Financial management and profitability of small and medium enterprises

Transcription

1 Southern Cross University Theses 2001 Financial management and profitability of small and medium enterprises Kieu Minh Nguyen Southern Cross University Publication details Nguyen, KM 2001, 'Financial management and profitability of small and medium enterprises', DBA thesis, Southern Cross University, Lismore, NSW. Copyright KM Nguyen 2001 is an electronic repository administered by Southern Cross University Library. Its goal is to capture and preserve the intellectual output of Southern Cross University authors and researchers, and to increase visibility and impact through open access to researchers around the world. For further information please contact

2 A THESIS SUBMITTED TO THE GRADUATE COLLEGE OF MANAGEMENT IN PARTIAL FULFILLMENT OF REQUIREMENTS FOR THE DEGREE OF DOCTOR OF BUSINESS ADMINISTRATION AT SOUTHERN CROSS UNIVERSITY, N.S.W., AUSTRALIA

3 Certificate I certify that the substance of this thesis has not already been submitted for any degree and is not currently being submitted for any other degree or qualification. I also certify that, to the best of my knowledge, any help received in preparing this thesis, and all sources used have been acknowledged in this thesis. Signature: Kieu Minh Nguyen Date: ii

4 Acknowledgements I owe a debt of gratitude to many people who helped me complete this thesis. I would like to acknowledge the help of all. First of all I would like to express my deepest acknowledgement to my supervisor, Professor Geoffrey Grant Meredith from the Graduate College of Management (SCU), for his valuable advice and recommendations. I acknowledge Dr. Lyndon Brooks, his assistants from the Graduate Research College (SCU), and Mr. Tho Dinh Nguyen from the School of Marketing (UTS) for their support with statistical techniques and data analysis. I also acknowledge Ms. Rosemary Graham from the International Office (SCU) for her comments on English in earlier drafts of my thesis. In the process of data collection for this research, many people contributed to the task and I am particularly grateful for their contributions. I am greatly indebted to Dr. Pham Van Nang, Dr. Le Bao Lam, and Dr. Le Thanh Ha from Ho Chi Minh City University of Economics for their introduction to contacts with the small and medium enterprises (SMEs) community located in Ho Chi Minh City. I also wish to thank Mr. Nguyen Trong Hanh, Vice Director of Department of Taxation, Mr. Du Quang Nam, Vice Director of Statistical Office Ho Chi Minh City; and Mr. Tran To Tu, Managing Director of Investment Consulting Corporation for providing secondary data related to the current practices of SMEs in Vietnam. I would like to thank the following organizations which supported me in completing my thesis and degree: the Swiss Agency for Development and Cooperation (SDC), the Swiss AIT Vietnam Management Development Program (SAV), the Mekong Project Development Facility (MPDF), the Small and Medium Enterprise Promotion Centre (Vietnam Chamber of Commerce and Industry VCCI), HCM City University of Economics, HCM City Statistical Office, HCM City Department of Investment and Planning, HCM City Department of Taxation. Specially, I would like to extend my sincere gratitude to the Government of Switzerland and Dr. Hans Stoessel, Director of SAV for granting the scholarship which enabled me to participate in a doctoral degree at Southern Cross University, New South Wales, Australia. iii

5 I would particularly like to thank the following friends for their support related to data collection: Mr. Doan Thanh Tuan, Ms. To Ngoc Huong, and Mr. Bui Hai Binh from Truong Doan Company Limited, Mr. Hoang Trong from Ho Chi Minh City University of Economics, Mr. Vo Sy Nhan from Ho Chi Minh City Department of Investment and Planning, and all my students who worked as fieldworkers for data collection. Finally, to my parents and my wife, I wish to extend my loving thanks for their encouragement. My greatest debt of gratitude is to my wife, Mrs. Que Thi Tran, who was patiently waiting me during my study in Australia. This thesis could not have been written without her daily encouragement. iv

6 Abstract After a decade of reforming policy, building and developing the multi-sector market economy, Small and Medium Enterprises (SMEs) in Vietnam have developed strongly and contributed to creating employment, increasing GDP, and raising the nation s volume of exports. However, SMEs have found difficulties on the way to development due to lack of management experience and financial resources, and due to uncertainty within the business environment. As a result, SMEs often faced obstacles during their operations. This thesis examines the relationship between financial management and profitability of SMEs to determine whether financial management practices and financial characteristics impact on SME profitability. Objectives of the thesis are (1) to investigate and describe features of financial management practices and financial characteristics of SMEs in Vietnam, (2) to develop and test a model of SME profitability, and (3) to contribute knowledge of the relationships between financial management and characteristics to improve SME profitability by using tools of efficient financial management. In terms of structure, the thesis has six chapters. The thesis begins by defining the research problem and questions, and providing a justification for the research study. Chapter one also reviews the research background, and presents definitions of terms, significance and scope of the study. Chapter two examines the economic background, business structure and the development of SMEs in Vietnam. This chapter also reviews previous research related to financial management for SMEs in Vietnam to identify gaps between financial management for SMEs in Vietnam and financial management for SMEs worldwide. Chapter three reviews financial management including financial management practices, financial characteristics and profitability of SMEs around the world, especially in the developed economies such as the United States of America (USA), the United Kingdom (UK), Australia and Canada. This review emphasizes profitability and the impact of financial management practices and financial characteristics on SME profitability. Objectives of this chapter are to review previous research related to the areas of financial management practices, financial characteristics, and profitability of v

7 SMEs and to build a model of the impact of financial management practices and financial characteristics on SME profitability. Chapter four discusses aspects of the research methodology including research design, data collection and data analysis methods, and hypothesis testing to support the model. Objectives of this chapter are: (1) to justify the research methodology of this study, (2) to explain research methodology used in the study, and (3) to demonstrate how research design, and data collection and analysis can be utilized in this study to answer the research questions outlined in the chapter 1. Data analysis and findings are presented in chapter five. This chapter presents descriptive findings of financial management practices, financial characteristics and SME profitability and findings of the research study related to testing the model of SME profitability. Objectives of this chapter are (1) to systematically present the descriptive findings of the research study, (2) to interpret significance of these findings based on data analysis, (3) to present the results of testing the model of SME profitability, and (4) to explain how the model, developed from a literature review, was supported by data analysis. Finally, the thesis ends with chapter six where conclusions are summarized and applications of the research findings are indicated for the financial management practitioners. The 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 research study provides many implications for financial management practices and contributes to knowledge of financial management of SMEs. The model of SME profitability can be used as guidance for actions to improve the profitability of SMEs in Vietnam. vi

8 Glossary of terms and abbreviations AFTA ANOVA APEC ASEAN CED CF CUR DER E.q EBT EBIT EFF EOQ FAIS FALP FDI FSSB GDP GSO IFC IRR MIRR MPDF NOI NPV PRO RE ROA ASEAN Free Trade Agreement Analysis of variance Asia Pacific Economic Cooperation Association of South East Asian Nations Committee of Economic Development Cash flows Current ratio Debt ratio Equation Earning before tax Earning before interest and taxes Efficiency of financial management practices Economic order quantity Financial and accounting information system Fixed asset management and long-term planning practices Foreign direct investment Financial Studies of the Small Business Gross domestic products General Statistical Office International Financial Corporation Internal rate of return Modified internal rate of return Mekong Project Development Facilities Net-operating-income Net present value Profitability Retained earnings Return on assets vii

9 ROE Return on equity ROI Return on investment ROS Return on sales SBA The Small Business Administration (United State of America) SBV The State Bank of Vietnam SME Small and medium enterprise SMENET Small and Medium Enterprise Net SPSS The Statistical Package for Social Science TA Total assets TAT Total asset turnover UK United Kingdom USA United States of America USM Unlisted Securities Market VCCI Vietnamese Chamber of Commerce and Industry VIDB Vietnam Investment and Development Bank VN Vietnam VND Vietnam dong Vietcombank Vietnam Bank for Foreign Trade WTO World Trade Organization WCSP Working capital management and short-term planning practices viii

10 Table of Contents CERTIFICATE... ii ACKNOWLEDGEMENTS... iii ABSTRACT... v GLOSSARY OF TERMS AND ABBREVIATIONS... vii TABLE OF CONTENTS... ix LIST OF TABLES... xiii LIST OF FIGURES... xvii CHAPTER ONE: INTRODUCTION TO THE STUDY 1.1 INTRODUCTION RESEARCH BACKGROUND RESEARCH PROBLEM Research questions Research objectives METHODOLOGY JUSTIFICATION FOR THE STUDY DEFINITIONS OF TERMS USED IN THE STUDY SIGNIFICANCE AND SCOPE OF THE STUDY ANALYTICAL MODEL FOR THE STUDY STRUCTURE OF THE STUDY CONCLUSIONS...16 CHAPTER TWO: THE ECONOMIC STRUCTURE AND SMEs IN VIETNAM 2.1 INTRODUCTION VIETNAM: BACKGROUND INFORMATION Overview of the country The Vietnam economy The Vietnam population and labour VIETNAM BUSINESS STRUCTURE Types of business in Vietnam Overview of enterprises in Vietnam Small and medium enterprises in Vietnam Policies for supporting SMEs...50 ix

11 2.4 SMALL AND MEDIUM ENTERPRISE FINANCE IN VIETNAM Types of finance Use of finance Financial management for SMEs Problems in financial management BUSINESS STRUCTURE AND SMEs IN HO CHI MINH CITY CONCLUSIONS...58 CHAPTER THREE: FINANCIAL MANAGEMENT AND PROFITABILITY OF SMEs 3.1 INTRODUCTION DEFINITIONS OF SMEs Qualitative definitions Quantitative definitions The forms of ownership of SMEs FINANCIAL MANAGEMENT FOR SMEs Defining financial management Objectives of financial management Major decisions of financial management The specific areas of financial management FINANCIAL MANAGEMENT PRACTICES The context of financial management practices Accounting information systems Financial reporting and analysis Working capital management Fixed asset management Capital structure management FINANCIAL CHARACTERISTICS OF SMEs Identifying financial characteristics Measuring financial characteristics Previous findings related to financial characteristics SME PROFITABILITY Importance of profitability Defining and measuring profitability Factors influencing profitability RELATIONSHIPS BETWEEN FINANCIAL MANAGEMENT AND SME PROFITABILITY MODEL OF THE IMPACT OF FINANCIAL MANAGEMENT ON SME PROFITABBILITY x

12 3.9 CONCLUSIONS CHAPTER FOUR: RESEARCH METHODOLOGY 4.1 INTRODUCTION APPRAISAL OF PRIOR RESEARCH METHODOLOGIES RESEARCH DESIGN Classification of research design Selecting research design or paradigm Selecting research methods or techniques VARIABLE DEFINITIONS, SURVEY INSTRUMENT AND MODEL DEVELOPMENT Variable measurements and survey instrument Model development Hypothesis statements DATA COLLECTION METHODS Secondary data collection Primary data collection DATA TRANSFORMATION DATA ANALYSIS METHODS General consideration Descriptive statistics Bivariate analysis Multivariate analysis CONCLUSIONS CHAPTER FIVE: DATA ANALYSIS AND FINDINGS 5.1 INTRODUCTION LINKS BETWEEN DATA ANALYSIS AND RESEARCH OBJECTIVES AND QUESTIONS DESCRIPTIVE FINDINGS OF THE RESEARCH STUDY Sample descriptions and SME characteristics Descriptive findings of financial management practices Descriptive findings of financial characteristics Descriptive findings of profitability of SMEs ASSOCIATIVE ANALYSIS AND FINDINGS OF THE RESEARCH STUDY Factor analysis and principal components of financial management practices Bivariate analysis and findings Multiple regression analysis and findings xi

13 5.4.4 Test for the difference of average profits between efficient and inefficient financial management groups of SMEs CONCLUSIONS CHAPTER SIX: CONCLUSIONS AND IMPLICATIONS 6.1 INTRODUCTION CONCLUSIONS RELATED TO RESEARCH QUESTIONS AND TESTING THE MODEL Conclusions related to financial management practices Conclusions related to financial characteristics Conclusions of SME profitability Summary of research question answers IMPLICATIONS OF THE RESEARCH STUDY Implications for financial management practices of SMEs Contributions to knowledge of this research into financial management for SMEs LIMITATIONS OF THE RESEARCH STUDY IMPLICATIONS FOR THE FURTHER RESEARCH Bibliography Appendix 1 Appendix 2 Appendix 3 Appendix 4 xii

14 List of tables Table Page 2.1 Changes in economic structure, State-budget revenue, State-budget revenue, Financial institutions in Vietnam, GDP index by economic sector and rate of inflation Index of exchange rate of USD/VND GDP index by economic industry Agriculture development over the years Industry development over the years Export and import value by major countries Population by sex and areas Population growth rates and structure Labor force by economic sector Labor force by the state and non-state sector Unemployment rate of labour force in Number of businesses by economic sector and average capital Number of businesses and employees on July 1, Definitions of SMEs in Asian countries Number of enterprises in manufacturing industry by scale of employees and total capital Business operation problems of SMEs in Vietnam The kind of SME support programs Some financial characteristics of SMEs in Vietnam Business structure of SMEs in Ho Chi Minh City Size of businesses in Ho Chi Minh City Summary of the quantitative definitions of small business Forms of SME ownership in the USA Legal status of small firms in the UK...66 xiii

15 3.4 Summary of advantages and disadvantages of each form of ownership Responsibility for the bookkeeping and accounting task Responsibility for preparation and use of financial information The results of survey of computer software application The most important applications of computer software The most important applications of computers Percentage of awareness and utilization of costing systems Evaluate the adequacy of accounting records Accounting information prepared externally or internally Summary of research areas related to the accounting system practices of SMEs Use of financial statement techniques by small manufacturers in Quebec Responsibility for financial statement interpretation Proportion of respondents indicating use of selected financial ratios Percentage of use of financial ratios Percentage of preparing accounting information both internally and externally Summary of the main research areas related to the financial reporting and analysis Cash surplus investment practices Instruments of short-term investment used Awareness and utilization of credit control systems Methods used by small and large enterprises to determine inventory level Working capital management: Frequency (%) of using or reviewing Summary of working capital management practices Percentage of firms using capital project selection methods The extent of use of formal methods of the capital investment evaluation Primary method of investment analysis Percentage use of different methods by small, medium, and large enterprises Percentage of kinds of screening rate used to evaluate the capital projects Methods of determining the required rate of return as using discounted cash flow Summary of fixed asset management practices Viewpoint guiding firms financing decisions Factors influencing percentage of bank debt usage xiv

16 3.35 Summary of literature review of financial characteristic variables Summary of measurement of financial characteristic variables Financial ratios used in the study of Meric and Meric (1997) Comparison of liquid ratios between Korean and USA firms Summary of measurement of SME profitability Classification of research designs Summary of advantages and disadvantages of the most typical surveys Model classification Number and percentage of SME sample and population Summary of multivariate techniques for the analysis of dependence Structure of SMEs in the sample by type of industry and form of ownership Sample distribution by form of ownership within industry Business characteristics of SMEs in the sample Characteristics of accounting system organization Responsibility accounting information system Using computer in accounting information system Kinds of financial statements prepared Frequency of preparing and analyzing financial statements Responsibility preparing and analyzing financial statements Kinds of financial analysis and ratios used Preparing cash budgets Cash balance determination Cash surplus or shortage Sales on credit and credit polices Frequency of reviewing receivable levels and bad debts Percentage of bad debts compared to sales Frequency of reviewing inventory levels and preparing inventory budgets Basis of determining inventory levels and using EOQ Model Frequency of evaluating investment projects and reviewing efficiency of using fixed assets after investing Methods used to evaluate investment projects xv

17 5.21 Frequency of preparing and reviewing financial budgets Kinds of financial budgets prepared Responsibility preparing financial budgets Frequency of comparing between budgeted and actual results Descriptive statistics of financial ratios Test for difference of means of financial ratios between two groups Comparison of current ratios Descriptive findings of SME current ratios Descriptive findings of SME debt ratios Descriptive findings of SME activity ratio Overview of SME profitability Relationship between profitability and types of business Relationship between profitability and business characteristics Total variance explained and three principal components of financial management practices Factor analysis results for measuring financial management practices Three principal components of financial management practices Correlation matrix of PRO, ROS, ROA, and ROE Correlation matrix of PRO and independent variables Correlation matrix of ROS and the independent variables SME profitability regression model using profitability as dependent variable Descriptive finding of relationship between profitability and current ratio Relationship between SME profitability and the efficiency of financial management practices Regression model of SME profitability after removing debt ratio SME profitability regression model using return on sales as dependent variable Descriptive statistics of profitability of two groups of SMEs Independent group test of mean profit difference Summary of conclusions related to financial management practices Summary of conclusions related to financial characteristics of SMES Summary of research questions and answers xvi

18 List of figures Figure Page 1.1 Structure of chapter Fields of the research problem Analytical model for the research Structure of the study Structure of chapter Political structure of Vietnam Business structure in Vietnam Breakdown of business by size SME financial management practices and the gap Structure of chapter The central position and role of financial management The relations among objectives of financial management A model of financial management Interaction between theories and practices of financial management Financial ratios linked to return on equity Model of the impact of financial management on SME profitability Structure of chapter Survey instrument for measuring accounting information system Survey instrument for measuring financial reporting and analysis Survey instrument for measuring cash management practices Survey instrument for measuring receivable management practices Survey instrument for measuring inventory management practices Survey instrument for measuring fixed asset management Survey instrument for measuring financial planning Analytical model for the research study Structure of SMEs in Vietnam and the target population A classification of multivariate methods xvii

19 5.1 Structure of chapter Distribution of sample by industry Distribution of sample by ownership Relationship between profitability and debt ratio Structure of chapter The revised model of SEM profitability xviii

20 Chapter One: Introduction to the Study 1.1 INTRODUCTION This chapter provides a general introduction to the research study. The purpose is to establish foundations for following chapters and the study as a whole, by providing a general picture of the study. This chapter is structured into ten sections as presented by figure 1.1 (page 2). Section 1.1 provides a general introduction to the chapter and section 1.2 examines the research background where the research problem is identified. Section 1.3 defines the research problem, presents a statement of the problem and expands the research problem in two subsections and Subsection addresses the research questions that will be respectively answered in chapters of the study. Subsection presents research objectives that the study covers in the process of solving the research problem defined. Section 1.4 briefly discusses the general aspects of research methodology such as selecting from alternative types of research and research design, whereas the details of research methodology will be discussed in chapter 4. Section 1.5 provides some justifications for the study including the rationale and arguments for the study. Section 1.6 explains the context of specialized terms used in the study and section 1.7 points out the significance and scope of the study. Section 1.8 presents the analytical model of the study fully developed in chapter 3. Section 1.9 describes overall structure of the thesis, and finally section 1.10 summarizes conclusions drawn from the research. Figure 1.1 provides a visual representation of the structure of the chapter.

