FINANCIAL MANAGEMENT PRACTICES OF SMALL FIRMS IN GHANA:-

AN EMPIRICAL STUDY.

BY

BEN K. AGYEI-MENSAH

ABSTRACT

The contribution of small firms to the national budget seems to be negligible as a result of

their inability to prepare financial reports. The factors that motivate the sample firms in

the Ashanti Region of Ghana in pursuing sound financial management practices are:

 Pressure from bankers (90%)

 Pressure from external accountants (80%)
 Pressure from providers of capital (70%)
The factors that prevent them from practising sound financial management practices

were:

 Qualified accountants too expensive to maintain (93%)

 Accounting records too difficult to understand (87%)

 Lack of internal accounting staff (73%)

Key Words: Financial management, small business management, small firms,

Ghana.

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BACKGROUND TO THE STUDY

The study is about how financial decisions are taken in the small firms, to identify the

factors that promote or inhibit the application of sound financial management practices,

and how to help them improve on their businesses.

There appears to be little doubt that small businesses do make a large net contribution to

the creation of new jobs compared with large businesses (Birch, 1979). Small firms have

played great roles in the development of various economies of the world. They are

recognized and acknowledged worldwide as vital and significant contributors to

economic development, job creation, and the general health and welfare of economies,

both nationally and internationally.

Financial management involves a wide spectrum of a company‟s financial decisions

(Parkinson C. and Ogilvie J. 1999). It covers areas such as:

(a) Determining the source of finance and dividend policy,

(b) Investment decisions including capital budgeting, assessing capital risk and cost of

capital,

(c) Working capital management,

(d) Managing interest rate and exchange rate risks.

Small firms who form part of the study do not pay dividends and do not have the

capacity to manage interest rate and exchange risks. In view of this the literature

reviewed were those that concentrate on capital budgeting and working capital

management practices in small firms.

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Small businesses defy specific definition hence; there is no generally accepted definition.

Over the years there have been many attempts at defining what constitutes a small

business. Researchers and policy makers, looking for an objective definition of small

business, have used a variety of criteria including: total worth; relative size within

industry; number of employees; value of products; annual sales or receipts; and net worth

Cochran (1981). However, the benchmarks vary considerably. Distinguishing variables

include, total assets, total employees, volume and value of turnover. The 1985 U.K.

Companies Act defined “small company” in respect of financial disclosure as companies

employing 50 or less employees, turnover not greater than £2.8 million and balance sheet

total not greater than £1.4 million. Based on an agency perspective, Ang (1991)

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.

A similar view was taken by Osteryoung and Newman (1993), who 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 any planned

financing.

The ultimate success of a firm‟s operations depends upon sound capital budgeting

decision. Entrepreneurs invest money in their businesses for a reason. The reason,

3
generally, is to receive a return on their precious resources. To test the link between

earnings performance and capital budgeting practices, Christy (1967) used growth of

earnings per share as an indicator of performance, but could not establish a consistent

relationship between earnings performance and capital budgeting practices.

There is little doubt that financial management systems continue to be of significance to

business success. Prior research by Raymond and Magnenat-Thalman 1982, Holmes and

Nicholls 1989, Nayak and Greenfield 1994 and Lybaert 1998 has asserted that the quality

of management accounting information utilized within the small business sector has a

positive relationship with an entity‟s performance.

According to Barrow (2001, p56), there is enough evidence which point to small firms

being inefficient users of working capital. As he puts it, “the smaller they are, the less

efficient they tend to be”. Dodge, Fullerton and Robins (1994) also reported that the

most important internal problems identified by small US firms relate to inadequate

capital, cash flow management and inventory control. In his often quoted research on

small business failure and bankruptcy, Berryman (1983), has also indicated that „poor‟ or

„careless‟ financial management is a major cause of small business failure.

Small business financial management practice is, as evidenced by the number of recent

studies cited earlier on, is a growing area of research. However, the research conducted to

date has been largely exploratory and descriptive in nature, tending to focus on small

samples of businesses in a variety of industries and locations in advanced economies.

