agreed by both parties. However, after the recent credit crisis, credit is less readily available, and when it is, the cost has increased while terms and conditions are less favorable for the client.
A good credit management starts with a defined credit policy which should outline the business strategic and operational requirements. The company will have to decide the terms of credit that it will offer to its customers (the strategy) as well as implementing procedures, limits and train personnel (operational).
2.4 Review of Previous Studies
Review of findings from previous research works revealed the following reasons behind the failure of SMEs. They are subject to a number of constraints that affect their ability survives and their failure to operate and grow arises from both internal and external factors.
Liquidity refers to the level of cash and near-cash assets held, as well as cash inflows and outflows of these assets. According to McMahon and Stanger (1995, p. 24) liquidity in a small enterprise is a matter of life or death for the small business since such a business can survive for a long time without a profit, but fails the day it can't meet a critical payment.
Literature tends to suggest that one of the major reasons for the high failure rates of SMEs was poor liquidity management practices. Drever (2005) sees the soundness of liquidity management as the most critical influence on survival and financial well-being in small enterprises. SMEs in general do not adopt best model of liquidity management practice that would suit their size, instead there is a tendency for them to follow large firm. Managing in a small business is not like managing part of a large organization. The assessment of liquidity management practices in small firms as well as how they should be improved should not be based according to the standards and practices used by large companies, but rather attention must be paid to the practices actually being used by owner-managers themselves.
According to Stokes and Wilson (2006), small business management differs from large organizations in many ways, mainly because of social structures, relationships and because of the level of resources available. Waynarczyk (2001) identifies three key aspects in which small and large firms differ: uncertainty, innovation and evolution. Nayak and Greenfield (1994) argue that owner-managers do not use financial management techniques very effectively. As a result, the process of financial management and associated decision-making in small firms remains something of "a black box" (Deakins et al., 2000).
Moreover, the needs and situation under which SMEs operate differ from that of large firms, thus they often require tailored management strategies. Small firms do not operate under the same economic and financial environment as large firms (Shutt and Whittington, 1987; Rainnie, 1989; Curran, 1990). (Hall, 1995) points out that small business environment exerts some pressure that can be different to the influences on larger organizations. Problems of the availability, cost of finance, and the burden of government regulations and paper work are examples of the preoccupation that concern the manager of a small enterprise but possibly do not concern many corporate managers in large organization (Scarborough & Zimmerer, 2000). Consequently, most small firms become insolvent and fail because they often could not access financial assistance from the financial institutions due to lack of the necessary requirement needed by the financial institutions.
Moreover, high failure rates or poor growth rates among small firms also arises from dominant of the owner managers' management skill (Cressy and Storey, 1995). The survival of small firms is largely dependent upon the ability of the owners to manage cash flows which in turn contribute to the management of relations with banks, the prime lenders to small businesses (Chittenden et al., 1999; Storey, 1994; Cosh and Hughes, 1998). Apart from investment portfolio and profitability, liquidity is the other factor that is decisive in the growth or failure of a business. Hence, decision making affects these decisive factors and thus contribute to the success or failure of the business.
Liquidity management is one of the most difficult aspect of small firm financial management and is considered to be more critical than that indicated in the financial management literature (Jarvis et al., 1996). Small firms usually retain smaller amount of accounts receivable and inventory. In addition to this, they rely heavily on current liabilities due to their very weak financial position. Thus, these firms maintain less liquidity and rely on credit facility to finance their operation. This credit facility most times comes from account payable. Consistent with Zimmerer and Scarborough (2005), small businesses are usually willing to assume greater risk and this attitude is normally reflected in the small firm's liquidity.
Furthermore, according to the Small and Medium Enterprise Federation, SMEs are particularly vulnerable to bad debts because they tend to have a smaller customer base than large enterprises. In addition to this, on average 91 per cent of daily business transactions are on credit terms (Chittenden et al., 1998). The small business experience situation where the production and sales cycle is shorter than the average age of account payable and in this situation, trade debt can build up in an ever increasing manner until a point is reached when it cannot be paid off in due date (Geoffrey, 1969; Anyanwu, 1996; Levy, 1993). Studies revealed that the most important reason behind small business failure was poor and/or careless management (Chittenden, Poutziouris and Michaelas, 1999). They stated that credit management in small firms fall behind best practices. As a result there is high rate and threat of insolvency in small business.
Liquidity management in small firms can be described as the planning and controlling of cash flow by owner-manager in order to meet their day to day commitments (Collis and Jarvis, 2000). Therefore, it can be said that cash flow is an integral part of everyday operations. Generally speaking, the root cause of many business failures stems from the inadequate management of available cash, the lack of available cash resources, or lack of access to appropriate financing facilities. In addition, there is also poor record keeping system in most small firm which reduces the ability of the firm to monitor the proper cash flow. Consequently, they are precluded them from the ability to compete effectively.
Moreover, several SMEs fail in a little time after they are started and this is mostly due to poor liquidity management. According to statistics, out of 30 enterprises that are created (start-ups), about 10 are likely to survive to become SMEs and only 3 out of the 10 businesses will become medium enterprises. It was also revealed that most small business fail at most within 2 years, while the strongest fail within 6 years. Previous studies confirmed that failure rate is high during start up stage of small firms (DTI, 1995; Cressy and Storey, 1995). Adequate financial capital is a pre-requisite at start-up as well as during the lifetime of an enterprise. It is considered to be vital for its survival as well as for its effective trading and development, as it can act as a buffer against unforeseen difficulties (Cooper, Gimeno-Gascon, and Woo, 1994; Chandler and Hanks, 1998; Venkataraman and Van de Ven, 1998; Cassar, 2004). Inadequate or inappropriate capital structure is often the most common reason for a large proportion of small business failures (Chaganti, DeCarolis, & Deeds, 1995).
At various stages of growth, different potential financial problems exist. This is shown in table 2.1below.
Stage
Potential Problems
Inception Growth I
Under capitalization "over-trading" liquidity crises
Growth II
Finance gap
Growth III
Loss of control
Maturity
Maintaining ROI
Decline
Failing ROI