21 Chapter One: Introduction to the Study Figure 1.1: Structure of chapter Introduction 1.2 Research background 1.3 Research problem Research questions Research objectives 1.4 Methodology 1.5 Justification for the study 1.6 Definitions of terms used in the study 1.7 Significance and scope of the study 1.8 The analytical model for the study 1.9 Structure of the study 1.10 Conclusions Source: Developed for the thesis 2

22 Chapter One: Introduction to the Study 1.2 RESEARCH BACKGROUND In the mid-1980s, Vietnam could be characterized as having a strong commandeconomy system. However, difficulties from 30 years of war and the inefficiency of the command-economy system had led the national economy to the brink of disaster. Faced with stagnant growth, a severe shortage of food, deficit budgets, increases in inflation and chronic trade imbalances, the Government of Vietnam initiated an economic renovation policy in December Economic reform has taken place in many areas but typically has focused on four main areas (Le, 1992). The first was to change from a centrally planned and controlled economy to a market economy regulated by the government. The second involved a shift from the policy of giving priority to the state and collective sectors to the policy of developing multi-sector businesses and promoting private businesses. The third was to change investment policy that had formerly emphasized heavy industries into policies of priority for development of food and consumer goods production, and goods production for exports. In terms of international economic relations, the government has encouraged all economic sectors to diversify exporting products and markets instead of focussing on the traditional ones such as the former Soviet Union and Eastern European countries (Le, 1992). It is apparent that since the government introduced the series of economic reforms known as doi moi (renovation), the private sector has rapidly grown in terms of the number of businesses, capital and employees. From the base of zero in 1991, the number of private businesses and limited companies had quickly risen to 28,811 in 1998 (Tran, 1998, p. 54) and almost all are small and medium enterprises (SMEs). SMEs have contributed considerably to growing GDP and creating jobs for labourage people. Vu (1998, p. 18) summarizes SME contributions as follows: providing a large number of diversified products, occupying 26 percent of GDP and 30 percent of industrial outputs, creating jobs for 4.5 million people, mobilizing temporarily unused resources such as land, capital, labour and management skills to develop production, and increasing export volume and lessening trade deficits. 3

23 Chapter One: Introduction to the Study In addition to achievements and contributions as mentioned above, SMEs in Vietnam are currently being faced with many serious difficulties such as shortage of capital for expanding and renovating equipment and technology, low productivity and competitiveness, lack of experience in terms of marketing, production management, and financial management. Of these difficulties, lack of financing resources and experience of financial management is currently one of the most serious issues (Ebashi, Sakai and Takada, 1997). Inefficient financial management may damage SME profitability and, as a result, the difficulties of SMEs will become greater. Conversely, efficient financial management will help SMEs to strengthen their profitability and, as a result, these difficulties can partly be overcome. Most commercial banks refuse to offer loans for SMEs because the banks think SME profitability could not cover loan risks. However, to date there has not been any research on SME profitability conducted in Vietnam. Conducting such research will enable commercial banks to evaluate SME profitability and make decisions on granting loans for SMEs. In addition, when the stock exchange is established in Vietnam, conducting research on SME profitability will help SMEs to improve their performances and reinforce financial management as a preparation to participate in stock exchange listing. Originating from recognition of the increasingly important role and contribution of SMEs as well as the recent promotion and supporting policy on developing SMEs, this research study is considered a contribution to improvement of financial management practices and profitability of SMEs in Vietnam. Firstly, it investigates financial management practices and financial characteristics of SMEs, and then, examines the impacts of financial management practices and financial characteristics on SME profitability. 1.3 RESEARCH PROBLEM Problem definition is essential before conducting a research project, especially quantitative research. Zikmund (1997, p. 82) recommends that formal quantitative research should not begin until the problem has been clearly defined. In Vietnam, defining the research problem of SMEs may begin with a consideration of the typical characteristics of management. Most SMEs have not appointed financial managers to be in charge of financial management of the company. Usually, the owner-managers 4

24 Chapter One: Introduction to the Study with the assistance of the chief-accountant control financial matters of the company. However, most owner-managers have no formal training in management skills, especially financial management. Moreover, the concepts of financial management have also only been recognized in Vietnam since the beginning of the 1990s when the economy was converted into a market economy. Currently, financial management is one of the challenges of SMEs. Lack of knowledge of financial management combined with the uncertainty of the business environment often lead SMEs to serious problems regarding financial performances. Regardless of whether owner-manager or hired-manager, if the financial decisions are wrong, profitability of the company will be adversely affected. Consequently, SME profitability could be damaged because of inefficient financial management. SMEs have often failed due to lack of knowledge of efficient financial management. Moreover, undercapitalization and uncertainty of the business environment cause SMEs to rely excessively on equity and maintain high liquidity and these financial characteristics probably affect SME profitability (Vuong, 1998). In summary, the problem that SMEs in Vietnam face appears to be that inefficient financial management practices have adversely affected their profitability. Therefore, the problem to be addressed in this research is to investigate the simultaneous effects of financial management practices and financial characteristics on SME profitability, and then, to determine the best measures for improving SME profitability in Vietnam by using efficient financial management tools. Figure 1.2 represents the fields of research problem in this study. Figure 1.2: Fields of the research problem Financial management practices Financial characteristics SME profitability Source: Developed for the thesis 5

25 Chapter One: Introduction to the Study Research questions Research questions involve the research translation of problem into the need for inquiry (Zikmund, 1997, p.88). The research problem defined above leads to the following research questions: How important are SMEs in Vietnam and are they profitable? (answered in chapters 2 and 5) How have researchers in the literature review, identified the context of financial management practices and financial characteristics, and how have they proposed to measure SME profitability? (answered in chapter 3) How important are financial management practices and financial characteristics to SME profitability? (answered in chapter 3) What are the relationships between financial management practices, financial characteristics and SME profitability? (answered in chapters 4 and 5) How do financial management practices and financial characteristics affect SME profitability? (answered in chapters 4 and 5) What action can improve financial management and profitability of SMEs in Vietnam? (answered in chapters 5 and 6) Research objectives A research objective is the researcher s version of a business problem. Objectives explain the purpose of the research in measurable terms and define standards of what the research should accomplish (Zikmund 1997, p. 89). In solving the research problem and answering the research questions mentioned previously, this study has the following objectives: to collect descriptive evidence on financial management practices, financial characteristics and profitability of SMEs in Vietnam to develop a model of the impacts of financial management practices and financial characteristics on SME profitability to contribute to knowledge of the relationships of financial management practices, financial characteristics and SME profitability. 6

26 Chapter One: Introduction to the Study 1.4 METHODOLOGY In choosing a research design, Zikmund (1997, p. 37) discusses three types of business research: exploratory, descriptive and causal research. Exploratory research is usually conducted to clarify and define the nature of a problem. Descriptive research is designed to describe characteristics of a population or phenomenon. Causal research is conducted to identify cause-and-effect relationships among variables where the research problem has already been narrowly defined. Choosing a type of research depends upon the research questions that the researcher wants to answer. This research study is designed to describe characteristics of financial management practices of SMEs and investigates the impact of the financial management practices and financial characteristics on SME profitability. Thus, descriptive was viewed as an appropriate research type. Also, this research is designed to identify the cause-and-effect relationships between efficient financial management practices and profitability of SMEs. Thus causal research was also implemented in combination with descriptive research. In summary, a combination of descriptive and causal research has been chosen for this research. Selecting research design is the next step after choosing type of research. There are four types of research design from which to select: survey, experiments, observation and secondary data (Zikmund, 1997). Selection of research design is based on the advantages and disadvantages of each kind of research designs and circumstances in which the research problem is defined. In this research, both survey and secondary data methods are used in combination. Survey was chosen as a research technique in this study to investigate and describe financial management practices of SMEs in Vietnam. Questionnaires were designed and directly delivered to SMEs to collect data related to financial management practices. The argument for choosing survey was twofold. Firstly, surveys provide quick, efficient and accurate means of assessing information about the population. Secondly, surveys are more appropriate in cases where there is lack of secondary data. 7

27 Chapter One: Introduction to the Study The secondary data method was used to examine the financial characteristics of SMEs. The variables such as liquidity ratios, financial leverage ratios, activity ratios, and profitability ratios are derived from financial statements. These financial statements are available from taxation departments of Vietnam and sometimes from businesses directly. One of the objectives of collecting data related to financial management practices, which are collected from the survey, and data related to financial characteristics of SMEs, which are derived from the financial statements, was to test hypotheses. This research study was designed to test two kinds of hypotheses. The first was the hypothesis of the simultaneous impacts of financial management practices and financial characteristics on SME profitability. The second was the hypothesis related to differences in the average profits between SMEs with efficient financial management practices and SMEs with inefficient practices. 1.5 JUSTIFICATION FOR THE STUDY Concerned with financial management practices, most previous researchers have concentrated on examining, investigating and describing the behaviour of SMEs in practising financial management. Five specific areas of financial management practices including accounting information systems, financial reporting and analysis, working capital management (including cash management, receivables management, inventory management and payables management), fixed asset management and capital structure management have long attracted the attention of researchers (McMahon, et al. 1993). Their findings are mainly related to exploring and describing the behaviour of SMEs towards financial management practices. Although they provided much descriptive statistical data and empirical evidence on SME financial management practices, it appears that there still are some gaps in the literature, which need to be addressed. Firstly, most empirical evidence comes from the developed economies such as the United States of America (USA), the United Kingdom (UK), Canada and Australia (McMahon et al. 1993). There seems to be a lack of evidence from emerging economies, especially from transiting economies such as Vietnam and China. 8

28 Chapter One: Introduction to the Study Secondly, most previous researchers focus on investigating and describing financial management practices whereas there has been little research examining the impact of financial management practices on SME profitability (McMahon et al. 1993). These are major gaps and it is difficult to convince business financial management practitioners of the need for changes in practices until evidence of the effects of financial management practices on SME profitability is provided and the relationship between the two variables are discovered. In addition to financial management practices, previous researchers provided valuable findings related to financial structures/characteristics of SMEs. Four variables including liquidity, financial leverage, activity and profitability are popularly used by previous researchers to identify and measure financial characteristics of SMEs (McMahon et al, 1993). There are many studies on financial characteristics of SMEs conducted by researchers over several decades. However, there still exist gaps in the literature related to financial characteristics of SMEs, which need to be supplemented. Firstly, it appears that the financial characteristics of SMEs in developing countries, especially in transiting economies such as Vietnam and China have not been investigated and empirical data has not been produced. Secondly, to date, there is no study, which examines the relationship or the impact of three variables: liquidity, financial leverage, and activity on profitability variable. This lack of empirical evidence from emerging economies and the lack of examination of the impact of financial management practices and financial characteristics on SME profitability are major gaps in the knowledge of financial management practices and financial characteristics of SMEs. Based on previous research findings and recognition of these gaps, a study of the impact of financial management on SME profitability is justified and a model of the impacts of financial management practices and the financial characteristics should be developed and tested by using the empirical data from emerging economies. Vietnam is one of many 9

29 Chapter One: Introduction to the Study appropriate countries to provide such data. Therefore, this study will extend previous studies by focusing on examining the simultaneous impacts of financial management practices and financial characteristics on SME profitability using the empirical evidence from Vietnam. 1.6 DEFINITIONS OF TERMS USED IN THE STUDY Specialized terms used in this study include SMEs, private company, limited company, stock companies, efficient financial management and profitability. These terms are adopted for Vietnamese context. In this study, SMEs refers to small and medium enterprises. Currently, Vietnam has not uniformly defined which criteria a business has to fulfil to be viewed as an SME. In this study, SMEs are understood to have the same definition given by the Vietnamese Chamber of Commerce and Industry (VCCI, 1998). According to VCCI, a SME is defined as a business unit that fulfils the following criteria, depending on its size: Small business: Manufacturing: less than 200 employees and VND5 billion capital Trading and services: less than 200 employees and VND5 billion capital Medium business: Manufacturing: employees and VND5 10 billion capital Trading and services: employees and VND5 10 billion capital As will be examined in more detail in chapter two, SMEs include many forms of business organization such as private enterprises, limited companies, joint stock companies, cooperatives and business households or family businesses. However, this study only focuses on the forms of business that set up a formal system of financial management. Based on this criterion, private enterprises, limited companies, and joint stock companies are the objects of this study whereas others such as cooperatives and family businesses are beyond the study. Also, the term company is used synonymously with the term enterprise in this study. Private enterprises are companies that are registered under the Vietnam Private Business Law. These companies have one owner who is responsible for all his or her assets. Limited companies are companies that are registered under the Company Law and they have 10

30 Chapter One: Introduction to the Study larger initial capital than private enterprises. Owners liability is limited to the initial capital that they have to invest in full at the time of establishment of the company. If there are more than 12 owners, a formal owner meeting and boards of director meetings must be held. Financial management is concerned with all areas of management which involve finance not only the sources and uses of finance in the enterprise, but also the financial implications of investment, production, marketing or personnel decisions and the total performance of the enterprise (Meredith, 1986). Financial management is concerned with raising the funds needed to finance the enterprise s assets and activities, the allocation of these scarce funds between competing uses, and ensuring that the funds are used effectively and efficiently in achieving the enterprise s goals (McMahon, Holmes, Hutchinson and Forsaith, 1993). However, financial management, in this study, is limited to a framework of five specific areas: (1) accounting information system (2) financial reporting and analysis, (3) working capital management, (4) fixed asset management, and (5) capital structure management. This limitation is necessary and appropriate to financial management practices of SMEs in Vietnam, given information available for research. Financial management objectives, in this research, refer to two main objectives: profitability and liquidity. Profitability management is concerned with maintaining or increasing a business s earnings through attention to cost control, pricing policy, sales volume, stock management, and capital expenditures (McMahon, 1995). Liquidity management is concerned with avoiding any damage at all to a business s credit rating, due to a temporary inability to meet obligation by anticipating cash shortages, maintaining the confidence of creditors, bank managers, pre-arranging finance to cover cash shortages (McMahon, 1995). Efficient financial management, in this research, is defined as financial management that achieves financial management objectives without wasting financial resources. Conversely, inefficient financial management is not to achieve financial management objectives or achieve the objectives but wasting or without minimizing financial resource utilization. Chapter 4 defines variables and criteria to measure the extent of efficiency of financial management. In this study the context of financial management practices include accounting information systems, financial reporting and analysis, cash management, receivable management, inventory management, 11

31 Chapter One: Introduction to the Study fixed asset management and financial planning. The extent of efficiency of each financial management component is measured by the sum of points of eight items on the nine-point scale (1 = not efficient at all, 9 = very efficient). If the sum of points of a financial management component of a business is greater than the average point of 40 (8 x 5 point average), the business is said to be efficient in practising that financial management component. Conversely, if that sum is less than the average point of 40, the business is said to be not efficient or inefficient in practising that financial management component. Lastly, a business is said to be efficient in financial management practices, if all components of financial management practices are efficient, that is, all sums of points of components are greater than the average point of 40. Manager refers to the person who is hired to run and manage the business whereas owner-manager refers to the person who plays the role of both owner and manager. Financial characteristics of the enterprise are represented by financial ratios, derived from financial statements. This information can be used to quantify the position of SMEs in terms of their profitability, liquidity, and leverage and to compare them with other or large enterprises (McMahon et al. 1993). In this study, financial characteristics are measured by three variables including liquidity, financial leverage and business activity, which are derived from financial statements. SME profitability is an abstract concept. There are many different ways to measure profitability. This research limits the measures of SME profitability at the following ratios: (1) return on sales, (2) return on assets, and (3) return on equity. This limitation is necessary to narrow the scope of the study and is suitable for financial management practices for SMEs in Vietnam. In addition, in this study, the concept of profitability is defined as a comparative concept. A business is said to be profitable if it produces annual average returns (average of return on sales, return on assets and return on equity) that are greater than the free-risk rate of interest, which was estimated as 5.4% percent at the middle of the year 2000 in Vietnam. Conversely, if the annual average profit of a business is not greater than the free-risk rate of interest, the business is said to be not profitable. The arguments for the concept of profitability will be explained in chapters 4 and 5. 12