Financial management systems have been analyzed for micro businesses of less than 10

4
employees (Nayak and Greenfield, 1994), of less than 20 employees (Holmes and

Nicholls, 1989; Mitchell et al., 1999), focused their attentions on new small businesses.

Though new businesses, with their inherent risk and vulnerability, justify separate study,

there is a need also not to ignore established businesses. Peel and Wilson (1996)

considered small firms within the classification to be used in this study, but were

restricted to only 82 respondents to their questionnaire.

There is currently less theoretical literature pertaining to the capital budgeting decisions

of small firms than there is empirical research. Keasey and Watson (1993), however,

have hypothesized that the factors which influence capital budgeting decisions differ

significantly in relation to small and large firms.

In view of their greater economic significance in relative terms, the capital budgeting

practices of small businesses in North America received considerable early attention from

researchers like (Soldofsky 1964, Luoma 1967, Scott et al. 1982, Grablowsky and Burns

1980). These results underscore the importance of the payback period, and informal

criteria in the evaluation of capital expenditures by small businesses. It is also noteworthy

that Soldofsky (1964) found there was considerable variation in the method of calculation

and use of formal criteria among his survey respondents.

The danger of business failure due to lack of sound financial management practices is

real. Gaskill, L. R., and H. E. Van Auken (1993) have reported that the most internal

problems identified by small US firms relate to inadequate capital, cash flow

management and inventory control. Berryman, (1983) indicated that „poor‟ or „careless‟

financial management is a major cause of small business failure. In addition, a major

5
survey by the Insolvency Practitioner Society, (CIMA 1994) indicated that 20 per cent of

UK corporate failures (the vast majority of which are small firms) were due to bad debts

or poor credit management.

Despite the importance of sound financial management practices to the small firms, it is

perhaps surprising that no previous research has been conducted on the working capital

management practices of small firms in the Ashanti Region of Ghana.

Furthermore, although research has been conducted on the capital budgeting techniques

used by large, medium, and small sized companies as cited by Sangster (1993), Louma

(1967), Grablowsky and Burns (1980), and Peel and Wilson (1986), no previous research

has focused on this aspect of financial management in respect of small firms in a

developing country setting.

METHOD

The mixed-method strategy was adopted for this study to reduce the possibility of

personal bias by not depending on only one method of approach or response coming from

one or few firms.

A mixed-method strategy is one in which more than one method of approach is used in

data collection and analysis while conducting research. This approach is similar to what

Denzin, (1978) described as triangulation.

Semi-structured interview based on open-ended, flexible questionnaires and some

structured interviews were conducted with several groups of people interested or

involved with the small business sector in Ashanti Region. The idea behind this is to

obtain cross-referencing data and some independent confirmation of data, as well as a

6
range of opinions. Inputs from the following groups were solicited: (1) Managers of small

scale businesses; (2) Representatives of banks who give loans to small-scale businesses;

and (3) Accountancy firms who have been auditing the accounts of small scale

businesses.

There are about 3,000 retail firms, employing 20 or less employees in the Ashanti Region

of Ghana. Considering the topic for the study, all the 3,000 firms constitute the

population for the study.

Much as the researcher would have liked to work with the entire population, he was

prevented from doing so as that would have been too difficult to handle effectively

considering the fact that this is an exploratory study. As a result 800 firms selling general

goods like, clothing, electrical and plumbing materials were selected to serve as the

sample population. The sample was selected from small retailers in the following towns

in Ashanti Region: 300 from Kumasi (Paul Sagoe lane and Adum), 100 from Bekwai,

100 from Mampong, 100 from Konongo, and 200 from Obuasi.

These traders were selected as they form the majority of small firms operating in the

Region. Most of the small shop owners started from humble beginnings with capital less

than ¢100,000 as „shoe shine‟ boys and „table top‟ traders. As their capital levels

improved they acquired bigger shops to operate their businesses.

The validity and reliability of any research data depend to a large extent on the source

and technique used in collecting the data.

A questionnaire eliciting details on, inter alia, capital budgeting and working capital

practices were mailed to the owner/managers of 800 firms selected randomly. The

7
accompanying letter asked for comments on the questionnaire and requested an interview

or telephone conversation.

