Formalised Strategic Financial Management in Small and Medium Sized Enterprises in the UK - Assignment Example

Making the case for effective and formalised strategic financial management in small and medium sized enterprises in the UK 2007 Introduction Financial management, that is the ways of raising, utilizing and monitoring funds, is crucial for any business, large or small. An effective financial management enables a company to maximize profits, increase shareholders’ wealth, expand the business and achieve long-term goals. In today’s world, the role of the Chief Financial Officer is not simply of managing the company’s finances but also to direct the funds towards the company’s broader strategic goals. Hence, financial management is not simply “number crunching” but an important strategic role for the company (Johanson et al, 1996). The finance function moves beyond internally driven strategies to those that drive competitive advantage of the company. For the small and medium businesses, financial management is all the more important since such companies have to operate under limited funds and have to utilize finance judiciously in order to expand and achieve goals. Accounting practices may be considered as twofold: 1) financial accounting is a score-keeping and reporting tool addressed to external audiences; 2) management accounting helps managers to control costs and increase revenues. The UK Accounting Standards Board Statement of Best Practices on the Operational and Financial Review calls for “discussion identifying the principal risks and uncertainties in the main line of business, together with a commentary on the approach on managing these risks, and, in qualitative terms, the nature of the potential impact on the results” (quoted in UNCTAD, 2000). In 2005, the government issued guidelines for reporting of Key Performance Indicators (KPI). The Operational and Financial Review (OFR) that was applicable till then was replaced with the new guidelines that was applicable to the 1290 quoted companies. In this paper, I will discuss the requirements for an effective and formal strategic financial management in small and medium businesses in the United Kingdom. First, I will discuss the economic backdrop of the business environment in the UK. Then, I will discuss various aspects of financial management like fund raising and dividend policies from the perspective of enterprises. The UK Economy The United Kingdom is the second-largest economy in Europe, after Germany and the fifth largest in terms of GDP at market prices (Economy Watch). With GDP in terms of purchasing power parity at $1.93 trillion in 2006, UK witnessed economic growth of 2.8 percent over the previous year. The UK is a major trading and financial services center, with 80.4 percent of its employment generated from the services. Economic growth was hampered after the 2001 slump and it lost its share in international trade after the emergence of offshore activities. However, output growth recovered in 2006, making it difficult for a section of the policy-makers to push for the UK to join the European Union (CIA). The brisk growth in 2006 was supported by moderate shortfall of labor supply compensated by inward migration. Although consumer price index rose just about 3 percent, it is expected to fall (OECD). The Bank of England has raised interest rates in order to control inflation. The last budget raised tax rates, which would dampen consumer sentiments a little. Although the gap in GDP growth rate between the UK and other Western European economies has narrowed, that with the US, Canada and Australia is still significant because of productivity differentials. The UK compares poorly with other OECD countries in terms of basic literacy and vocational skills, as a result of which there has not been much productivity growth despite significant investments in information technology. The education system is improving but many people drop out of education without getting an apprenticeship for a vocation (OECD, 2004). The investment levels in the UK are moderate, at 17.2 percent of GDP in 2006 (CIA). This is partly the result that industrial growth rate in 2006 was stagnant on the previous year. However, in 2007, economic activity grew on the basis of consumer spending and business services (Bloomberg, 2007). Although the housing market and financial services in the UK are booming, there are fears that global credit market crisis will affect the UK financial markets soon. The housing market has been a major driver of the UK economy for a decade now. The construction sector is still buoyant and rising mortgage rates have not yet affected it. Since 1999, UK households have been deficit spending, implying that they are borrowing in the mortgage market and selling assets to the non-residential sector, mostly corporate entities. With mortgage rates tightening and household prices falling worldwide, the source of growth through this mechanism is limited in the near future. Slackening in the construction sector will also have ramifications in the associate industries like transport. Strategic choices for small and medium businesses In order to create a new strategy successfully, a company needs to study the industry and the competition. It also has to secure commitment to the strategy down the line of executives so that it can be successfully executed. It is often more difficult to execute a strategy than creating it since it may come up with resistance from some quarters. A wide array of managerial skills need to be garnered to make a strategy winning. It is most important to integrate different types of skills across different management levels in a coordinated manner. According to Thompson, Stickland and Gambler (2007), a winning strategy may be executed by uniting the entire organization towards the strategy, generate commitment and enthusiasm and fit the organization towards the strategy. While the top managers take the lead role in designing and executing the winning strategy, all managers, including financial managers, and workers need to take up roles in the process. According to Porter’s (1980) theory, a company has to decide on its winning strategies on the basis of competition in the industry as defined by the five forces: 1) the threat of entry of new competitors (new entrants), 2) the threat of substitutes, 