32 Chapter One: Introduction to the Study 1.7 SIGNIFICANCE AND SCOPE OF THE STUDY Completing this study brings together aspects of theory and practice. For theory, this study is an expansion of previous studies on financial management practices and financial characteristics of SMEs by focussing on examining the simultaneous impacts of financial management practices and financial characteristics on SME profitability. In addition, utilizing data from Vietnam, one of the emerging economies, contributes to the literature of SME financial management, which traditionally concentrates on SMEs of developed economies rather than SMEs in other economies. Using data from Vietnam to test theories of financial management helps to confirm and expand the scope of theoretical applications. In practice, this study is significant for financial management practices in Vietnam. Results will indicate relationships between financial management practices, financial characteristics and SME profitability and will assist owner-managers and financial managers to improve performance and profitability of their businesses by managing financial matters efficiently and effectively. 1.8 ANALYTICAL MODEL FOR THE STUDY The analytical model for this research, which is developed and justified in the literature review chapters, and which ultimately provides structure to the empirical chapters, is illustrated in figure 1.3 (page 14). This analytical schema represents the model of the effects of financial management practices and financial characteristics on SME profitability. The model demonstrates that SME profitability is expected to be positively influenced by efficient financial management practices and financial characteristics. This analytical schema presented in Figure 1.3 can be expressed in mathematical notation as follows: P m = f(a s, F a, W o, F i, C s, L s, FL a, AC o ) (Eq. 1.1) where: P m = SME profitability ratios, viewed as dependent variables 13

33 Chapter One: Introduction to the Study A s = Accounting information system practices, viewed as independent variables F a = Financial reporting and analysis practices, viewed as independent variables W o = Working capital management practices, viewed as independent variables F i = Fixed-asset management practices, viewed as independent variables C s = Capital structure management practices, viewed as independent variables. L s = Liquidity ratios, viewed as independent variables FL a = Financial leverage ratios, viewed as independent variables AC o = Activity ratios, viewed as independent variables. Figure 1.3: Analytical model for the research Financial management practices: Accounting information system Financial reporting and analysis Working capital management Fixed asset management Capital structure management Financial planning Efficient financial management SME profitability: Return on sales Return on assets Return on equity Financial characteristics: Liquidity ratios Financial leverage ratios Activity ratios Source: Developed for the study Chapter 4 will present, in more detail, definitions and measures of dependent variable (profitability) and independent variables such accounting information system, financial reporting and analysis, working capital management (including cash management, receivables management, inventory management), fixed asset 14

34 Chapter One: Introduction to the Study management, capital structure management, and financial planning. In addition, the model of simultaneous effects of financial management practices and financial characteristics on SME profitability will be developed from the literature review in chapter 3 and with variables defined in chapter 4 of the study. 1.9 STRUCTURE OF THE STUDY This research is structured into 6 chapters. Chapter 1 introduces the research including research background, research problem, research questions, research objectives and justifications for the research. Chapter 2 examines the economic structure, and the current practices and role of SMEs in Vietnam. Chapter 3 provides a literature review of financial management practices, financial characteristics and SME profitability. Chapter 4 discusses methodology utilized in the research. Chapter 5 analyses the data collected and presents the findings of the research. Chapter 6 points out conclusions and the implications of the research in the world of business administration. Figure 1.4 (page 15) illustrates the structure of the study and the relationships between chapters. Figure 1.4: Structure of the study Chapter 1: Introduction to the Study Chapter 2: The Economic Structure and SMEs in Vietnam Chapter 3: Financial Management Practices, Financial Characteristics and Profitability of SMEs Chapter 4: Research Methodology Chapter 5: Data Analysis and Findings Chapter 6: Conclusions and Implications Source: Developed for the thesis 15

35 Chapter One: Introduction to the Study 1.10 CONCLUSIONS This research examines the simultaneous impacts of financial management practices and financial characteristics on SME profitability using evidence from Vietnam. To date, there is no significant research related to financial management practices and financial characteristics of SMEs conducted in Vietnam and there is also no research that examines the simultaneous impact of financial management practices and financial characteristics on SME profitability. This research is designed as a combination of descriptive and explanatory research in which a sample of 160 SMEs are drawn from a list of over 14,000 SMEs in Ho Chi Minh City for personal interview. Gathered data will be processed by computer and the Statistical Package for Social Science (SPSS) is the main computer software utilized in data analysis. In term of data analysis, this study applies both descriptive and inferential statistics. Descriptive statistical techniques will be applied to describe characteristics of financial management practices and financial characteristics of SMEs in the sample. Inferential statistical techniques such as bivariate analysis for measuring the association, bivariate analysis for testing the difference, factor analysis, and multivariate analysis will be applied to test the hypotheses of association and differences (chapter 5). Findings of this study will be applied to increase efficiency of financial management practices and improve profitability of SMEs in Vietnam (chapter 6). To provide an in-depth picture of business environment in which SMEs operate, chapter 2 will respectively examine and present information on background of the economy, business structure and SMEs in Vietnam whereas chapter 3 reviews the literature of financial management for SMEs around the world. 16

36 Chapter Two: The Economic Structure and SMEs in Vietnam 2.1 INTRODUCTION As of 2000, Vietnam, a country suffering from 30 years of war and 10 years of economic mismanagement, stands on the threshold of a new era an era of international relations and economic development. After a decade of strong efforts, its economy and finance have been substantially reformed, and is integrating into the world economy. Vietnam has made substantial progress in rearranging its foreign debt arrears and started to benefit from financial assistance and foreign direct investment (FDI) since the end of 1980s. Although challenges remain, Vietnam s achievements over the past years foretell its capacity to prevail. This chapter provides an overview of Vietnam s economy and performance of small and medium enterprises (SMEs) in Vietnam. Objectives of the chapter are (1) to provide a literature review of economic background, business structure and the development of SMEs in Vietnam, and (2) to identify gaps in financial management for SMEs in Vietnam compared with financial management for SMEs worldwide. This chapter is structured into 6 main sections. Section 2.1 provides a general introduction to the chapter, including the objectives and structure of the chapter. Section 2.2 examines information on Vietnam such as geographic location, history, political structure, the process of economic and financial development, and its population and labour force. Section 2.3 concentrates on examining Vietnam business structures with special emphasis on SMEs and the support policy for SME development. Section 2.4 analyzes all aspects of SME finance in Vietnam including types of finance, use of finance and financial management. Section 2.5 provides an overview of business structure of SMEs in Ho Chi Minh City where SMEs are considered the largest groups in term of numbers and are representative of SMEs in the whole country. Section 2.6 summarizes the conclusions drawn from reviewing the background of economy and SME performances in Vietnam. Figure 2.1 (page 18) provides a visual outline of the structure of the chapter.

37 Chapter Two: The Economic Structure and SMEs in Vietnam Figure 2.1: Structure of chapter Introduction 2.2 Vietnam: background information Overview of the country Vietnam population Vietnam economy Vietnam labour force 2.3 Vietnam business structure Type of business Small and medium enterprises Overview of enterprises in VN Policies for supporting SMEs 2.4 SME finance in Vietnam Types of finance Use of finance Financial management for SMEs 2.5 Business structure and SMEs in HCM City 2.6 Conclusions Source: Developed for the thesis 18

38 Chapter Two: The Economic Structure and SMEs in Vietnam 2.2 VIETNAM: BACKGROUND INFORMATION Section 2.2 reviews information on Vietnam background including geographical location, historical overview, economic development process, population and labour. This section is structured into three subsections. Subsection provides an overview of the country. Subsection examines the process of economic development since the country was reunified in Section reviews population and labour force in Vietnam Overview of the country When asked about Vietnam many around the world probably answer that it is a poor country damaged seriously by conflicts. That was the position in the late 1970s. As of 2000, the country has seen increasingly remarkable changes. Harvie (1996, p. 1) presents a current impression of Vietnam since the country has introduced its marketoriented economic policy. Vietnam has only recently emerged as a participant in the most rapidly growing region of the world economy, the Asia Pacific economy. It is poised to become one of Asia s most vigorous market economies during the remainder of the 1990s and into the twenty-first century, having rejected central planning, and is widely tipped to become Asia s next economic dragon The geographical location Schuwalow (1996, p.189) described Vietnam as the country that extends more than 1,600 kilometres along the east coast of Indochina, from the Chinese-border mountain and the Red River delta in the north, the Laotian and Cambodian borders, to the fertile Mekong River delta in the south. Although in its extreme north the country is more than 500 kilometres wide, much of the middle section is a relatively narrow strip of coastal land. For a considerable distance it is 80 kilometres wide, and in the south expands again to about double that width (see the map, page 20). Vietnam s total land area is 325,360 square kilometres, and 75 percent is hill country or mountains. Climate is typically monsoon, and the temperature varies considerably according to latitude. In the tropical south, conditions are warm to hot throughout the year and the humidity is usually high. In the north, particularly in the highlands, markedly warmer and cooler seasons occur and temperatures are much lower than those at sea level. 19

39 Chapter Two: The Economic Structure and SMEs in Vietnam 20

40 Chapter Two: The Economic Structure and SMEs in Vietnam Historical overview After the government of South Vietnam fell on 30 April 1975, the north and the south of Vietnam were reunified by a national election held in April 1976 and in July of the same year the Socialist Republic of Vietnam was established. This reunification came in an attempt to transform the south from a basically market economy to a planned economy. Collectivization and nationalization respectively happened in agriculture and other industries. In the meantime, trade with the western countries was greatly restricted due to the United States of America trade embargo. Vietnam s conflict with Cambodia during and border conflict with China in 1979 further hampered the country s progress. Throughout the 1980s most people associated Vietnam with the word war. However this perception is slowly fading as a new image of Vietnam emerges. Currently Vietnam is a country at peace with a vast variety of natural resources, a high literacy rate (90 percent), and an increasingly skilled and hard labour force. Although an often-difficult business climate has been experienced in the past, Vietnam is currently changing and amending many of its laws in order to attract more foreign investment and trade opportunities (Vietnam Embassy in USA, 1999). By the mid-1980s, a decline in the former Soviet Union aid and government s tight control over economic policy proved to be an economic disaster leading to a decline of production in many sectors, and an increasing reliance on imports. In response to this inefficiency, the Vietnamese Government initiated a series of economic reforms known as doi moi ("renovation") in December The main goals of doi moi were to improve lagging productivity, to raise living standards, and to curb rapid inflation, which reached almost 500 percent a year in mid-1980s (Kimura, 1993). Renovation process included macro-economic stabilization, the recognition of Vietnam s private sector, and the promotion of foreign trade and investment. Following this paradigm, Vietnam has attempted to transform itself into a market-oriented economy, and opened itself to the outside world. After more than a decade of doi moi, Vietnam has experienced huge growth in investment, industry and an expansion of trade (20% per annum on average) and has had considerable success in restructuring the economy (Vietnam Embassy in USA, 1999). The government has opened the country to foreign investment, by allowing many joint venture and wholly foreign-owned enterprises to flourish. Regulations and rules have more and more become liberalized. 21

41 Chapter Two: The Economic Structure and SMEs in Vietnam In July 1995, Vietnam became a full member of the Association of South East Asian Nations (ASEAN). On January 1 st 1996, Vietnam became a member of the ASEAN Free Trade Agreement (AFTA) and in 1998 Vietnam was admitted into the Asia Pacific Economic Cooperation (APEC) and has since signed trade agreements with a number of countries and territories (Australian Department of Foreign Affairs and Trade, 2001). As of 2000, Vietnam is closer then ever to establishing a long-term trade relationship with the United States of America, and has submitted an application to enter the World Trade Organization (WTO). In recent years, the government has planned to establish a Vietnamese stock market and new laws on foreign investment are currently being promulgated and amended in order to make Vietnam more attractive to foreign investment. After many years of preparation, the stock market was finally opened and launched the first transaction on 26 June 2000 (USA Department of Commerce, 1998) Political structure In Vietnam, leadership structure is divided into three levels. The General Secretary is in charge of representing and dealing with issues concerning the Vietnamese Communist Party. The Prime Minister is in charge of handling government affairs and day-to-day business of the country. Finally, the President focuses on security issues and the armed forces. Vietnam is a socialist country under the leadership of the Communist Party. The Communist Party has nearly 2 million members and strongly influences every aspect and at every level of Vietnamese life. The party holds a national congress every five years to outline the country s overall direction and formalize policies (Commercial Chamber of Vietnam in USA, 1998). The National Assembly, which includes 450 members, representing all walks of life throughout the country, and is open to non-party members, is the highest state authority and the only body with constitutional and legislative power. The National Assembly elects the President of the State and the Prime Minister (figure 2.2, page 23). The Prime Minister is in charge of handling government affaires with assistance of 18 ministries. At its meeting, the National Assembly examines reports and plans presented by the ministries involved, and National Assembly members have rights to ask ministries to clarify and answer questions raised by members (Commercial 22

42 Chapter Two: The Economic Structure and SMEs in Vietnam Chamber of Vietnam in USA, 1998; Australian Department of Foreign Affairs and Trade, 2001). Figure 2.2: Political structure of Vietnam The National Assembly Supreme People s Court President Supreme People s Procuracy Prime Minister Ministry of Defense Ministry of Industry Ministry of Planning and Investments Ministry of Interior Ministry of Trade Ministry of Technology and Environment Ministry of Foreign Ministry of Finance Ministry of Education and Training Ministry of Transportation and Communications Ministry of Agriculture and Rural Development Ministry of Fishery and Aquatic Products Ministry of Health Ministry of Construction Ministry of Information State Bank of Vietnam Ministry of Justice Government Office Source: Adopted from the Commercial Chamber of Vietnam in the U.S.A. and Australian Department of Foreign Affairs and Trade The Vietnam economy Since unification of the north and south, the process of the Vietnam economy development can be divided into three main periods: the central-planned economy period ( ), the policy reform period ( ) and the transition economy period (1990 present). This subsection reviews the development of Vietnam economy throughout each period with a special emphasis of the effects of the government s economic policy. Its purpose is to review the background in which SMEs operate and develop because the process of SME development is linked to the process of economic policy reform. 23

43 Chapter Two: The Economic Structure and SMEs in Vietnam The central-planned economy period ( ) The central-planed economy period is characterized by state intervention in almost all activities of the economy. When the war ended in 1975, along with the unification of the country, the integration of the economies of the north and the south of Vietnam was set in motion. Vu (1994, p. 4) mapped out points which characterized the Vietnam economy in that period as follows: The state determined the important economic activities of the country through a system of production plans and product distribution and strictly regulated pricing and interest rates. The state sector and the collectives constituted the foundation of the economy, the collectives being heavily subsidized in activities such as investment and loans and they quickly developed to become a sizable part of the national economy. Large-scale private enterprises were not encouraged to expand further, but were singled out to be finally incorporated into either state or collective units. The market mechanism operated only in small businesses and the household economy, that is to say, in only a part of the agricultural, handicraft, and consumer goods retailing sectors. Many input factors used for production were not allowed to be bought or sold on the market but were allocated by the state s planned distribution systems. The state monopolized foreign trade. Due to historical circumstances, Vietnam s trade relations had been mainly with the former Soviet Union and Eastern European countries through bilateral treaties. Foreign trade companies under the control of the state implemented these trade treaties, and the profitand-loss account of foreign trade was entirely taken care of by the state. The finance of the state was not separated from that of state-owned enterprises. The state undertook to compensate for losses incurred by stateowned enterprises by means of subsidies, and when these enterprises produced profits, these profits were channelled back to the state budget. All production activities were subsidized by the state through its provisions of raw materials and other inputs of production. Machinery and equipment were imported with aid funds and credit loans, and sold at low prices to state-owned enterprises. 24

44 Chapter Two: The Economic Structure and SMEs in Vietnam For this reason, the budget deficits and foreign debt would have increased along with any increase in outputs. Such policies were not conductive to motivating individuals and companies to boost enterprising economic activities. The economic institutions had no room for private individual s creativity and business dynamism. Thus, although income distribution was egalitarian and all members of society were assured the basic necessities of life, there was, however, no incentive for individuals to use their talents or assiduity in work to make larger contributions to the country. This is demonstrated by failure of the five-year plan. In 1980 food production attained only 69 percent of its target; coal, 52 percent; electricity, 72 percent; cotton fabric, 39 percent; paper, 37 percent (Vu, 1994). The economy s growth was seriously hampered by the centrally planned system The policy reform period ( ) The policy reform period is characterized by the changes in management mechanisms of the economy. After ten years, the practical results proved that the central-planned economic system was not efficient and effective. In 1986 the Government recognized that policy reform was the survival goal. The year of 1986 was viewed as the year of beginning policy reform. Vu (1994, p. 7) confirmed the path taken by Vietnam s economic reform was marked by the important conclusions on the system of concepts regarding economic renovation drawn up by the Sixth National Congress of the Communist Party of Vietnam in December In this congress the following changes in policies were mapped out: confirmation of the long-term development of the multi-sector economy, eliminating the former discrimination against the private economy, allowing private sector to compete with other sectors on an equal footing in a healthy competitive environment, confirmation of the importance of market relations in the economy, renovating the economic structure, using available resources to meet the main objectives: developing agriculture, promoting the production of consumer 25