Since most of the respondents did not have finance background the researcher had to

explain most of the technical terms to help in obtaining the appropriate responses. To

prevent a situation whereby some of the respondents will try to hide information the

researcher visited each to examine some of the documents requested for. Documents like

profit and loss accounts, balance sheets, cash flow statements and business plans were

examined. During the visits to the respondents, opportunity was taken to observe how

things were done in the various shops.

Telephone conversations and interviews were held with Chartered Accountants and

officials from the National Board for Small Scale Industries and bank officials to

collaborate the responses. These interviews ensured the establishment of rapport and

permitted greater depth and probing of some personal views. This helped in obtaining

more complete data. The data were gathered during the period 13th March to 29th May

2006. On the average each interview lasted 2 hours.

Out of the 800 sample firms, 280 responded to the questionnaire, giving a response rate

of 35%. However, given the nature of small firms and the low response usually

associated with most mail surveys, this response rate may be considered reasonably

adequate for an exploratory study. Three of the responses received were not usable due to

incomplete data. The rest of the responses from 277 firms were used in this study.

8
SUMMARY OF FINDINGS

The main findings of the study are discussed below;

The majority of employees of the firms studied are family members. They were not

recruited through the normal process hence they were not offered any written contract of

employment.

The owner/managers did not receive salaries at the end of the month as they do not

classify themselves as employees.

With the recent high interest rates being charged by the banks it will be in the small

firm‟s own interest if they can finance capital projects from retained earnings. Despite

these difficulties with bank credit 36% of the firms studied still go in for the loans as they

have no other alternatives.

The fact that 36% of the respondents raised funds from friends and family members

confirms what Osei, et al (1993) found in their study under the title, “The impact of

structural adjustment on SMEs in Ghana”. Some complained bitterly that they expected

their children who they supported to travel abroad for their education on completion will

remit them to finance their capital projects but have refused to do so. Thus, only 4% of

the respondents received support from the relations abroad.

Working Capital management practices

9
Working capital is the capital available for conducting the day-to-day operations of an

organisation. It is often defined simply as “current assets less current liabilities”.

Working capital is essential to a firm‟s long-term success and development, and the

greater the degree to which the current assets cover the current liabilities, the more

solvent the company.

Berryman, (1983) indicated that „poor‟ or „careless‟ financial management is a major

cause of small business failure. In addition, a major survey by the Insolvency

Practitioner Society, (CIMA 1994) indicated that 20 per cent of UK corporate failures

(the vast majority of which are small firms) were due to bad debts or poor credit

management. According to Peel, M. J., and Wilson, N. (1994), “if the financial/working

capital management practices in the small firm sector could be improved significantly,

then fewer firms would fail and economic welfare would be increased 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 10% of respondents claimed that they never used

cash budgeting, whereas 33% used cash budgeting „very often‟. 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. In Anvari and Gopal (1983)‟s

study, only 26 percent of the respondent to the survey said they used formal techniques to

determine the level of their cash

10
In order to reduce the debtor days to a more respectable figure companies will offer

customers inducements, in the form of cash discounts. These discounts may well speed

up collection but reduce the amount from each sale when collected. Credit management

thus involves balancing the benefits to be gained from extending credit to customers

against the costs of doing so, and finding the optimum level of credit and discounts which

will maximize the firm‟s profits.

To have a good credit management a firm should assess the credit risk of its customers.

This involves giving consideration to having a credit control policy and following the

procedures.

The study found that 64% of the firms reviewed their debtors‟ credit period with 8%

reviewing it very often. However, a smaller proportion (60%) reviewed their debtors‟

discount policy, and only 10% reviewed it very often. Seventy-eight per cent (78%)

claimed that they never reviewed bad and doubtful debts and only 35% of respondents

claimed their firms never reviewed their customers‟ credit/risk standing. Bad debts can

be major problem to small businesses, especially in the current economic climate where

margins may already be squeezed and the high inflation rates may add salt to injury.