3) the bargaining power of buyers, 4) the bargaining power of suppliers and 5) the degree of rivalry between existing competitors. To enter a new market and thereby evolve a winning strategy, the small business needs to innovate a product. Rogers (1962) defined innovation as a product, service or idea perceived as new by the customer. A small business adopts a type of innovation on the basis of relative advantage, compatibility, observability, trialability and complexity. While adoption is positively relative to the first four factors, the last factor has a negative impact. The innovation is adopted by consumers in five specific phases – by the early innovators who are a small group of people who initiate the innovation, the early adoptors, who are the initial purchasers, early majority and late majority when more customers take to the innovation and laggards who enter into the market at a late stage. In order to execute any of the above strategies, the company has to make an all-out effort gearing the entire organization towards it. Raising funds, monitoring finances to its best uses and payout policies are then no longer internally decided but driven by the wider strategic choices. The main objectives of financial management then are to create wealth for business, generate cash and provide adequate return on risk-bearing investment. For this are required financial planning (for acquiring capital, make payments to staff and fund sales on credit in the short term, to provide for expansion in the medium term and for acquisitions in the long term), financial control in order to secure and efficiently use the assets and financial decision making in terms of mergers & acquisitions and dividend payouts. Often, small and medium businesses continue to operate with financial systems that they have outgrown. Typically, most small businesses begin with installing financial accounting software that is capable to handle small accounts. Once the company outgrows the accounting system, it ends up having multiple accounting packages. In order to create a strategic financial plan, there are four essential stages of financial management as follows (joint-review): Strategic financial planning involves cross-cutting across programs including human resources, investment, asset management and operations. Sources of Funds Perhaps the most serious bottleneck that SMEs face is that of raising funds. Since SMEs lack equity financing and also have limited debt funds, the finance gap that such companies face are often critical. Most SMEs raise the initial funds from friends and family while more funds are available from financial institutions and banks as well as from own savings after two years of operations and after five years of operation, companies rely mostly on debt funds from financial institutions and less on own savings (Hussain et al, 2006). The SMEs can raise debt funds in UK mainly from the four clearing banks (Berry and Jarvis, 2003). On the other hand, there are many European banks that operate in the UK and these can be a source of funds for the SMEs. However, typically the European banks that operate in the UK market deal with medium sized companies and not the small ones. Even the medium sized companies that plan to raise large loans have to have sufficient business projections since European banks lend on the basis of ‘going concern’ principles (Berry and Jarvis, 2003). European banks have a more long term vision and greater business perspective that UK banks. Cash Management Cash management is a means to short term assets and maintain liquidity. Under perfect market assumptions like Modigliani and Miller (1958, 1961, cited in Eiji and Westerman, n.d), companies require to maintain liquid balances only because of market imperfections. Since additional debt or equity funds to pay suppliers and employees involve transaction costs, it is more convenient to hold cash even when it does not earn high interests. The main aim of cash management is to maintain flexibility, liquidity and profitability for which it is essential for the company to develop banking relationships. Increasingly, companies prefer to structure banking operations so that international credit lines synchronize with businesses. As early as the 1980s, MNCs moved towards transaction banking and in the early 1990s, companies tried to reduce the number of banks they operated with. Now, most companies want the banks to tie in transaction prices and quality with flexibility and profitability. Since European banks compete with each other as well as other international banks across the world, banks are offering new products to rope in more and bigger customers. One such mechanism is global account manager within the bank. Cash management services are one important product offered by international banks. For export companies or those that operate in multiple locations, maintaining balances in different locations is expensive for the organization since it involves a large amount of manual work besides interest outflows. Offsetting credit and debit balances eliminates overdraft charges, interest payments on short-term borrowings, minimizing withholding taxes on credit interest. Cash management services provided by global banks are often the chief criterion for the company to select the banking partner (Messner, 2003). Dividend policy A firm’s dividend policy depends on its policy of distributing profits with shareholders. However, the effect of the dividend policy on its shareholders’ value is a controversial topic in financial management. While some theorists postulate that a firm’s dividend outflows decrease (Litzenberger and Ramaswamy, 1979) or increase (Gordon, 1959) the shareholder value, others find dividend policies irrelevant (Miller and Scholes, 1978) for the firm’s value (cited in Holder, et al 1998). In the ultimate analysis, the dividend policy depends on the firm’s strategic choice. The firm’s dividend policies determine whether to re-deploy its profits for its expansion or to pay higher returns to shareholders’ equity. Dividend payout may be of two kinds – cash dividends or share repurchases. The dividend policy is a complex decision for the firm and it determines the financing pattern of a firm’s investment and expansion strategy. A firm can expand its investment by reducing the dividend payout and increasing