45 Chapter Two: The Economic Structure and SMEs in Vietnam goods, increasing the export of goods and services, and enlarging its external economic relations, stabilizing the socio-economic environment by reducing the inflation rate, the budget deficits, and excessive government expenditure, and improving the living standard of people, and carrying out an open-door policy in relations with foreign countries. Policy reform mentioned above opened opportunities for changes in activities of the economy including changes in economic structure, financial and banking system, and price and market relations. Changes in economic structure Developing a multi-sector economy led to change in economic structure. In Vietnam s economic ideology, the national economy could be divided into several economic sectors based on the form of ownership and means of production. Before policy reform, the economy consisted of two sectors: state-owned and collective. Since policy reform, the following main sectors were officially recognized (Le, 1992): state sector, based on the state ownership, collective sector, based on the voluntary contribution of capital by a group of people to set up joint units and use labour forces of the collective s members and their relatives, private sector including the family or household businesses and private companies, and joint sector between state and other sectors. Table 2.1 (page 27) demonstrates changes in economic structure during the period in which the non-state sector had increasingly risen in terms of national income, labour and labour in industry. For example, labour force working for state sector declined to 10.4 percent in 1991 from 14.7 percent in 1986 whereas labour force working for private sector increased to about 90 percent in 1991 from 85 percent in This showed that private sector played a major role in creating employment. 26

46 Chapter Two: The Economic Structure and SMEs in Vietnam Table 2.1: Changes in economic structure ( ) 1986 (%) 1991 (%) State Non-state State Non-state National income Labour Gross industrial output Labour in the industry Source: Statistical data of Socialist Republic of Vietnam ( ) Previously, the state and collective sectors constituted the main part of the national economy. The private sector, especially private companies, were not encouraged to develop but were instead the target of nationalization, collectivization or transformation to state-private joint ventures. With policy reform, enterprises of all ownership forms received equal treatment and competition in the market. There still existed differences in terms of motivations and attitudes between the state and nonstate sectors but it was not necessary to distinguish between the various sectors as mentioned above (Vu, 1994). Creating equally competitive environment forces all enterprises regardless of the state, collective or private sectors to consolidate its competitiveness. Changes in financial systems There were three main changes in the financial system in this period (Vu, 1994). The financial reform in 1985 was the first comprehensive financial readjustment aimed at decreasing the state budget deficit and inflation rate. Details of this reform were as follows: trimming subsidies allocated by the state to enterprises through the low prices of raw materials and other inputs of production, switching from the price system fixed by the central government to the system in which the prices are determined by the market through negotiation by buyers and sellers, reforming the wage system to do away with the rationing of fixed quantities of food and other necessities, and 27

47 Chapter Two: The Economic Structure and SMEs in Vietnam readjusting the revenue and expenditure policy of the state budget to step by step reduce deficits and control the rate of inflation. Taxation reform was the second change in the financial system. Before 1989, taxes were collected from non-state economic sectors. The two main kinds of taxes were the agricultural tax, based on quantity and quality of land used, and the industrial and trade tax, based on turnover of collective and private businesses (Table 2.2). Table 2.2: State-budget revenue, (million dong) Revenue from state sector 60, ,801 1,184,945 2,085,838 Net sales 56, ,220 1,027,627 1,616,870 Depreciation 893 4,911 3,724 71,300 Others and service revenue 2,548 9,670 78, ,000 Taxes on commercial export and import , ,668 Revenue from non-state sector 23,277 97, ,216 1,505,988 Industry and trade tax 8,325 38, , ,949 Agriculture tax 3,834 12, , ,093 Non-commercial export and import tax 6,171 17,441 56, ,715 Others 4,947 29, , ,231 Total 83, ,290 1,758,161 3,591,826 Source: Statistical Yearbook, 1991 The state sector did not pay any tax but had to transfer most of its profit and turnover to the state budget. Therefore, one of the most important tasks of taxation reform was to eliminate the administrative supply-withdraw system of state enterprise finances and to build a new tax system applicable to every business. The new tax laws promulgated including the following kinds of taxes: agricultural tax, turnover tax, profit tax, special commodity consuming tax (cigarettes, alcoholic products, automobiles), import-export tax, tax on the use and exploitation of natural resources, tax on housing and the use of land, and personal income tax. After reforming tax systems, not only discrimination between the state and non-state sectors was eliminated but also the state-budget revenue was increased. Table 2.3 (page 29) shows changes in terms of sources and amounts of tax revenue compared with table 2.2, which shows the sources and amounts before reforming tax policy. 28

48 Chapter Two: The Economic Structure and SMEs in Vietnam Table 2.3: State-budget revenue, (billion dong) Tax collected from state enterprises 2,080 3,817 5,887 8,878 Tax collected from joint ventures 1,091 1,942 4,242 5,104 Industry and trade tax ,821 2,942 Agriculture tax ,294 1,350 Export and import tax 732 1,099 2,194 6,398 Housing and land tax Income tax Fees and others 1,036 1,271 2,905 4,138 Depreciation ,660 1,939 Total 6,153 10,083 20,175 31,171 Source: Statistical Yearbook, 1994 The third change was to restructure the national financial apparatus and management. Formerly, Vietnam s financial system had operated at two levels: central and local. At the local level there were three sub-levels: provincial, district and village in the countryside or residential in urban areas. During the Vietnam War and central-planned economy period, financial and fiscal decision-making had been strictly concentrated at the central level. With policy reform, it was to be decentralized and liberalized to grant more powerful decision-making in finance and fiscal issues for the lower (province and district) levels. Changes in banking systems Until 1988 there were only three state-owned banks in Vietnam: the State Bank of Vietnam (SBV), the Vietnam Investment and Development Bank (VIDB), and the Vietnam Bank for Foreign Trade (Vietcombank). Unlike other countries, in Vietnam the SBV played both roles of central and commercial banks (The World Bank Group, 1997). This was never seen in countries based on a market economy. The VIDB and Vietcombank basically operated as commercial banks. The VIDB was in charge of providing funds and loans for the state long-term investment projects while the Vietcombank specialized in providing loans and banking services for all international economic activities. Reform in the banking system was initiated in 1988 by issuing the Decree 53/HDBT to divide the banking system into two categories: the State Bank played the role of central bank and the specializing banks played the role of commercial banks. 29

49 Chapter Two: The Economic Structure and SMEs in Vietnam In addition, two other state-owned commercial banks: the Vietnam Industrial and Commercial Bank and the Vietnam Bank for Agricultural Development were established. Four state-owned banks were allocated primary funds from the state budget and operated as commercial banks (The World Bank Group, 1997). At the end of 1990, the Government started liberalizing the banking system. Since 1990 the nonstate sectors have been allowed to establish commercial banks. Dozens of joint stock banks were established in cities such as Hanoi, Hai Phong, and Ho Chi Minh City. Some were based mainly on the participation of state units, others on mixture of state and private operations, while the rest were entirely private (Vu, 1994). Banking system reform quickly changed the banking system in Vietnam to comprise development and investment banks, state-owned commercial banks, foreign banks branches, joint-venture banks, joint stock banks, credit co-operatives, and financial companies (Table 2.4). All the banks are self-managed and operate as business organizations. Gradually the system of state subsidization providing lowinterest-rate credits was removed, and interest rates were stabilized at higher levels than the rate of inflation. Table 2.4: Financial institutions in Vietnam, 1995 Institution Number of Institutions State Bank of Vietnam 1 State commercial banks 4 Joint stock banks 46 Joint venture banks 4 Foreign banks 17 Financial companies 2 Financial leasing company 1 Insurance company 1 Credit co-operatives 120 Total 198 Source: Australia and New Zealand Banking Group, 1996 Changes in price systems Vietnam s transition to the market economy started alongside price reform (Vu, 1994, p.26). Since 1989, prices have not been fixed by the state, except in the case of items such as electricity, water, coal, and cement used for the major state construction projects. The decentralization of the price decision-making process and the introduction of a free-market price system have given rise to a better balance between total demand and supply in the entire economy and between different regions, as well 30

50 Chapter Two: The Economic Structure and SMEs in Vietnam as encouraging economic exchange. The system of price management changes from one extreme of total state-monopolized control to the other extreme of prices set by free market forces without state intervention (Vu, 1994). These changes created a substantial foundation for the economy in the transition period The transition economy period ( ) The transition economy period has been characterized by the high growth rate in GDP and stabilization of price and financial system. Unlike Russia and Eastern European countries, Vietnam s transition from a centralized to a market economy was smooth (Dana, 1994). The economic achievements and changes in the economic and social life have only started in 1990 though the innovation policy had been initiated since At the beginning of 1990s, the Vietnam economy has been known as one of the economies that achieved high growth rates (Le, 1997). Le (1997) summarized the Vietnam s recent economic achievements as follows: GDP growth rate has annually averaged 8.0 percent since 1991 whereas rate of inflation, once in triple digits 1980s, has been brought down to a single digit level at the end of 1990s (Table 2.5). Table 2.5: GDP index by economic sector and rate of inflation (%) Rate of inflation GDP growth rate State sector Non-state sector n/a n/a n/a n/a n/a Collective n/a n/a n/a n/a Private n/a n/a n/a n/a Household n/a n/a n/a n/a Foreign-invested n/a n/a n/a n/a Others n/a n/a n/a n/a Source: Statistical Yearbook, 1994, 1998 and 1999 Per capita income has risen from about USD140 in 1991 to USD300 in The exchange rate, which strongly fluctuated in 1980s, has been fairly stable in recent years (Table 2.6, page 32) 31

51 Chapter Two: The Economic Structure and SMEs in Vietnam Table 2.6: Index of exchange rate of USD/VND (%) January February March April May June July August September October November December Source: Statistical Yearbook, 1999 The country has benefited from significant expansion and diversification of external trade (Table 2.10, page 35). Vietnam Embassy in the USA (1999) provided an overview of Vietnam economy since the country started the transition economy in Major industries such as agriculture, oil, gas and mining, manufacturing, and international trade have considerably grown in recent years. Agriculture is currently the dominant economic sector, accounting for nearly 30% of GDP and employing 70% of the work force. Agricultural growth has averaged about 4.25% per annum from 1991 to 1998 (Table 2.7), laying a solid base for growth in related industries, particularly in food processing. Table 2.7: GDP index by economic industry (%) Agriculture Industry Trade and services Total Source: Statistical Yearbook, 1994 & 1998 Total food output reached a record 27.4 million tons in Vietnam was the world s third largest exporter of rice, with 85% of cultivated land devoted to rice growing. Besides rice, the main agricultural products are corn, tropical vegetables and 32

52 Chapter Two: The Economic Structure and SMEs in Vietnam fruits, cassava, potatoes, sugarcane, cashew nuts, soybeans, groundnuts, coconuts, coffee, tea and rubber (Vietnam Embassy in the USA, 1999). Vietnam s S-shaped coastline is over 3,200 km long and supports a vibrant seafood industry. In 1994, of the 1.5 million tons of fishery products, some 70% came from the ocean and the remainder from fish farms and fresh-water sources. Fishery production reached 1.5 million tons in 1995, making seafood become one of the country s major exports. Earnings from seafood exports reached US$ 580 million in 1995 and are expected to top US$ 1 billion by the year Table 2.8 summarizes the achievements of agriculture in recent years. Table 2.8: Agriculture development over the years Unit Gross output value billion dong 20,667 49,061 64,877 92, ,517 Cultivation " 16,394 37,540 49,921 71,589 87,618 Livestock " 3,701 10,152 13,113 17,792 17,551 Service " 572 1,369 1,843 2,625 2,348 Labour force 1000 people 21,895 23,208 23,548 24,725 25,124 Growth rate % Source: Statistical Yearbook 1994, 1998 Vietnam s oil reserves, estimated at 1.7 billion barrels, are among the largest in the world. The country started to produce oil in 1986 through a joint venture with the former Soviet Union. Oil production reached nearly 7 million tons in 1994 and 7.7 million tons in The government plans to raise production to million tons per year by the year 2000 (Asia Business Network, 1997). Vietnam s oil sector is on a path of rapid growth. Since 1986, 29 productionsharing contracts have been signed between PetroVietnam, the state-owned oil company, and various foreign oil companies. In addition to the White Tiger field, the country s only oil source prior to 1995, two more fields Dai Hung (Big Bear) and Rong (Dragon) are now also producing oil. All of the current oil production is for export, with most crude oil destined for Japan. However, the government is planning and seeking foreign investment for two refinery projects with a capacity of six million tons each. Natural gas reserves, estimated at 100 billion cubic meters, represent another huge potential export. A pipeline was recently completed to harness gas potential instead of burning it off. The development of gas-related industries is being considered by the government of Vietnam as well as by foreign companies. 33

53 Chapter Two: The Economic Structure and SMEs in Vietnam Vietnam is endowed with an abundance of other mineral resources such as coal (3-3.5 billion tons), bauxite (3 billion tons), iron ore (700 million tons), copper (600,000 tons), tin (70,000 tons), chromate (10 million tons), and appetite (1 billion tons). The country is also rich in granite, marble, clay, and silica sand. Almost all of these resources remain largely untapped. Foreign investment in the extraction and processing of these minerals, particularly the mining and processing of those minerals used in infrastructure projects, such as steel, is strongly encouraged by the government. The industrial sector employed about 12% of the country s work force and generates about 30% (including construction) of GDP. Over the past years, the industrial sector has grown an average of 13.0% per annum (Table 2.7, page 32). Light industry, particularly in food processing, textiles and footwear, are the major sectors, although most factories were operating with old or obsolete equipment. The textile and garment industry presently accounted for around 16% of industrial output, but it was a key source of employment and one of the country s major exports. The yearly production of the industry was about 450 million running meters of woven fabric, 15,000 tons of knitting fabric and 100 million units of garments and other products. Total textile export earnings reached around US$ 700 million in 1995, making it become the second biggest export after crude oil. The textile industry was forecasted to produce one billion running meters of fabric and to export between US$ 2 billion and US$ 2.5 billion worth of products in Heavy industry makes up an insignificant portion of output and, like light industry, currently suffers from a handicap of old and obsolete machinery and technology. Government investments in this sector have included power stations, telecommunication, and coal, shipyards, engineering, steel, and fertilizer, chemical and cement plants. High-tech industries such as electronics are also receiving increasing attention. Table 2.9 summarizes achievements of industry in recent years. Table 2.9: Industry development over the years Unit Gross output value billion dong 14,011 18,117 23, , ,685 Number of establishment 393, , , , ,948 Labour force 1000 people 3,392 3,450 3,522 3,653 1,210 Growth rate % Source: Statistical Yearbook 1994,

54 Chapter Two: The Economic Structure and SMEs in Vietnam In the centrally planned system, the government tightly controlled external trade. Targets were fixed for both imports and exports. A complex system of multiple exchange rates was maintained. Under the renovation program, trade was gradually liberalized. Whereas in 1981 there were only 12 import-export companies, the number rose to 35 in 1987 and 1,250 in 1995 (including private firms). Foreign-invested entities can handle the importation of their own equipment, machinery and materials or parts needed for the construction and operation of their projects as well as the export of their products (Vietnam Embassy in the USA, 1999). Table 2.10 summarizes the achievements of export and import activities in recent years. Though achieving the objectives mentioned above, like other transition economies, Vietnam economy still has to face many problems and challenges for the future. These problems and challenges significantly affect the business environment where SMEs start up and grow. The next subsection will review these problems and challenges. Table 2.10: Export and import value by major countries (million USD) Exports value 2,348 2,685 3,686 5,261 6,826 8,956 9,308 Asia 1,902 2,168 2,919 3,945 5,254 6,017 5,472 Europe ,172 2,208 2,615 America Africa Australia and ocean Import value 2,133 3,474 5,076 7,704 10,626 11,360 11,311 Asia 1,663 2,719 3,911 6,339 8,613 9,086 8,970 Europe ,020 1,083 1,540 1,726 1,637 America Africa Australia and ocean Trade balance ,390-2,443-3,800-2,404-2,003 Source: Statistical Yearbook 1994, Problems and challenges for the future Although the Vietnam economy in the transition period has achieved its recent successes, ability to maintain a fast rate of economic growth and development and to become the next newly industrialized country in Asia requires the country to successfully address its main problems and challenges. Harvie (1996) pointed out the key challenges the Vietnam economy has to face as follows: 35