Firms that provide most or all goods or services on credit to more or all of their

customers are likely to experience bad debts situation on a large scale. Thus it is not

unusual for a major customer‟s downfall to cause the insolvency of its suppliers by not

paying outstanding debts.

The study found that a high proportion (98%) of firms stated that they had never used

factoring services. This confirms the fact that, factoring is not popular in small firms.

This is similar to what Grablowsky and Rowell (1980) found in their study conducted in

11
Virginia. In that study only 30% of respondents used credit reporting services such as

Dun & Bradstreet. With reference to stock control, the study found that only 20% and

40% used the economic order quantity model and reviewed their reorder levels. In

Grablowsky and Rowell (1980)‟s study; only 6% used the economic order quantity for

optimizing inventory.

The study found that 68% of respondents financed recent capital investment projects

using loans from banks and friends. Even though taking loans and overdrafts are accepted

forms of corporate finance, too much reliance will greatly affect the survival of the small

firms.

The responses revealed that all the firms (100%) were pursing the objective of

“increasing profitability”. On the basis of these findings, smaller firms appear to be

pursuing similar objectives to their larger counterparts. The theory of company finance is

based on the assumption that the objective of a firm is to maximize the wealth of its

owners.

Capital Budgeting practices.

Banks normally will finance projects with following characteristics:

i. Shorter pay back periods,

ii. Higher returns on capital employed

iii. A positive net present value (NPV), implying that future cash flows from

the project under review, expressed in their present value terms using an

appropriate interest rate was positive, implying profitability of the project

under review.

12
 iv. A positive internal rate of return (IRR) of the project, implying that the

rate at which the project generates funds, relative to the cost of capital is

positive.

Turning to the capital budgeting techniques used by the firms in the study, only (36%)

of respondents indicated that they have ever used the pay back method. The other capital

budgeting techniques; Accounting rate of return (ARR), Discounted cash flow [including

Net present value(NPV), and Internal rate of return (IRR)], none of the respondents have

ever used them.

Factors promoting and inhibiting financial management practices

The importance of analyzing past corporate financial statement in the investment

decision-making process cannot be over-emphasized. A financial statement highlights

the previous financial performance of a business and gives a broader picture of the

financial capability of the borrower and the manner the business‟ finances have been

managed.

None of the respondents have ever used computers to prepare their accounts. The

availability of affordable computers and suitable software has played an important part in

promoting the practice of sound financial management.

Stuart McChlery, et al, (2004)‟s study also identified the use of computerized accounting

system as a major factor in promoting sound financial management system.

The firms that prepared monthly management accounts were motivated to do so due to

the following factors:

13
 1. Pressure from bankers (90%) It is interesting to note that the study revealed

that most firms prepare financial statements when they have to support their

loan applications with these statements.

2. Pressure from external accountants/auditors (80%): The external

accountants are normally approached by these small firms to help prepare

financial statements like, cash flow and income statements to help in the

filing of their tax returns.

3. Pressure from providers of capital (70%): About 70% of the firms studied

received financial support from their relations living outside the country and

one of the conditions which they have to fulfill to be able to attract such

support is to furnish these people their annual financial statements.

Even though all the respondents stated that they have employed internal accounting staff

60% do not prepare management accounts at the end of the month. The factors that

inhibit the preparation of monthly management accounts were:

 Qualified accountants too expensive to maintain (93%). To these respondents

they are scared by the consultancy fees qualified accountants charge their clients.

The qualified accountants also complain that these small firms have poor

payment culture despite the fact that they spend a lot of time when it comes to

the auditing of small companies.

 Accounting records too difficult to understand (87%). The lack of accounting

knowledge on the part of owner/managers account for this situation.

14
  Lack of internal accounting staff (73%). The inability of these small firms to

pay good salaries to their employees makes it very difficult to attract qualified

accounting staff.

The lack of internal accounting staff as an inhibiting factor for the practice of sound

financial management system collaborates with the findings of Stuart McChlery, et al

(2004).

From the discussions that the researcher had with stakeholders like, bank managers and

chartered accountants based on the responses from the study, it came to light that

accounting is generally not viewed as a core part of many businesses hence these small

firms tend not to employ qualified finance personnel. Most of these small firms assume

they are saving money by employing cheap labour to carry out accounting functions.

