Need to understand SME capital budgeting
Supportive policies need to be developed not only to provide funds to small businesses, but also to help them with liquidity management
The lifeline of any business is finance. The allocation and use of funds – technically known as capital budgeting – is one of the most important strategic decisions of any business. But is this decision different for small businesses compared to large ones? The allocation of capital in small firms is often more important than in large firms – given their lack of access to capital markets – because the funds necessary to correct an error may not be available. In addition, large companies allocate capital to many projects, so that a mistake in one can be offset by success in others.
Although capital investment is a relevant area for small businesses, the majority of studies over the past four decades have focused on the capital budgeting decisions of large companies and similar data does not exist for them. small organizations. As a result, little is known about the capital budgeting practices of small businesses. Given the proportion and importance of small businesses in economies around the world and their continued motivation for more efficient use of resources to stay competitive, there is a definite need for information on the methods used by small businesses. companies to accumulate and allocate their scarce capital.
The small and medium-sized enterprise (SME) sector is the backbone of any growing economy and is recognized as the engine of growth – accounting for around 70 percent of employment and contributing significantly to gross domestic product (GDP ). The contribution of this sector emerges from statistics provided by the Confederation of Indian Industry (CII) which show that it contributes about 6.11 percent to manufacturing GDP and 24.6 percent to GDP for services. In addition, it accounts for 45 percent of India’s total exports and provides jobs for around 120 million people. It manufactures over 8,000 diverse products, ranging from low-tech items to high-tech items. Globally, 99.7% of all businesses in the world are SMEs and the remainder, 0.3%, are large companies.
The SME sector in India accounts for 95 percent of all industrial units. Since this sector is of crucial importance to any economy, good financial management is of the utmost importance for its survival. It is a known fact that financial problems are often a major cause of small business failure. The two major problems, under-capitalization and the difficulty of obtaining external financial support, are often linked to poor budget management. Poor housekeeping and in some cases a lack of proper financial record keeping prevent small businesses from benefiting from traditional lending sources because these businesses cannot demonstrate financial viability.
Many early-stage SMEs underestimate the cost of running a business and therefore fail to manage the cash flow and amount of operating capital required. Several studies have attempted to establish the existence of the association between the performance of SMEs and specific financial practices. Evidence suggests that the financial success of SMEs is positively associated with effective management of financial matters, such as planning, keeping financial records, obtaining external funding, professional financial advice and others. factors.
The theory of capital budgeting is based on certain assumptions such as maximizing shareholder wealth by investing in all projects with positive net present value (NPV) and rejecting those with negative NPV; and access to perfect financial markets, allowing it to finance all valuation projects. However, the applicability of these assumptions to small businesses may be questionable. The principle of separation, which states that investment decisions can be made regardless of the tastes and preferences of shareholders, does not apply to small businesses and small businesses. According to the NPV technique, projects are accepted if the NPV is positive, that is, if the cash outflows are less than the present values of future cash inflows discounted at the company’s cost of capital. However, because stocks of small companies are not easily traded, market-determined discount rates are not appropriate in small companies. One of the most important differences between capital budgeting for large and small businesses is that in the former decisions can be made independently of the shareholders’ perspective, but in the latter it is essential that owners be involved in the decision-making process.
Small businesses also find it difficult to raise funds in the financial markets. In fact, the shortage of equity and long-term funds continues to hamper the growth of SMEs in the country. In addition, research shows that small businesses are unable to access bank loans due to the opacity of their information and the lack of strong banking relationships.
Also, for some small businesses it is not possible to raise funds through a public issue and for others it can be prohibitively expensive. The aforementioned cash constraints encourage small businesses to maintain sufficient cash balances to be ready for any potentially attractive investment opportunity.
Although the SME sector is a major contributor to the overall economy, over the past four decades financial research has limited itself to understanding the capital budgeting techniques preferred by large organizations and has studied the use of capital budgeting. Sophisticated tools like NPV, Internal Rate of Return (IRR), Profitability Index (PI) and simple tools like recovery.
In research conducted on 333 small businesses in India, it became evident that small businesses in the country use less sophisticated methods to analyze potential investments than those recommended by investment budgeting theory. In particular, the survey results show that these companies use discounted cash flow analysis (DCF) less frequently than “gut feeling”, payback period and accounting rate of return.
Although 46 percent of respondents have advanced professional degrees, they may not have financial skills and their small management team may not be competent enough to undertake a capital budgeting analysis. In addition, hiring an external consultant to implement DCF techniques can be costly for small businesses.
Since capital projects are relatively smaller in size, it may not be economical to bear the cost of their analysis. This suggests that small businesses with small projects can make sense when they depend on less sophisticated techniques or the “intuition” of owners. Since small businesses are concerned with basic survival, they tend to be cash-driven and therefore may focus on recovery methods.
Small business owners are also uncomfortable forecasting beyond the immediate future as they face greater uncertainty in cash flow and capital budgeting.
There is a gap between education, government policies and the real world of business. Traditional business training focuses primarily on the financial management of large companies. However, the main focus must now shift to the financial management of small businesses. In addition, favorable policies need to be developed not only to provide funds to small businesses, but also to assist them in the management of funds.
The writer is an associate professor at Amity University, Noida. The opinions expressed are personal.