55 Chapter Two: The Economic Structure and SMEs in Vietnam Deploy its resources effectively Vietnam needs to utilize its scare resources efficiently, through raising productivity in the agricultural sector, utilizing the entrepreneurial flair of southern business owners, encouraging overseas Vietnamese to invest locally, merging viable state enterprises with private investors and utilizing overseas development assistance effectively. Create equitable wealth Vietnam needs to narrow the gap between the poor and rich people during the process of economic development. Control the rate of population growth Vietnam is a relatively poor country that is likely to remain impoverished until it is able to control the growth of the population. Annual increase in population puts further strain on the limited resources of the country and puts severe pressure on the nation s resources. Create employment The abilities to maintain political stability and the formation of a consumer class providing the foundations for further industrialization will require the government to bring about the creation of jobs across the broad spectrum of society, ranging from peasant farmers to university graduates. Maintain sound economic management of the economy Attainment of a stable macro-economy is a key prerequisite for further development of the economy, as clearly evidenced by the experiences of the dynamic economic neighbours. This will create the necessary environment for the market-based economy. Invest in human capital and physical infrastructure There will be a pressing need for Vietnam to invest in the education of its people and also in its physical infrastructure. Whilst Vietnam has an abundance of cheap labour, this will not be enough when it eventually hits shortages in trained and skilled workers. Create strong and efficient institutions Vietnam lacks the necessary institutions to support a market-oriented economy. It needs to develop a modern central bank, an independent judiciary, a modern banking system and supportive capital market for the fledgling private sector. Reduce its reliance on primary exports (oil, rice and seafood) Vietnam remains exposed by fluctuations of world commodity prices and heavily dependent upon exports of crude oil, sea products and rice. 36

56 Chapter Two: The Economic Structure and SMEs in Vietnam Prevent the North/South, and rural-urban split from widening A gulf between the north and south of Vietnam, as a result of history, politics, and economics, threatens to become even more pronounced as free market reforms take root. Ho Chi Minh City is destined to become Vietnam s leading commercial centre and international focal point. In order to prevent regional disparities the government needs to divert more investment to the north and other underdeveloped provinces. Maintain political stability Whilst economic reform has been a key component of the developmental program, political reform is not on the agenda. Recently, Mekong Project Development Facilities (MPDF), a multi-donor program managed by International Financial Corporation (IFC) examined the current state and indicated four big problems that Vietnam economy has to face including: GDP growth rates have been falling That growth has slowed significantly in Vietnam is scarcely a matter of debate. GDP growth has fallen from a high of 9.3 percent in 1996 to 4.8 percent in Growth rates have roughly halved across all major sectors: industrial growth has dropped from a high of 16 percent in 1995 to 8 percent in 1999, and growth in services has fallen from 8.8 percent in 1996 to 2.5 percent in 1999 (MPDF, 1999). Both unemployment and underemployment are rising Unemployment in urban areas was officially estimated at 7.4 percent for 1999 and the underemployment rate for rural was reported at 28.2 percent (MPDF, 1999). Foreign direct investment has sharply declined since 1998 The number of new foreign-invested projects was estimated to total 252 in 1999, a seven-year low from a high of 411 projects in 1995 (MPDF, 1999) Growth in exports has fell precipitously in 1998 Seventy two percent and 65 percent of Vietnam s exports in 1996 and 1997, respectively, were shipped to Asian countries. Monetary crises of Asian countries caused Vietnam s exports sharply declined in 1998 and 1999 (MPDF, 1999). 37

57 Chapter Two: The Economic Structure and SMEs in Vietnam In recent years, the financial and monetary crises of Asian countries have remarkably affected the process of economic development in Vietnam and made these problems and challenges become more serious. Vietnam was affected by the East Asian crisis, although the consequences were not as severe as in neighbouring countries. The crisis had in particular an impact on the external trade of Vietnam. East Asia accounted for 70% of Vietnam s exports and foreign investment. As a result of the crisis, the exports of Vietnam to these countries stagnated and fell by respectively 5% and 20% in 1997 and 1998 (Pool, 2000) The Vietnam population and labour This subsection examines the population and labour and their potential effects on the economic and SME development in Vietnam Population Vietnam is a small country but very crowded with city population, and the population growth rate is relatively high. At the beginning of 1980s, the population of Vietnam was about 53 million. Its population has risen to 76 million at the end of 1990s, an increase of 43 percent after 20 years (Table 2.11). Table 2.11: Population by sex and areas (in thousands) Total 53,722 59,872 66,233 73,962 76,327 By sex Male 26,018 29,285 32,327 36,095 37,581 Female 27,704 30,587 33,906 37,867 38,829 By areas Urban 10,301 11,360 13,281 14,575 17,918 Rural 43,321 48,512 52,952 59,387 58,409 Source: Statistical Yearbook 1994, 1999 In recent years, the government has recognized that a population boom in poor countries like Vietnam will threaten development and stability of the economy. Therefore the government has carried out strong measures to restrict population growth. As a result, population growth rate of Vietnam has declined to 1.7 percent at the end of 1990s (Table 2.12, page 39) from 2.3 percent at the beginning of 1990s. 38

58 Chapter Two: The Economic Structure and SMEs in Vietnam Table 2.12: Population growth rates and structure (%) Population growth rate Population structure Male Female Urban Rural Source: Statistical Yearbook 1994, Labour force Vietnam s well-educated but inexpensive labour force is one of the country s primary assets. Investors view the low wages and a high literacy rate (90%) of Vietnamese workers as one of the most attractive aspects of the country s investment environment (Geib, 1999). The labour force - estimated at nearly 34 million in is growing at an average of 5 million in each of five years. Every year around one million new workers enter the market (Table 2.13). Ninety percent have a secondary level education, and 57,000 are college or university graduates. Nevertheless, a shortage of skilled workers in certain areas as well as qualified management personnel has lifted salaries in some sectors of the economy, but this situation is likely to equalize as training programs and educational institutions respond to the new demands of the more open economy. Table 2.13: Labour force by economic sector (in thousands) Industry 2, , , , ,656.0 Construction 1, Agriculture and forest 15, , , , ,443.4 Transportation Trade and services 1, , , , ,190.2 Education and health , , ,294.8 Others , ,577.3 Total 21, , , , ,994.2 Source: Statistical Yearbook 1994, 1998 and Vietnam data bank After the policy reform in 1986, the private sector had been encouraged to develop. There was a movement of labour force from the state sector to the non-state sector. This either makes the labour force in the non-state sector rise and the labour force in the state sector decline or makes the growth rate of labour force in non-state sector higher than that of labour force in state sector (Table 2.14, page 40). 39

59 Chapter Two: The Economic Structure and SMEs in Vietnam Table 2.14: Labour force by the state and non-state sector (in thousands) State sector 3, , , , ,266.9 Non-state sector 18, , , , ,727.3 Total 21, , , , ,994.2 Source: Statistical Yearbook 1994, 1998 and Vietnam data bank Although foreign investor views labour-force as a key potential factor and labour costs are quite low, the rate of unemployment is still high, especially in the north of Vietnam. Table 2.15 shows the rate of unemployment in The rate of unemployment of the whole country was 6.85 percent while Hanoi and Ho Chi Minh City account for 9.09 and 6.76 percent respectively. Table 2.15: Unemployment rate of labour force in 1998 (%) Over 15 years old Working age Total Female Total Female Whole country Hanoi Hai Phong Da Nang Ho Chi Minh City Source: Statistical Yearbook 1998 In summary the details of Vietnam s background as reviewed above provides an overview of the business environment in Vietnam. Generally, the business environment has significantly improved since the government introduced its reform policy. Policy on development of the multi-sector economy which was mapped out since 1986 and transition to the market economy in recent years brought about significant achievements in developing the economy, improving business environment, encouraging the private sector and integrating into the regional and world economy. 2.3 VIETNAM BUSINESS STRUCTURE The previous sections provided an overview of the Vietnam economy with a special focus on policy reform. This section will examine business structure in Vietnam including types of business, development of SMEs and the government policy to support for SMEs. 40

60 Chapter Two: The Economic Structure and SMEs in Vietnam Types of business in Vietnam With the policy of developing a multi-sector economy and attracting foreign investment, the Vietnam business structure has currently diversified consisting of many different economic sectors. The business structure in Vietnam can be classified into many different types depending upon the breakdown basis. Based on form of ownership, the business structure in Vietnam includes two main sectors: domestic and foreign-invested. The domestic sector can be further divided into the state and non-state sectors. There are five types of business in nonstate sector: private enterprises, limited liability companies, joint stock companies, collectives or co-operatives and individual households. Figure 2.3 illustrates all types of business in Vietnam by form of ownership. However, this research only concentrates on private enterprises, limited liabilities companies, and joint stock companies the main types of non-state business in Vietnam. Other sectors such as foreign-invested companies, state companies, co-operatives and individual households are beyond scope of the study. Figure 2.3: Business structure in Vietnam Business structure in VN Domestic sector Foreign-invested sector Non-state sector Private enterprises* State sector Central Limited liability companies* Local Joint stock companies* Co-operatives Individual households (*) Target population of this research Source: Developed for this research 41

61 Chapter Two: The Economic Structure and SMEs in Vietnam A second way to breakdown the business structure in Vietnam is based on size of the businesses. Based on size of the businesses, the business structure in Vietnam can be classified into three types: small, medium and large enterprises (Figure 2.4). This study only focuses on examining small and medium enterprises whereas the large enterprises are beyond the scope of this study. These definitions below vary from the VCCI definitions explained on page 10. Small enterprise was defined as business having less than 50 employees and/or a total capital of less than VND 1 billion (Document 681/CP-KTN issued by the government in 1998). Medium enterprise was defined as business having from 51 to 200 employees and/or a total capital ranging from 1 to VND 5 billion (Document 681/CP- KTN issued by the government in 1998). Large enterprise was defined as enterprise with more than 200 employees and/or a total capital of more than VND 5 billion in capital (Document 681/CP-KTN issued by the government in 1998). Figure 2.4: Breakdown of business by size Business structure Small enterprise - Labour: < 50 - Capital: < dong 1 bil. Medium enterprise - Labour: Capital: 1 dong 5 bil. Large enterprise - Labour: > Capital: > dong 5 bil. Source: Developed for this research A third way to break-down the business structure in Vietnam is based on industry. Based on the characteristics of industry, the business structure in Vietnam can be classified into businesses operated in the following major industries: agriculture and forestry, fishery, mining, manufacturing, electricity, construction, trade and services, hotels, and finance and banking. In scope, this study only considers small and medium businesses operating in manufacturing and trading 42

62 Chapter Two: The Economic Structure and SMEs in Vietnam industries. Other industries such as agriculture, fishery, mining, construction, and others are outside the scope of this study Overview of enterprises in Vietnam According to Statistical Yearbook 1995, there were 32,064 registered enterprises in Vietnam at the end of Of this number, 6,310 were state enterprises; 18,243 private enterprises, 7,346 limited companies and 165 stock companies. During 1994 and 1995, the number of state enterprise grew by an average of 400 whereas the number of non-state enterprises grew by that of 6,500 each year (Table 2.16). Of the non-state enterprises, the number of private enterprises were the biggest (18, 243 enterprises with the average capital of VND170 million), the next was the limited company (7,346 enterprises with the average capital of VND780 million). Stock companies were insignificant in terms of number of enterprises and percentage (Table 2.16 and 2.17, page 44) but they represented the biggest in terms of average capital (VND10.33 billion). State enterprises had been undergoing reorganization and consolidation since 1991 and there had been large declines in their total number, but in 1994 they began to grow again, primarily because of joint ventures with foreign companies (Ebashi, Sakai and Takada, 1997). Table 2.16: Number of businesses by economic sector and average capital (billion dong). End of 1994 Licensed in 1994 End of 1995 Licensed in 1995 No. Ave. No. Ave. No. Ave. No. Ave. Capital capital Capital Capital Private sector 19, , , , Private enterprises 14, , , , Limited companies 5, , , , Stock companies State sector 5, , Central management 1, , Local management 4, , Total 25, , , , Source: Statistical Yearbook 1994, 1995 In accordance with the Decision 115/TTg issued by the Prime Minister on March 13, 1995, the General Statistical Office (GSO) and other relevant ministries had carried out a survey of businesses and enterprises in Vietnam s territory. The results of survey published in 1997 by GSO revealed that there were 23,708 43

63 Chapter Two: The Economic Structure and SMEs in Vietnam enterprises in Vietnam on July 1, 1995, broken down as follows: 5,873 state enterprises, 10,916 private enterprises, 4,242 limited liability companies, 118 stock companies, 1,867 collective businesses and 692 foreign-invested companies. These businesses and enterprises created employment for by 1.3 million people (Table 2.17). The number of businesses provided by the result of the survey is not compatible with that of Statistical Yearbook because the Yearbook did not subtract the number of businesses, which did not operate due to bankruptcy. Table 2.17: Number of businesses and employees on July 1, 1995 Type of businesses Number of Percentage Number of Percentage businesses employees Domestic sector 23, % 1,263, % State enterprises 5, % 886, % Collectives 1, % 87, % Private enterprises 10, % 127, % Limited liability companies 4, % 147, % Stock companies % 13, % Foreign-invested sector % 81, % Total 23, % 1,345, % Source: Size and Effectiveness of 1.9 Million Businesses in Vietnam s Territory, GSO 1997 Table 2.17 shows that the domestic sector was the major sector which accounted for 97.08% of enterprises, and the private enterprises were the biggest (47.04%), the next were state enterprises (24.77%), limited liability companies and stock companies were respectively and 0.50%. Although the number of state enterprises is less than that of private enterprises, they employed up to percent of employees Small and medium enterprises in Vietnam This subsection reviews the background, role, current status, difficulties and problems of SMEs in Vietnam in recent years. The main objective of this subsection is to address the current status and problems that SMEs face Background In recent years, promotion of small and medium enterprises (SMEs) has been given more attention (Nguyen, 1999). The eighth National Congress and the fourth session of the Central Conference of the Vietnam Communist Party confirmed promotion 44

64 Chapter Two: The Economic Structure and SMEs in Vietnam policy for small and medium enterprises of all economic sectors. Many laws such as company law, private enterprises law, co-operative law, home investment promotion law, civil law, and commercial law had been passed to create a favourable environment for the development of small and medium enterprises (Nguyen, 1999). As a result, SMEs in Vietnam have developed, not only in term of quantity but also in terms of structure and quality of performance. Once the government commenced programs of promotion for SME development, the studies on SMEs have attracted many researchers. In terms of supporting policy, finance, and research, the definition of SMEs should be clarified. In Vietnam there has not been a common definition of SMEs. Some popular definitions are examined below Definitions of SMEs The concept of SMEs has only existed in recent years in Vietnam. As of 2000, there is no formal definition of what constitutes a small and medium enterprises in Vietnam (Esbashi, Sakai, and Takada, 1997). Below are some popular definitions of SMEs stated and used in Vietnam. 1) Definition used by the Vietnam Industrial and Commercial Bank Enterprises with capital of between VND5.0 and 10.0 billion and/or 500 1,000 employees are medium enterprises ; those with less than VND5.0 billion in capital and/or 500 employees are small enterprises. 2) Definition used by Ho Chi Minh City Enterprises with less than VND1.0 billion in capital and/or 100 employees are small enterprises, those with VND billion in capital and/or 500 employees are medium enterprises. 3) Definition used by the Vietnam Chamber of Commerce and Industry (VCCI) A SME is defined as a business unit that fulfils the following criteria, depending on its size: Small business: Manufacturing: less than 200 employees and VND5 billion capital Trading and services: less than 200 employees and VND5 billion capital Medium business: Manufacturing: employees and 5 VND10 billion capital 45

65 Chapter Two: The Economic Structure and SMEs in Vietnam Trading and services: employees and 5 VND10 billion capital 4) Definition defined as Document 681/CP-KTN issued by the Government in 1998 A small enterprise is defined as one with less than 50 employees or a total capital of less than VND 1 billion or with a turnover less than VND 1 billion. A medium enterprise is one having a number of employees ranging from 51 to 200 persons or a total capital, ranging from 1 billion to VND 5 billion. Table 2.18 compares definitions of SMEs in Vietnam with those of some Asian countries. All countries define SMEs based on two criteria: number of employees and the amount of capital or assets. Also note that the definitions in Table 2.18 are not consistent on whether the amount of capital or assets and number of employees are to be linked with and or or. Some countries such as Singapore, Taiwan, Thailand, Philippines use and, Vietnam and Japan use or whereas Korea and Malaysia neither use and nor or (Table 2.18). Table 2.18: Definitions of SMEs in Asian countries Country Definition Japan Less than 300 employees or less than 100 million yen in legal capital Singapore Greater than 30% in local equity and less than S$12 million in fixed assets Korea Less than 300 employees Taiwan Less than NT$40 million in paid capital and less than NT$120 in total assets Malaysia Less than MR2.5 million in shareholder s fund Thailand Less than 200 employees and 100 million bath in investment capital Philippines Less than 200 employees and 40 million peso in total assets Vietnam Less than 500 employees or less than VND10 billion in total assets Source: The APEC survey on small and medium enterprises 1994, APEC Committee on Trade and Investment, Ministry of Economic Affairs, Chinese Taipei The role of SMEs in Vietnam SMEs play a very important role in developing the economy and solving social problems at the present stage when the economy is transiting into the market economy. Vu (1998) summarized the contribution of SMEs in developing the economy. SMEs in Vietnam have: provided a large number of diversified products, representing 26 percent of GDP and 30 percent of industrial outputs created jobs for some 4.5 million people 46