The practicing accountants the researcher talked to also confirmed that most small firms

come to them when they have to present financial statements and cash flow to their

bankers to support their loan applications.

The hypothesis that; „owner/managers of small firms who have good educational

background tend to practice sound financial management as they appreciate its

importance‟, has not been supported by evidence from the study. This is because all the

owner/managers who were university graduates did not prepare any form of management

accounts. Thus there is no relationship between the educational background of

owner/managers and the use of financial management practices.

15
Considering the importance of efficient management of cash by small firms, it is not

surprising that only 10% of the respondents claimed they never used cash budgeting,

where as 33% used cash budgeting „very often‟. However, most of them still keep large

cash balances in their bank accounts which do not earn any interest.

Sixty four per cent of the firms reviewed their debtors‟ credit period with 8% reviewing it

very often. However, a smaller proportion (60%) reviewed their debtor‟s discount policy

and only 10% reviewed it very often.

The study revealed that the three most influential factors which compel the sample firms

to pursue sound financial management practices were:

 Pressure from bankers (90%) It is interesting to note that the study revealed that

most firms prepare financial statements when they have to support their loan

applications with these statements.

 Pressure from external accountants/auditors (80%): The external accountants are

normally approached by these small firms to help prepare financial statements

like, cash flow and income statements to help in the filing of their tax returns.

 Pressure from providers of capital (70%): About 70% of the firms studied

received financial support from their relations living outside the country and one

of the conditions which they have to fulfill to be able to attract such support is to

furnish these people their annual financial statements.

The most influential factors that account for the inability of the sample firms to pursue

sound financial management practices were:

 Qualified accountants too expensive to maintain (93%). To these

respondents they are scared by the consultancy fees qualified accountants

16
 charge their clients. The qualified accountants also complain that these

small firms have poor payment culture despite the fact that they spend a lot

of time when it comes to the auditing of small companies.

 Accounting records too difficult to understand (87%). The lack of

accounting knowledge on the part of owner/managers account for this

situation.

 Lack of internal accounting staff (73%). The inability of these small firms to

pay good salaries to their employees makes it very difficult to attract

qualified accounting staff.

 The business is too small (73%). Some owner/managers feel it is only big

firms that have to keep proper books of account and prepare financial

statements regularly. This is an erroneous impression which should be

discarded as the survival of their businesses depends on practicing sound

financial management.

The study shows that 68% of the respondents financed recent capital projects from loans

from banks and friends. This implies that these firms are not able to generate enough

funds internally to finance capital projects. Some of them who were expecting support

from their children working abroad were highly disappointed as these kids did not assist

them.

The fact that 36% of the respondents raised funds from friends and family members

confirms what Osei, et al (1993) found in their study under the title, “The impact of

structural adjustment on SMEs in Ghana”.

17
Seventy-two per cent (72%) of the firms studied stated that their bankers have been fair

in the last two years by passing on reductions in interest rates to their businesses.

Seventy six percent (76%) also stated that they are satisfied with the services being

provided by their bankers hence they do not have the intention of replacing them.

The popularity of payback as an investment evaluation method continues to grow, as is

evidenced in this study, despite its known drawbacks. While academicians unanimously

condemned the use of the pay back as misleading and worthless in reaching investment

decisions, it continues to flourish as the most widely applied formal technique. The

problem with the use of the pay back method as an investment evaluation method is that

all cash flows with the payback period are given equal weight. Also cash flows outside

the payback period are ignored and it is very difficult to determine how long the payback

period should be. Only (36%) of the respondents indicated that they have ever used the

pay back method. These firms used the pay back method because the information

presented to them is easy to understand.

The other capital budgeting techniques like Accounting rate of return, Discounting cash

flow and internal rate of return have never been used by the firms studied. Thus the

findings of the study run contrary to earlier studies done in US by Luoma (1967) and

Grablowsky and Burns (1980). In Luoma‟s study 63% used the pay back method, 30%

used the accounting rate of return and 22.2% used the discounted cash flow method.