internal accruals of current profits. On the other hand, a firm might decide to increase dividend payouts when a firm achieves a high growth stage and further expansion may lead to high risks or excess funds. The relationship between a firm’s dividend policy and shareholders’ wealth was first studied by Modigliani and Miller (1961). According to them, dividend payouts simply alter the allocation of funds between the shareholders’ income and capital gains, without affecting the net value. Modigliani and Miller (1961) found dividend policy irrelevant for shareholders’ wealth on the basis of assumptions of perfect capital markets in which there are no transaction costs, rational behavior of economic units, perfect knowledge about firms’ investment policies and cash flows and managers acting on behalf of the firm’s shareholders (Holder et al, 1998). The independence of shareholders’ wealth from the dividend policy will not hold true in the absence of each of these assumptions. For example, Titman (1984) shows that stakeholders other than equity holders have incentives to maximize shareholders’ wealth in order to reduce transaction costs, e.g that of job searches by employees or maintenance costs by customers (Holder et al, 1998). In the real world, shareholders expect higher dividends. In most cases, announcements of dividends are usually followed by favorable sentiments in the share market indicating that shareholders’ are positively affected by higher dividend payouts, irrespective of Modigliani-Miller’s dividend irrelevance theory. This is perhaps because of the simplifying assumptions of the theory that is typically not adhered to. For example, investors do not usually have perfect information about the firm’s intrinsic values. The asymmetry of information exists between the firm’s managers and investors and the release of certain information immediately affects the firm’s share value. Dividend payouts have a signaling effect on the firm’s value in that it indicates that the firm will continue to pay out higher dividends in the future and also will be committed to higher earnings to sustain the dividend payouts. Also, higher dividend also indicates lower free cash flows of the firms, a phenomenon that is favorably accepted by investors in the face of conflict of interest between managers and investors of firms. Free cash flow usually affects the firm’s value negatively since investors perceive it as an indication to financial slack on the part of the managers. In both cases, higher dividend payouts increase the share value and higher shareholder value of the firm (Natti, 2006). According to the stakeholder theory, the firm’s investment decisions like dividend payout ratios affect the operating income (Cornell and Shapiro, 1987). The non-investor stakeholders’ interests affect the firm’s investment decisions through legal relationships like product contracts (product warranties, wage contracts, etc.) that incur explicit costs and other non-contractual relationships that incur implicit costs. Larger the implicit costs, the larger the requirement of firms to sell goods and services. As the firm invests more to meet the implicit costs of non-stakeholders’ claims by reducing dividend payouts, higher is the shareholders’ value through reduction of transaction risks. Such firms that have higher investments to meet non-stakeholders’ claims, however, require higher liquidity since they may need to meet implicit claims any time. Typically, these firms have conservative financing modes with limited debt burdens. Although such firms finance their operations more through equity in order to avoid financial distress brought about through debt, they may limit the dividend payout ratios in order to maintain sufficient liquidity so that cash accruals rather than debt may finance their expansion or regular operations. According to Myers (1984), firms prefer internal accruals related to investment decisions over external financing. Shapiro (1990) maintains that lower dividend payouts signal that the firms are able to meet the implicit stakeholders’ claims. In order to estimate the implicit stakeholders’ claims, Cornell and Shapiro (1987) consider alternate product lines and brands of a firm. There may be exchanges across products and brands of firms in relation to its stakeholders’ claims. For example, if a firm decides to brand all its products under a single category, then the stakeholders’ claims might be higher than it would otherwise be. Stakeholders would then feel that default on any implicit claim would have a higher effect on the firm’s value than it would be on a diversified firm with unrelated lines of business. There is also a line of argument that corporations attract double taxation through the corporate income tax as well as the personal income tax when dividends are paid to investors. Corporate entities are here considered separate entities from investors. While some researchers have argued that “double taxation” of dividends are voluntary payments of corporations and should not be taxed since the organization has already paid corporate tax, proponents of the tax argue that investors could live on dividends without paying any taxes if there was no dividend tax (investopedia). On the whole investors would rather have the corporation plough back the profits rather than receiving dividends if dividend taxes are higher than corporation tax. Conclusion The purpose of financial management has evolved from accounting practices to strategic decision-making in which financial managers have an important role to play in developing a winning strategy for the small or medium business. A company’s winning strategy depends on its competitive advantage as well as the level of innovation. This determines its funds requirements at the initial stages of business as well as during the growth phases. The role of the financial manager then is to effectively raise funds from most cost-effective sources, direct the funds towards the highest return on investments and to monitor the use in terms of plough-back into the company or dividend payouts. For a small or medium business in the UK, where the economy is recovering to a high growth phase, there are immense possibilities of raising funds not only from internal sources but also from European banks. 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