66 Chapter Two: The Economic Structure and SMEs in Vietnam mobilized unused resources such as land, capital, labour, and management skills into development of the economy and contributing to increase of export volume. Nguyen (1999) found that SMEs annually contribute approximately 31 percent of the total industrial output and create jobs and income for million people. According to Vuong (1998), during the period of , the private sector capitalized almost USD3 million, created 3.5 million jobs and made a significant contribution to Vietnam s GDP growth, in which 90 percent come from SME contribution, and only 10 percent from large firms The current status It is difficult to gain reliable facts from a literature review regarding the current status of SMEs in Vietnam. This is for two main reasons. Firstly, there is little research undertaken related to this field. Secondly, most research, especially the research conducted by the local researchers, is not reliable and very poor in term of scientific and academic methods. In Vietnam, there have recently been some surveys on the current status of enterprises conducted by both local and foreign organizations. Typical surveys are listed below: enterprises census taken by the General Statistics Office (GSO) on July 1, 1995 survey on small and medium enterprises conducted by Ebashi, Sakai and Takada in March 1997 survey on Vietnamese private sector conducted by Mekong Project Development Facilities (MPDF) in May Of these surveys, only the survey conducted by Ebashi, Sakai and Takada (1997) concentrated on considering the current status of SMEs in Vietnam. The survey conducted by MPDF only focused on larger private enterprises. Regarding the number of enterprises and number of SMEs in Vietnam, there are many different opinions. Based on the census conducted by GSO on July 1, 1995, Ebashi, Sakai and Takada (1997) concluded that 96.7% of manufacturing enterprises in Vietnam are 47

67 Chapter Two: The Economic Structure and SMEs in Vietnam SMEs. Some 96.7% of enterprises have no more than 500 employees and 91.3% have less than VND10.0 billion in total capital (Table 2.19, page 49). According to Nguyen Tien Quan (1999), Director of Non-state Economic Development Centre, there are 5,960 state enterprises in which medium and small enterprises account for 65.9%. Of 1,396 foreign invested enterprises, medium and small enterprises account for 33.6% and of 19,480 cooperatives and united cooperatives, medium and small cooperatives account for 65.9%. Also, of 34,000 business establishments having registered under company and private enterprise law, medium and small enterprises of responsibility limited companies account for 94.6% and of private enterprises account for 99.4% Difficulties and problems Small and medium enterprises in Vietnam are faced with many problems irrespective of their process of development. In their interview of 14 SME manufacturers (5 in Hanoi, 4 in Ho Chi Minh City, 2 in Dong Nai and 3 in Binh Duong), Ebashi, Sakai and Takada (1997) found the main problems that SMEs in Vietnam have to face as listed below by the order of serious concern. Funding rising A large number of the interviewed SME owners saw financial shortfalls as one of the biggest problems. They needed funds primarily to finance plant and equipment investment and for securing working capital to cover expenses involved in exporting their products until they could receive payments from exporters. Export licenses Companies who wanted to export goods directly to foreign countries were required to obtain a direct export license. Companies who were not eligible for the license had no choice except to export goods on consignment through government enterprises. Even those who had the license were required to visit Hanoi every year to renew their licenses. Industrial land Interviews also found that in cities such as Hanoi and Ho Chi Minh City, there was increasing concern for pollution problems because of the mixture of residential and industrial areas. Moreover, urban areas were increasingly and seriously short of industrial estates. 48

68 Chapter Two: The Economic Structure and SMEs in Vietnam Table 2.19: Number of enterprises in manufacturing industry by scale of employees and total capital Total number of By number of employees By scale of total capital (billion VND) enterprises >501 <5 >5 <10 >10 (July 1, 95) % % % % % % % % % Manufacturing total 8, Food, foodstuff and drinks 3, Tobacco Textile Garment, tanning, leather Leather goods Wooden, bamboo, rice stubble products Paper products Publishing, printing, copying Coke, mineral oil products Chemicals, chemical products Rubber, plastic products Non-metal products 1, Metal Metal products Machinery and equipment Office machine, computer, calculator Electric machines & equipment Radio, TV and communication equipment Medical instruments, optics & clocks Motorbikes, trailer Other means of transportation Bed, wardrobe, tables, chairs and others Re-processing

69 Chapter Two: The Economic Structure and SMEs in Vietnam Business administration SME managers were deeply aware of the importance of acquiring more sophisticated management skills. Many owners have recently attended seminars and training sessions for managers. Other problems such as human resource development, quality control, smuggle effect were less serious than the four problems listed above. Additionally, Ebashi, Sakai and Takada (1997) conducted a questionnaire survey to identify management practices and problems, and the needs of SMEs for government support program. Table 2.20 below shows the result of the survey. This result demonstrated that 51 percent, the highest percentage, of SMEs faced with financial issues. Table 2.20: Business operation problems of SMEs in Vietnam Problems Percentage of interviewees faced with problems (%) Financing 51.0 Tax 32.3 Production investment 26.7 Technology development 20.3 Recruiting 17.9 Sales 17.5 Raw material supply 16.7 Regulation 13.5 Production 9.2 Export 7.6 Information access 4.8 Distribution 3.6 Outside manufacturers 2.0 Source: Survey conducted by Ebashi, Sakai and Takada, Policies for supporting SMEs Countries around the world have policies to support small and medium enterprises. The objectives of SME support policy are different depending on the country s stage of economic development (Ebashi, Sakai and Takada, 1997). In Vietnam, the necessity of policies to support SMEs has been supported with the following objectives: expand export and improve the living standard of the residents raise capital and labour productivity create jobs for residents 50

70 Chapter Two: The Economic Structure and SMEs in Vietnam change economic structure create an equal competitive environment between state and non-state enterprises. Finally, regarding the needs for SME support programs, Ebashi, Sakai and Takada (1997) listed various support programs that SME owners in Vietnam expect (Table 2.21). Table 2.21 demonstrated that 46.6 percent, the highest percentage, of SMEs expect the support programs related to financial issues. Table 2.21: The kind of SME support programs Kind of programs Percentage of interviewee expecting programs (%) Expansion of bank financing 46.6 Sales tax reduction 45.4 Development of aid for environment 36.7 Simplification of administrative procedures 35.1 Stable supply of electricity 25.1 Technological assistance 25.1 Development of industrial parks 23.5 Financial support for exporting 18.3 Deregulation in exporting 13.5 Foreign information service 12.4 Improvement of law 10.8 Improvement of water supply 9.2 Promotion of industrial associations 8.8 Technological information services 8.4 Deregulation in production investment 6.8 Improvement of traffic infrastructure 6.4 Training service for technology 6.4 Training service for business administration 4.8 Establishment of training institution for engineers 3.6 Management information service 2.0 Source: Survey conducted by Ebashi, Sakai, and Takada 2.4 SMALL AND MEDIUM ENTERPRISE FINANCE IN VIETNAM This section reviews aspects of finance and financial management of SMEs in Vietnam. The objective of this section is to examine the current state of small and medium enterprise financial management in Vietnam, including type of finance, use of finance, financial management practices and problems of financial management. While there is a large number of articles and books on financial management for SMEs around the world, there is very little research and literature on finance and financial management for SMEs in Vietnam. 51

71 Chapter Two: The Economic Structure and SMEs in Vietnam Types of finance SMENET Online Vietnam (1999), a SME support organization, summarizes the types of finance available in Vietnam for SME owners as sources of finance for their operations. They include owners equity, family loans, friends loans, bank loans, share capital, supplier advances, buyer advances, leasing, hire-purchasing, and factoring. Owners equity remains the first choice of SMEs because it has advantages of making the business owner independent of third parties. However, owners equity is often not sufficient to allow for business growth. For growth, the businesses need an external source of finance. The traditional debt financing sources such as bank loans, loans from family or friends, supplier or buyer advances are popular types of debt finance. Other recent types of finance such as leasing, hire-purchasing and factoring were only introduced on the financial market in Vietnam in 1990s (SMENET Online, 1999). In recent years, some SMEs have used sources of financing from the International Financial Corporation (IFC). IFC provides a wide variety of financial products from which its clients can choose (SMENET Online, 1999). This allows IFC to offer a mix of financing that is tailored to meet the needs of each project. However, the bulk of the funding, as well as leadership and management responsibility, lie with private sector owners. Loans are the IFC s largest product. IFC provides fixed and variable rate loans in any of the leading currencies. These loans typically have maturities of 8 to 12 years, with grace periods and repayment schedules determined on a case-by-case basis in accordance with the borrower s cash flow needs. If warranted by the project, IFC provides longer-term loans and longer grace periods. IFC s equity investments are based on project needs and anticipated returns. IFC is never the largest single shareholder in a SME and IFC does not take an active role in company management. IFC is considered a passive investor. To meet national ownership requirements, IFC shareholdings can, in some cases, be treated as domestic capital or local shares. IFC usually maintains equity investments for a period of 8 to 15 years and is considered a long-term investor (SMENET Online, 1999). Other financial products offered by IFC include credit and equity lines, venture capital, and leasing. IFC is investing in credit lines and private equity funds to make longer-term finance available to SMEs as they seek to enhance their 52

72 Chapter Two: The Economic Structure and SMEs in Vietnam competitiveness in more open economies around the world. Credit lines to developing country banks help redress the limited availability of term funding that constrains the ability of these banks to provide working capital and investment financing for their corporate customers. Leasing is often essential to the development of SMEs, which typically lease costly capital equipment. Leasing plays a critical role in financial sector development in countries with small economies or low per capita incomes (SMENET Online, 1999) Use of finance In the middle of 1999 Kack and Lindgren (1999) conducted exploratory research related to financing SMEs in Vietnam. They interviewed 16 SMEs in Ho Chi Minh City to identify what type of financing sources they used during and after their establishment. Regarding financing during the establishment, SMEs were classified into two groups: those who had obtained bank loans and those who had used alternative financing. Of sixteen SMEs, only one SME (Toan Luc) obtained a bank loan as a source of capital at establishment. The residual 15 SMEs financed their establishments by using capital from their relatives, friends, or from owner savings. The main reason for not choosing the bank as a source of capital was the lack of SME assets that could be used as collateral. Regarding financing after the establishment, the SMEs were also classified into two groups: those who have obtained bank loans and those who have not used bank loans to finance their operations. Of sixteen SMEs, only seven enterprises (ADC Company, Ann s Tourist and Trading Ltd, Autec Ltd, Hunsan Ltd, Orient Plastic Company, Saigon Private Garment Ltd, and Vien Thang Ltd) obtained bank loans after establishment. The other SMEs had financed their business after the establishment by using profits, long supplier credits, customer payments in advance, co-operation with foreign companies and networks consisting of relatives and friends. The main reasons they did not use bank loans were (1) lack of assets to offer as collateral, (2) lack of good relations and stipulations with the banks, and (3) high interest rate charged on bank loans. Kack and Lindgren (1999) also found there are several misfits regarding distribution of capital in Vietnam. Firstly, according to general regulations, 53

73 Chapter Two: The Economic Structure and SMEs in Vietnam commercial banks had to require collateral for their loans. However, this requirement was not equal between private and state companies. Private companies had to offer collateral to obtain bank loans whereas state companies do not. Secondly, there were difficulties in evaluating collateral but this may differ from time to time. Hence the problem is not collateral itself, but unequal regulations and the difficulties of banks in evaluating collateral. Thirdly, different rules for different banks and different rules from time to time made SMEs avoid banks due to common assumptions of poor stipulation, expensive fees, and changing policies, and owners turned to seeking sources of finance from their families, relatives and friends. However, often due to lack of capital, SMEs could not accept business options for further expansion. Sam Korsmor (Vietnam Investment Review, 1998) also found that SMEs in Vietnam face more difficulties than those in regional countries because the state and non-state do not rest on an equal playing field. Say, there are two companies one state company and one private enterprise. The state company will be granted the loan every time because it holds a government guarantee. This discrimination may negatively impact on private SME growth. Unless the government had created an equal playing field, it would not be realistic to discuss promotion policies for SMEs Financial management for SMEs Financial management in general and financial management for SMEs in particular has only become popular in Vietnam in the 1990s when the economy moved into a market economy. To date, there is little research related to financial management for SMEs. Vuong Quan Hoang (1998) found that the current ratio and quick ratio are extremely important for SMEs in Vietnam because they usually have little permanent working capital. Regarding financial characteristics of SMEs in Vietnam, his findings are summarized in Table Table 2.22: Some financial characteristics of SMEs in Vietnam Characteristics Minimum Average Maximum Current ratio 1.15x 2.1x 7.1x Quick ratio n.a 1.2x n.a Equity/total assets 25% 61. % 90% Short-term ratio n.a 67% n.a Source: Vietnam Investment Review,

74 Chapter Two: The Economic Structure and SMEs in Vietnam By applying linear regression analysis, it had been found that equity and shortterm liability ratios have a correlation coefficient of about In other words, the equity ratio and short-term ratio are moderately related. The short-term debt ratio is relatively high (67%) because SMEs had difficulties in accessing long-term sources of capital and they, therefore, are willing to use short-term borrowing to finance noncurrent assets Problems in financial management As mentioned earlier, there is almost no significant research regarding financial management for SMEs in Vietnam. Based on the exploratory research conducted by Kack and Lindgren (1999) and findings of Vuong Quan Hoang (1998), the following gaps are found in SME financial management practices in Vietnam: SMEs in Vietnam use equity as the major source of finance. Sometimes, equity ratios are up to 90 percent. Due to difficulties in obtaining long-term loans, SMEs in Vietnam are willing to use short-term loans to finance non-current assets. SMEs in Vietnam seem likely to maintain very high current ratios. These financial management practices might adversely affect SME profitability. However, the findings above are not enough evidence to conclude on the relationships between SME financial management practices and its profitability. Therefore further descriptive research regarding the financial management practices and impact of financial characteristics and financial management practices on SME profitability is justified to provide more convincing evidence. Moreover, because of the uncertainty of the business environment SMEs in Vietnam tend to maintain relatively high liquidity ratios and low financial leverage ratios. These financial characteristics may adversely affect SME profitability. Figure 2.5 (page 56) represents the gap between financial management practices in Vietnam and findings from the literature reflecting other country trends. 55

75 Chapter Two: The Economic Structure and SMEs in Vietnam Figure 2.5: SME financial management practices and the gap Literature review of financial management practices of SMEs in Vietnam Difficulties in obtaining bank loans High risk business environment Results: Framework of: High equity ratio/low debt ratio Financial leverage High current ratio Liquidity Using short-term loans to finance non-current assets. Profitability The gap Research problem: How does the gap impact on SME profitability? Source: Developed for this research 2.5 BUSINESS STRUCTURE AND SMEs IN HO CHI MINH CITY Section 2.3 and 2.4 respectively reviewed business structure and SMEs in Vietnam. However, because of constrain of time and funding, this research only focuses on investigating SMEs in Ho Chi Minh City where SMEs are considered to be representative of the country. This section examines business structure of SMEs in Ho Chi Minh, which is defined as the target population for this research. According to the Ho Chi Minh City Department of Investment and Planning, at the present time, there are 14,806 businesses (consisting of 4,909 private enterprises, 8,030 limited liability companies, 322 joint stock companies and 1,545 businesses belonging other sectors) operating in Ho Chi Minh City with over VND18 56

76 Chapter Two: The Economic Structure and SMEs in Vietnam billion in total capital, and over 280,000 employees (Table 2.23). This figure accounts for all businesses that have been established since 1990, the year of commencing the transition economy period. Table 2.23: Business structure of SMEs in Ho Chi Minh City Year Private enterprise Limited company Joint stock Others Total company , , , , , , , ,166 2, ,520 4,837 Total 4,909 8, ,545 14,806 Source: Ho Chi Minh City Department of Investment and Planning (2000) In terms of business size, almost all of these businesses are small and medium enterprises with the average total capital of VND327 million for private enterprises, VND1, 617 million for limited liability companies and VND11, 257 million for joint stock companies. In term of number of employees, these businesses have an average number of employees of 3 for private enterprises, 33 for limited liability companies and 18 for joint stock companies (Table 2.24). Table 2.24: Size of businesses in Ho Chi Minh City Forms of business Number of Capital (Million VND) Number of employees business Total Average Total Average Private enterprises 4,909 1,609, ,043 3 Limited companies 8,030 12,989,401 1, , Joint stock companies 322 3,625,031 11, , Others 1, , n/a n/a Total 14,806 18,335,244 1, , Source: Ho Chi Minh City Department of Investment and Planning (2000) With an average total capital and number of employees as mentioned earlier, most businesses in Ho Chi Minh City are considered small and medium enterprises. These businesses satisfy the criteria of SME definition as indicated in chapter 1. 57

77 Chapter Two: The Economic Structure and SMEs in Vietnam 2.6 CONCLUSIONS Vietnam is in transition to a market-oriented economy and has achieved stability and relatively high growth rates. Its policy of developing the multi-sector economy has created a substantial and attractive foundation for enterprises in all economic sectors. Based on this policy reform, SMEs in Vietnam have had opportunities to develop and create employment. However, as of 2000, there are still differences in policy between the state and non-state enterprises as well as between large and small enterprises. These differences in policy mean small and medium enterprises have many problems in the process of development. Financing is one of the most difficult issues faced by SMEs (Ebashi, Sakai and Takada, 1997). SMEs cannot easily obtain bank loans for establishment and further expansion. This leads SMEs to use equity as a major source of finance and use shortterm loans to finance non-current assets. Moreover, different rules for different banks and different rules from time to time lead to negative impacts on financial policy for SMEs. As a result, they often maintain relatively high current ratios to respond to the regularly changing business situations. Probably, financial management practices of SMEs as mentioned above, have adversely affected profitability. In addition, operating in an uncertain business environment probably makes the financial characteristics of SMEs in Vietnam differ from that of SMEs in other countries. As a result, financial characteristics may adversely affect SME profitability. These conclusions are viewed as the foundation for conducting research on the impact of financial management practices and financial characteristics on SME profitability in Vietnam. Chapter 3 will review the literature on financial management practices and financial characteristics of SMEs around the world as a framework for comparisons with financial management practices of SMEs in Vietnam. 58

78 Chapter three: Financial Management and Profitability of SMEs 3.1 INTRODUCTION This chapter follows from chapter 2 as a review of the literature on financial management. Chapter 2 provided an overview of the economic development and performance of SMEs in Vietnam. Chapter 3 reviews financial management including financial management practices, financial characteristics and profitability of SMEs around the world, especially in the developed economies such as the United States of America (USA), the United Kingdom (UK), Australia and Canada. It emphasizes profitability and the impact of financial management practices and financial characteristics on SME profitability. The objectives of this chapter are to review previous research related to the areas of financial management practices, financial characteristics, and profitability of SMEs and to build a model of the impact of financial management practices and financial characteristics on SME profitability. This chapter is structured into nine main sections (Figure 3.1, page 60). Section 3.1 introduces the general purpose and objectives of the chapter. Section 3.2 reviews definitions of SMEs, both qualitative and quantitative. Section 3.3 defines the objectives, major decisions and the specific areas of SME financial management. Section 3.4, 3.5 and 3.6 respectively review the previous studies on financial management practices, financial characteristics and SME profitability conducted by previous researchers in the developed economies. Section 3.7 concentrates on examining the relationships between financial management practices, financial characteristics and SME profitability. Section 3.8 develops a model of the impact of financial management practices and financial characteristics on SME profitability. Lastly, section 3.9 provides the conclusions that are drawn from the literature review and figure 3.1 (page 60) provides a visual outline of the structure of the chapter where the sections are combined as a whole.