The differences in the results may be due to cultural factors. This is because most

owner/mangers of small businesses in the US are literate and thus understand the use of

18
these capital budgeting techniques. The availability and use of qualified finance

personnel in the developed economies contribute significantly to the use of these

advanced capital budgeting techniques.

Unlike his counterpart in the advanced economies, the owner/managers of the small firms

studied do not have access to qualified finance personnel as they cannot afford to pay

them well.

From the findings of the study enumerated above the following conclusions can be made.

CONCLUSIONS:

In theory, the same general principles of financial management apply to small firms as

they do to large firms.

Small firms do not follow the right procedure when engaging their staff. All the firms

studied even though have employed people they did not give them any appointment

letters when they were first engaged. This practice runs contrary to the labour law and

should be discouraged.

From the above findings it can be concluded that left on their own the owner/managers of

the sample firms will not prepare any management accounts. For a profit making entity

the main strategic objective is to maximize share holder wealth. This means achieving

the maximum profit possible consistent with balancing the needs of the owners. The

profits made by an entity can only be measured by preparing financial statements. Thus

19
it will be very difficult for the owner/managers of the small firms studied to be able to

compute their profits when they do not prepare financial statements.

Sound financial management is essential to the success of a business. Successfully

managing financial resources is important in new as well as expanding businesses, so

time should be taken to develop and implement financial plans that will ensure the

success of small firms.

The action and inactions of owners of small firms could also act as significant barriers to

the development of sound financial management systems. The lack of understanding of

accounting information presented in the form difficult to understand could act as barriers

in implementing sound financial systems.

The findings of this study collaborates to a greater extent with the findings of previous

research done in U.K. by the Chartered Institute of Management Accountants (CIMA),

by revealing that there are factors which influence the small firms to either pursue sound

financial management practices or do otherwise. The factors which apply in the U.K. are

different from those that apply to small firms in Ghana.

Because small firms are much less likely to employ accountants it was not surprising to

note that none of the respondents did ever us the more sophisticated capital budgeting

techniques like discounted cash flow. It is not advisable to use the pay back on its own

for investment appraisal and it should be combined with at least one other technique,

20
preferably, based on discounted cash flow procedures, to ensure that all project returns

are taken into account.

The inability of small firms to make use of Computerized accounting systems also act as

a barrier to the successful implementation of sound financial management practices.

A study of Ghana‟s economic history shows that most small firms collapse on the death

of the owner/managers. This results from the fact that whilst these owner/managers were

alive they did not have any succession plan in place for the continuance of their

businesses. Some do not even allow their employees know their major suppliers as they

think their employees may take their businesses from them if they are allowed to have

contact with their major suppliers. Thus lack of faith in employees of these small firms

has contributed significantly to the low survival rate of these small firms.

There is a thin line between tax avoidance and tax evasion. A significant number of

small businesses are bent on paying little or no taxes and sometimes put pressure on

auditors and accountants to comply with their wishes. Qualified accountants engaged by

small firms should exercise great caution not to compromise their professional integrity

to assist these firms to evade the payment of taxes. This is crucial as most of these

accountants double as accountants and auditors to these small firms and the temptation to

compromise on their professional integrity is so great.

Professional accountants engaged in providing services to small firms should charge

reasonable fees to enable these companies use their services. The inability of these small

21
firms to pay the high fees charged by qualified accountants is often cited as the main

reason why these companies avoid using their services. The qualified accountants should

not also use the small fees being recommended to cut corners in the services provided to

the small firms.

As stated in earlier on, this is an exploratory study, the prime objective of which is to

encourage further research. Future researchers could also consider an area such as; the

relationship between firm size, finance and financial management practices and the

relationship between these factors and firm performance.

About the author;

Ben K. Agyei-Mensah, [ B.Ed (Hons.);Dip. Econs; MBA, ACMA]; is a lecturer in
Accounting and Finance at the Christian Service University College, Kumasi, Ghana.
He is a chartered management accountant and currently at the dissertation stage of
Doctorate of Business Administration (DBA) programme with SMC University of
Switzerland.
e-mail: [email protected].

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