79 Chapter Three: Financial Management and SME Profitability Figure 3.1: Structure of chapter Introduction 3.2 Definition of SMEs 3.3 Financial management for SMEs Defining financial management Major decisions of financial management Objectives of financial management Specific areas of financial management 3.4 Financial management practices The context of financial management Accounting information system Financial reporting and analysis Working capital management Fixed asset management Capital structure management 3.5 Financial characteristics Identifying financial characteristics Measuring variables of financial characteristics Previous findings related to financial characteristics 3.6 SME profitability Importance of profitability Defining and measuring profitability Factors influencing on profitability 3.7 Relationships between financial management and SME profitability 3.8 The model of impact of financial management on SME profitability 3.9 Conclusions Source: Developed for the thesis 60

80 Chapter Three: Financial Management and SME Profitability 3.2 DEFINITIONS OF SMEs This section reviews the definitions of small and medium enterprises (SMEs) from the literature. Obtaining a definition is the starting point for reviewing literature on the aspects of SME financial management. There is no universal definition of small enterprise (Scarborough and Zimmerer, 1984; Back, 1985 and Meredith, 1993). In theory and practice, there are many terms used to refer to SME including small business, small enterprise, small firm, small company, small and medium enterprise, and small and medium-sized enterprise. They all are somewhat different in meaning but distinguishing differences among these terms is not the purpose of this study. In this study all these terms are used as if having the same meaning. Although there are several definitions of small and medium enterprises, definitions are basically classified into two types: those based on qualitative characteristics and those based on quantitative characteristics of small and medium enterprises (Back, 1995) Qualitative definitions Qualitative definitions define small and medium enterprises based on their qualitative characteristics. The great advantage of these definitions is that they attempt to capture the essential nature of small business. However, the problem is that they vary from country to country and from industry to industry. This study mainly reviews the definitions of small business in the developed countries such as the United States of America (USA), the United Kingdom (UK), Australia and Japan. In the USA, based on four key factors identified by the 1947 Committee of Economic Development (CED), the authorities define a small firm to be one which: 1) has independent management 2) has capital supplied and ownership held by an individual or small group 3) has an area of operation which is localized in one community, and 4) is small in relation to other firms in the industry. 61

81 Chapter Three: Financial Management and SME Profitability The Small Business Act of 1953 of USA defines a small business as one which is independently owned and operated and not dominant in its field of operation. The act also empowers the Small Business Administration (SBA) to identify standards of size for number of employees and sales volume that small business must meet. When reviewing the quantitative definitions, these standards will be examined in more detail. In the UK, the qualitative definitions adopted by the Bolton Committee (1971) identified three major characteristics of small business: Firstly, in economic terms, a small firm is one that has a relatively small share of the market, and is unable to influence the price or quantity of goods or servicing. Secondly, an essential characteristic of a small firm is that it is managed by its owner or part owner in a personalized way, and not through the medium of a formal management structure. Thirdly, it is also independent in the sense that it does not form part of a larger enterprise and that the owner-managers should be free from outside control in making their principal decisions. In Australia, the qualitative definition commonly used was devised by the Wiltshire Committee of Inquiry in Wiltshire (1973) defines a small business as: A business in which one or two people are required to make all the critical decisions (such as finance, accounting, personnel, purchasing, processing or servicing, marketing, selling) without the aid of internal specialists and with specific knowledge in only one or two functional areas. The second annual report of small business released by the Department of Industry, Technology and Commerce (1992, p.5) employs a definition of a small enterprise that is based on the following characteristics: independently owned closely controlled by owner-managers who have responsibility for principal decisions owner-managers contribute most, if not all, of the capital operations are locally based, although its market might not be. 62

82 Chapter Three: Financial Management and SME Profitability The problem of definitions of small business in Australia is that each State Government has its own definition. For instance while the Western Australia Small Business Advisory Service has followed the Wiltshire Committee s definition, Victoria and New South Wales have their own definitions, which emphasize the role of ownership, legal structure, market share and management (Price, 1984, p. 2). A small business is one which is wholly owned and operated by an individual, or individual persons in a partnership or by a proprietorship company and which has relatively small share of the market in which it competes; is managed personally by the owners or directors; is not part of a larger business or enterprise. The Small Business Agency of New South Wales includes in its definition reference to annual turnover and the number of employees (Price, 1984). A small business is one, which is owned and operated by an individual or group of people either, as a sole trader, in partnership, or as an incorporated company. In majority of cases the annual turnover of business generally does not exceed $500,000. In addition to the definitions of small business stated by the organizations mentioned above, there are many other different definitions of small business put forward by many authors and researchers. Meredith (1986, p.3) defines small enterprises as enterprises where one or two owners are required to make all critical decisions, and these owners, therefore, rely on specialist advice multiplier agents. McMahon (1995, p. 3) confirmed that many people think small business should be defined as: A business in which one or two persons are required to make all the critical management decisions: finance, accounting, personnel, processing or servicing, marketing, selling, etc. without the aid of internal specialists and with specific knowledge in only one or two functional areas. Although qualitative definitions have the great advantage of attempting to capture the essential nature of small business, they still have the disadvantage of being unworkable in carrying out research or in gathering statistical information. It is, therefore, useful to define small business from the quantitative characteristic perspective. 63

83 Chapter Three: Financial Management and SME Profitability Quantitative definitions Quantitative definitions define small and medium enterprises based on their quantitative characteristics. Unfortunately, quantitative characteristics may be difficult to measure. Firstly, there are a variety of ways in which enterprise size can be measured, including (1) number of employees, (2) sales revenue or turnover, (3) total assets, and (4) net worth. The first of these is the most widely used measure of size in qualitative definitions of small enterprise around the world, although the second and the third also find significant use (McMahon et al. 1993). Secondly, the quantitative characteristics of small enterprises vary from industry to industry and from country to country. For example, an enterprise, which is small in one industry such as cement manufacture, may be regarded as large in another industry such as trading or tourism. Similarly, an enterprise, which is considered small by the USA standards, may be relatively large in other countries such as Thailand, Malaysia or Vietnam. Regarding the number of employees, in the USA the government decided to use 500 employees as the general cut-off between small and other businesses (Back, 1985, p.4) while most studies in Australia have assumed a firm is small, if it employs less than 100 employees (Back, 1985, p.3). In addition to the number of employees, some other countries such as the USA, Britain, Japan define small business based on turnover and industry breakdown. Table 3.1 (page 65) summarizes the quantitative definitions of SMEs in the developed countries. The quantitative definitions of SMEs, especially their quantitative characteristics, are very important because they provide the bases for carrying out research and gathering statistical information. They also provide quantitative standards for the comparative studies between SMEs in one country and SMEs in another country. 64

84 Chapter Three: Financial Management and SME Profitability Table 3.1: Summary of the quantitative definitions of small business Country Industry Quantitative characteristics Retailing Annual sales or receipts not exceeding $2 to $7.5 million, depending on the industry Services Annual receipts not exceeding $2 to $8 million depending on the industry Wholesaling Yearly sales must not be over $9.5 to $22 million, depending on the industry The US Agriculture Annual receipts not exceeding $1million General construction Average annual receipts not exceeding $9.5 million Special trade construction Average annual receipts not exceeding $1 or $2 million Manufacturing Maximum number of employees may range from 250 to 1,500, depending on the industry. Manufacturing 200 employees or less Retailing Turnover 50,000 pa or less Wholesale 200,000 pa or less The UK Construction 200,000 pa or less Mining 25 employees or less Motor trader Turnover 100,000 pa or less Miscellaneous services Turnover 50,000 pa or less Road transportation 5 vehicles or less Australia Manufacturing 50 employees or less General Turnover not exceeding $500,000 Manufacturing Less than 300 employees Japan Wholesales Less than 100 employees Retail and service Less than 50 employees Sources: (1) Small Firms, Report of the Committee of Inquiry on Small Firms (Bolton, 1971), (2) Small Business Management (Price, 1984), (3) The US Small Business Administration, Business Loans for the SBA, Washington, D.C., September The forms of ownership of SMEs In general, SMEs in every country have many different legal forms of ownership. This subsection reviews the main legal forms of ownership of SMEs. In the USA, there are three forms of ownership: proprietorship, partnership and corporations (Walker and Petty, 1978, p.6; Scarborough and Zimmerer, 1984, p.68). The percentage of each of the major business ownership forms is examined in Table 3.2. Table 3.2: Forms of SME ownership in the USA Proprietorship Partnership Corporation Percentage of business Percentage of business receipts Source: Effective small business management, Scarborough & Zimmerer (1984, p.69) 65

85 Chapter Three: Financial Management and SME Profitability In the UK the Bolton (1971) reported that the legal forms of small firms consists of sole proprietorships, partnerships, quoted and non-quoted companies, limited and unlimited companies. Of these forms, the majority is the unlimited companies while the quoted companies are not significant (Table 3.3). Table 3.3: Legal status of small firms in the UK Quoted Co. Nonquoted limited Co. Unlimited Co. Partnerships Sole proprietorships Manufacturing 1 24 employees employees employees Non-manufacturing Catering Constructions Motor trades Retail distribution Road transport Wholesale distribution Source: Adopted from Report of the Committee of Inquiry on Small Firms, Bolton (1971) In summary, there are several legal forms of ownership for SMEs. Three of the most popular forms are proprietorships, partnerships and company. Each form of ownership has both advantages and disadvantages. Table 3.4 (page 67) lists all these advantages and disadvantages by the forms of ownership (Scarborough and Zimmerer, 1984). Legal forms of ownership also have a certain influence on the financial management practices and financial characteristics. This will be examined in more detail in the next sections (section 4 and 5) where financial characteristics of many different kinds of SMEs are compared. Related to the legal forms of ownership, as indicated in chapter 2, state enterprises, private enterprises, limited companies, joint stock companies, cooperatives and households are the popular legal forms of ownership of SMEs in Vietnam. However, as indicated in chapter 1, this study only focuses on private enterprises, limited companies and joint stock companies. 66

86 Chapter Three: Financial Management and SME Profitability Table 3.4: Summary of advantages and disadvantages of each form of ownership Form of ownership Proprietorship A business owned and managed by an individual. Partnership An association of two or more persons who engage in business in businesses coowners for the purpose of making a profit Corporation A separate legal entity apart from its owners and it may engage in business make contracts, sue and be sued and pay taxes. Advantages Simplicity in creation Least costly form of ownership to start up The owner receives all the profit The owner has total decision making authority There are no special legal restrictions Easy to establish Division of profits Larger pool of capital Large pool of talent Ability to attract limited partners Little government regulation Flexibility Taxation Limited liability of the stockholders Ability to attract capital Ability of the corporation to have perpetual life Transferable ownership Large pool of skill, expertise, and knowledge Potential for economies of scale Disadvantages Unlimited personal liability Limited skills and capability Limited access to capital Lack of continuity of the business Unlimited liability of least one partner Capital accumulation Difficulty in disposing of partnership interest without dissolving the partnership Potential for personality and authority conflicts Partners are bound by the law of agency Cost and time involved in the incorporation process Taxation Potential for diminished managerial incentives Legal restrictions and regulatory red tape Potential loss of control by the founder(s) of the corporation. Source: Adopted from Effective Small Business Management, Scarborough & Zimmerer, FINANCIAL MANAGEMENT FOR SMEs This section provides a general framework of financial management for SMEs from the literature. At the same time, it points out the specific areas of financial management in the literature that will be reviewed. This section is structured into four subsections. Subsection reviews the definitions of SME financial management. Subsection discusses the objectives of financial management. Subsection examines the major decisions that the financial managers or owner-managers have to make in financial 67

87 Chapter Three: Financial Management and SME Profitability management. Finally, subsection summarizes the specific areas of financial management that will be more particularly discussed in the next sections Defining financial management The main objective of this study is to review financial management and its impact on profitability of small and medium enterprises. Before reviewing the relations between financial management and SME profitability, the concept of financial management needs to be clarified. According to Meredith (1986) financial management is one of several functional areas of management but it is the central to the success of any small business. This definition emphasizes the central role and position of financial management in relation to the other specific areas of business management. Figure 3.2 describes the central role and position of financial management in relation to specific areas of business management. Figure 3.2: The central position and role of financial management Marketing management Sales management Personnel management Engineering management Financial management Customer management Production management R & D management Quality management Source: Adopted from the Central Role of Financial Management (Meredith, 1986) 68

88 Chapter Three: Financial Management and SME Profitability McMahon et al. (1993, p.3) defines financial management based on mobilizing and using sources of funds: Financial management is concerned with raising the funds needed to finance the enterprise s assets and activities, the allocation of theses scare funds between competing uses, and with ensuring that the funds are used effectively and efficiently in achieving the enterprise s goal. According to McMahon et al. (1993), modern financial management involves planning, controlling and decision making responsibilities embracing: Various types and sources of finance an enterprise may employ, how these may be accessed, and how to choose among them. Alternative ways in which finance raised may be used in an enterprise and how to select those that are likely to prove most profitable. Different means of ensuring that finance entrusted to specific activities realizes the returns that were anticipated on its allocation to them. However, according to Meredith (1986) financial management is concerned with all areas of management, which involve finance not only the sources, and uses of finance in the enterprises but also the financial implications of investment, production, marketing or personnel decisions and the total performance of the enterprise. English (1990) argues financial management is concerned with what is going to happen in the future. Its purpose is to look for ways to maximize the effectiveness of financial resources. Definitions mentioned above only emphasize areas or scopes of financial management, which financial management is concerned with, but they do not emphasize the objectives of financial management. While English (1990) indicated financial management consists of working simultaneously toward three objectives: liquidity, profitability and growth. The next subsection discusses more detail on these objectives Objectives of financial management Like many other management sciences, financial management, firstly, establishes its goal and objectives. Objectives of financial management are foundations or bases for 69

89 Chapter Three: Financial Management and SME Profitability comparing and evaluating the efficiency and effectiveness of financial management. The final goal of financial management is to maximize the financial wealth of the business owner (McMahon, 1995). This general goal can be viewed in terms of two much more specific objectives: profitability and liquidity. Profitability management is concerned with maintaining or increasing a business s earnings through attention to cost control, pricing policy, sales volume, stock management, and capital expenditures. This objective is also consistent with the goal of most businesses. Liquidity management, on one hand, ensures that the business s obligations (wages, bills, loan repayments, tax payments, etc.) are paid. The owner wants to avoid any damage at all to a business s credit rating, due to a temporary inability to meet obligation by: anticipating cash shortages, maintaining the confidence of creditors, bank managers, pre-arranging finance to cover cash shortages. On the other hand, liquidity management minimizes idle cash balances, which could be profitable if they are invested (McMahon, 1995). In addition to the two objectives mentioned by McMahon, English (1990) viewed growth as another objective of financial management. He also emphasizes the relationships between the three objectives by putting them on a triangle as illustrated in figure 3.3 below. Figure 3.3: The relations among objectives of financial management Liquidity Growth Profitability Source: Adopted from Financial Management for Small Business, English (1990) 70

90 Chapter Three: Financial Management and SME Profitability While discussing the objective function of a privately held small firm, Ang (1992) indicated that its objective function is to maximize three components. The first is to maximize its current market price, to avoid unwanted mergers and to obtain outside financing in the securities market. The second is to maximize long term or intrinsic value, if the two values diverge. The last is to maximize non-owner manager s own pecuniary and non-pecuniary incomes by avoiding control rights. Whether the absence of marketable securities means that small firms need not be concerned with current performance and can concentrate on long-term values, depends on the organizational types and circumstances. Profitable firms, where outside funding is not a major concern, can afford to maximize long-term value whereas for those small businesses, which need outside financing, current performance may be very important. Thus, a number of small businesses would have a weighted average objective function consisting of both current profit and long-term value. Weight for current profit is expected to be higher for small businesses approaching loan re-negotiation, initial public offering, potential sale to an acquirer, signing long-term contracts with supplier or customers and possible dissolution of a partnership. On the other hand, its weight will be smaller when the business is due to pay estate taxes, renegotiate employee contracts, discourage a non-managing family member from their shares, and avoid tax on excess accumulation. In making decisions related to financial management, the owner-manager or the financial manager should remember objectives of financial management and balance between liquidity and profitability objectives, and between current and long-term (growth) objectives Major decisions of financial management Generally, previous authors had no differences in opinions of major decisions in financial management. Ross, Westerfield and Jaffe (1999, p.1) indicated three kinds of decisions the financial manager of a firm must make in business: (1) the budgeting decision, (2) the financing decision, and (3) decisions involving short-term finance and concerned with the net working capital. Similarly, Ang (1992) also indicated three main financial decisions including the investment decisions, financing decisions and dividend decisions. 71

91 Chapter Three: Financial Management and SME Profitability McMahon (1995) suggested another way of identifying the major decisions of financial management is to look at the balance sheet of a business. There are many decisions regarding items on the balance sheet. However, they are classified into three main types: investment decisions, financing decisions and profit distribution decisions (McMahon, 1995). Investment decisions: (1) relate to the amount and composition of a business s investment in short-term assets (cash, stock, debtors, etc.) and fixed assets (equipment, premises, facilities, etc.), and (2) relate to the achievement of an appropriate balance between the two classes of assets. Financing decisions: (1) relate to the types of finance used to acquire assets, and (2) relate to the achievement of an appropriate balance between short-term and long-term sources, and between debt and equity sources. Profit distribution decisions: (1) relate to the proportion of profit earned that should be retained in a business to finance development and growth, (2) and the proportion, which may be distributed to the owner (McMahon, 1995). These major decisions of financial management will be discussed in more detail in the next section where the specific areas of financial management are respectively clarified The specific areas of financial management Most authors and researchers approach the specific areas of financial management in different ways depending upon their emphasis. This section reviews the specific areas of financial management, which have regularly been raised and discussed by the recent authors and researchers such as Walker and Petty (1978), Barrow (1984), Meredith (1986), Cohen (1989), English (1990) and McMahon (1995). Walker and Petty (1978) define the main areas of financial management including planning (cash planning and control, asset-required forecasting, profit planning), financial leverage, investment decision-making, working capital management (cash, receivable and inventory management) and sources of financing (short-term and long-term financing, 72

92 Chapter Three: Financial Management and SME Profitability intermediate financing and going public). Barrow (1984) emphasizes a practical rather than theoretical perspective. Instead of identifying specific areas of financial management, he listed the tools of financial analysis, including business controls; measure of profitability; control of working capital (or liquidity); control of fixed assets, cost; volume; pricing and profit decisions, and business plans and budgets. Meredith (1986) emphasizes information systems as a base for financial management including financial management records and reports. This is considered very important because the owner-managers or financial managers find it is difficult, if not impossible, to make decisions if they lack finance information. Cohen (1989) focuses on working capital management and tools of financial management such as ratio analysis, profitability measures and bread-even analysis. English (1990) emphasizes objectives of financial management including liquidity, profitability and growth. Therefore, the specific areas that financial management should be concerned with are liquidity management (cash flow budgeting, working capital management), profitability management (profit analysis, profit planning), and growth management (capital resource planning and decisions). McMahon (1995) examines specific areas of financial management including all areas that relate to items on the balance sheet of the business. The specific areas financial management covers consist of managing working capital, managing long-lived assets, managing sources of finance, planning financial structure, and planning and evaluating profitability. In summary, financial management is concerned with many specific areas. Probably the balance sheet of a business may demonstrate how to recognize these areas including: current asset or working capital management, fixed asset or long-lived asset management, funding management, financial budgeting and planning, leverage and capital structure, financial analysis and evaluating performance of the business, and 73

93 Chapter Three: Financial Management and SME Profitability profit distribution (dividends and retained earnings policy). Figure 3.4 below, adopted from financial management for small business (McMahon, 1995), illustrates a model of financial management, which covers most issues discussed earlier and shows relations between objectives and decisions of financial management. Figure 3.4: A model of financial management uses Financial management makes Resources: Capital Labor Raw materials Technology Information Decisions: Investment Financing Profit distribution with Specific objectives: Profitability Liquidity General/Final goal To maximize the owner s wealth Source: Adopted from Major Decisions in Financial Management (McMahon, 1995) This study examines financial management practices in relation with objectives, decisions and specific areas of financial management. Objectives, decisions and areas of financial management are relevant to financial management practices. The specific areas of financial management are viewed as a theoretical framework for financial management practices while objectives and decisions of financial management are viewed as factors influencing financial management practices. Figure 3.5 (page 75) illustrates interaction 74

94 Chapter Three: Financial Management and SME Profitability between theoretical and practical aspects with influence of objectives and decisions of financial management. Figure 3.5: Interaction between theories and practices of financial management Specific areas of financial management: Current asset management Fixed asset management Funding management Financial budgeting and planning Leverage and capital structure Financial analysis and evaluating performance Profit distribution Objectives of financial management: Liquidity Profitability Growth Decisions of financial management: Investment decisions Financing decisions Profit distribution decisions Financial management practices: Accounting information system practices Financial reporting and analysis practices Working capital management practices Fixed asset management practices Capital structure management practices Financial planning practices Profitability Source: Developed for the thesis Figure 3.5 presents the relationship between specific areas of financial management and financial management practices. However, the purpose of this study is not to cover all areas of financial management but only to examine the areas of financial management practices such as accounting information system, financial reporting and analysis, working capital management practices, fixed asset management practices, capital structure management practices, financial planning and financial characteristics 75

95 Chapter Three: Financial Management and SME Profitability including liquidity, financial leverage, and activity. Section 3.4 and 3.5 respectively review financial management practices and financial characteristics. 3.4 FINANCIAL MANAGEMENT PRACTICES The previous section provides a review of SME and financial management. This section reviews SME financial management practices in the developed economies such as the USA, Canada, the UK and Australia. Firstly, the context of financial management practices should be defined and then the aspects of financial management practices, which may affect SME profitability, will be reviewed and discussed in more detail The context of financial management practices Financial management practices in the SME sector have long attracted the attention of researchers. Depending on different objectives, researchers emphasize different aspects of financial management practices. McMahon, Holmes, Hutchinson and Forsaith (1993) and McMahon (1998) summarize their review of financial management practices in Australia, the UK and the USA. In their review the context of financial management practices includes the following areas: 1. Accounting information systems the nature and purpose of financial records, bookkeeping, cost accounting, and use of computers in financial record keeping and financial management 2. Financial reporting and analysis the nature, frequency and purpose of financial reporting, auditing, analysis and interpretation of financial performance 3. Working capital management non-financial and financial considerations in asset acquisition, quantitative techniques for capital project evaluation, investment hurdle rate determination and handling risk an uncertainty in this context 4. Financial structure management financial leverage or gearing, accounting to lenders, knowledge of sources and uses of finance, non-financial and financial 76

96 Chapter Three: Financial Management and SME Profitability considerations in financial structure decisions and non-financial and financial considerations in profit distribution decisions 5. Financial planning and control financial objectives and targets, cost-volumeprofit analysis, pricing, financial budgeting and control, and management responsibility centers 6. Financial advice internal and external sources and types of financial advice and use of public accounting services 7. Financial management expertise informal and formal education, training and experience in financial management, relevant qualifications, and overall financial management expertise. However, the purpose of this study is not to cover all the contexts of financial management practices as indicated above but to review selected financial management practices that affect on or are related to SME profitability. These include accounting information systems, financial reporting and analysis, working capital management, fixed asset management, and capital structure management Accounting information systems In the developed economies such as the USA, Canada, the UK and Australia, accounting system practices in SMEs have long attracted the considerations of many researchers. This section examines the accounting system practices and computer utilization in accounting. In these fields, D Amboise and Gasse (1980), Raymond and Magnenat- Thalmann (1982), Cheney (1983), Raymond (1985), DeThomas and Fredenberger (1985), and Farhoodman and Hryck (1985) are considered key researchers in the USA and Canada. Further research in the 1990 s was carried out by Gul (1991), Chen (1993) Palmer (1994), and Gorton (1999). D Amboise and Gasse (1980) studied the utilization of formal management techniques in 25 small shoe manufacturers and 26 small plastic manufacturers in Quebec, Canada and found that 88 percent of the businesses used a cost accounting system. Regarding accounting standards, DeThomas and Fredenberger (1985), in a survey of over 77

97 Chapter Three: Financial Management and SME Profitability 360 small enterprises in Georgia, found that the standards of financial record keeping was very high. In addition to cheque and deposit receipts, around 92 percent of respondents had some form of record keeping. Over 50 percent of respondents used an in-house bookkeeper for recording transactions, whereas preparing financial statements was carried out by external accountants (Table 3.5). Table 3.5: Responsibility for the bookkeeping and accounting task Percentage of response (%) Recording transactions Preparing financial statements Owner-manager In-house bookkeeper Outside accountant Source: Adapted from DeThomas and Fredenberger (1985) Regarding the use of financial information, DeThomas and Fredenberger s (1985) study indicated that 96 percent of the respondents had financial statements prepared, the responsibility for evaluating and using the information was within the business itself and only four percent relied on an outside accountant (Table 3.6). Table 3.6: Responsibility for preparation and use of financial information Percentage (%) Responsibility for interpreting financial statement information: No specific responsibility Owner/manager responsibility In house bookkeeper Outside accountant Specific use of financial statement information: Not used at all Cursory use Formal use 11 Source: Adapted from DeThomas and Fredenberger (1985) For computer software applications in accounting, Raymond and Magnenat- Thalmann (1982) conducted a survey of 129 small manufacturing businesses, whose number of employees totaled between 20 and 250 and sales varied from $0.5 to $ 25 million, in Another survey of 464 small businesses was carried out by Raymond in 1985 in the province of Quebec. The results of the two surveys are summarized in Table 3.7 (page 79). In the 1990 s, Chen (1993) found that accounting still was the most important and widely software in the small business studied. 78

98 Chapter Three: Financial Management and SME Profitability Table 3.7: The results of survey of computer software application Applications Raymond and Magnenat-Thalmann (1982) Raymond (1985) Percentage use Percentage use Accounts receivable Accounts payable General ledger Billing Sales analysis Inventory Order entry Cost accounting Budgeting n.a 35.4 Purchasing n.a 31.5 Forecasting n.a 31.3 Production control Production scheduling Word processing Personnel n.a 15.1 Payroll 79 n.a Others Source: Adapted from Raymond and Magnenat-Thalmann (1982) and Raymond (1985) In the USA, researchers conducted many surveys of the most important applications of computers in accounting. Cheney (1983) reports on a survey of 30 small and medium-sized businesses in a variety of industries in Georgia. In his survey, the respondents were asked to indicate the most important applications of computer software in use and the results are summarized in Table 3.8. The results revealed that the most important applications of computer software are in the areas such as payroll, accounts receivable, accounts payable and general ledger. Table 3.8: The most important applications of computer software Application Number of respondents Percentage use Payroll Accounts receivable Accounts payable General ledger Inventory Sales analysis Order entry 9 30 Bill of materials 3 10 Source: Adapted from Cheney (1983) 79

99 Chapter Three: Financial Management and SME Profitability In the survey of 69 small enterprises across the USA, Farhoomand and Hryck (1985) reported on the most important applications of computers, which are presented in Table 3.9, in which accounting was rated as the highest percentage. Similarly, Palmer (1994) interviewed 36 small independent retail owner-managers and found that 33 percent of the sample businesses used computerized accounting systems. Table 3.9: The most important applications of computers Application Percentage rating as most important Accounting 32 Word processing 16 Spread sheet 13 Database management 12 Point of sale 4 Telecommunications 1 Others 22 Source: Adapted from Farhoomand and Hryck (1985) Reviewing previous research results shows accounting and financial management applications dominated the use of computers in small and medium enterprises in the North America in 1980 s and 1990 s. In the UK the most significant studies of small enterprises were conducted by Bolton Committee (1971). Additionally, there are several researchers who studied accounting systems such as Corner (1967), Murphy (1978 and 1979), Lovett (1980), Arnold-McCulloch and Lewis (1985, 1986) and Gorton (1999). According to McMahon et al. (1993) the inadequacy of financial record keeping system in small enterprises was well documented in the main Bolton Report (1971) and in various supplementary research reports. This situation reflected a poor appreciation of the significance of financial management amongst owner-managers who were often technically-or salesoriented. Concerned with costing systems, Corner (1967) reported on the results of studies including 119 small enterprises, 62 medium-sized enterprises and 29 large enterprises in The study results showed the extent of use of costing systems in large enterprises was 82.1 percent, while in small and medium enterprises was 62.1 and 69.4 percent respectively. Awareness of use of costing systems was found to be very high in the study of Murphy (1978 and 1979) whereas the utilization of costing systems was lower (Table 3.10, page 81). Murphy (1978) explained that smaller enterprises were often aware of the 80

100 Chapter Three: Financial Management and SME Profitability importance of sound costing systems but they lacked the time and expertise to install such systems. Table 3.10: Percentage of awareness and utilization of costing systems Size category (employees) Awareness (%) Utilization (%) Source: Adapted from Murphy (1978) Lovett (1980) found that many businesses either had no costing system at all or relied on periodic attempts to estimate the cost of a product through a rough calculation of the labor and materials content plus a mark up for overhead and profit. In Australia Peacock (1985, 1987, and 1988), Williams (1986), Holmes (1987) and Holmes and Nicholls (1988) are typical researchers who published results of studies of accounting information system practices. Peacock (1985) investigated the effects and causes of more 1,000 proprietary company failures in South Australia during ten years and found that 4.6 percent of failures had inadequate or no accounting records. In another study of company failures in South Australia, Peacock (1987) reviewed the bankruptcy reports of 418 unincorporated businesses for four years (from 1981 to 1985) and found that 50.5 percent of these used single entry systems, 32.8 percent used bank and taxation records whereas only 2.1 percent utilized double entry systems. In a more recent study, Peacock (1988) found a significant element in the failure of many of the businesses was inefficient or absence of accounting records. More than half of the businesses failed were found to have no records or only basic bank and taxation records. Peacock s (1985, 1987, and 1988) findings are very important as examining the impact of accounting system practices on performance of SMEs. Williams (1986) evaluated the adequacy of accounting records for 10,570 failed and surviving small enterprises operating throughout Australia. The results, which are summarized at Table 3.11 (page 82), are compatible with Peacock s (1986, 1987,1988) findings in that a significant proportion of owner-managers kept inadequate accounting records. 81

101 Chapter Three: Financial Management and SME Profitability Table 3.11: Evaluate the adequacy of accounting records Standard Percentage (%) Excellent 9.33 Good Average Inadequate Poor/ non-exist 2.28 Source: Adapted from Williams (1986) Holmes (1987) conducted a survey of accounting information requirements of 928 small enterprises operating in Sydney, Melbourne and Brisbane. Fifty-seven percent of respondents indicated they used the journal/ledger (double entry) systems. This finding is rather in contrast to Peacock s (1987) findings of types of records maintained by failed enterprises, where only 2.1 percent of respondents were found to use double entry systems. In a more recent study, Holmes and Nicholls (1987) analyzed the use of accounting information by Australian small firms. The owner-managers were asked to indicate the accounting information prepared at least once a year by either business or an external accountant. The responses are listed in Table Table 3.12: Accounting information prepared externally or internally Information Internally prepared Externally prepared Statutory Tax return Statutory accounts Financial statements Budget Profit/Loss Cash flow Additional Ratio analysis Manufacturing statement Source & application of funds Break-even analysis Cash flow statement Production reports Job costing reports Source: Adapted from Holmes and Nicholls (1987) An inspection of the data in Table 3.12 suggests that a significant difference exists between the internal and external preparation of accounting information. In order to check this hypothesis, tests of equality of proportion were carried out and the testing results supported the conclusions that statutory information is sought mainly from external accountants, whereas additional management information tends to be prepared within the business. 82

102 Chapter Three: Financial Management and SME Profitability In summary, the accounting system practices of SMEs have long attracted the attention of many researchers. Several findings have been found and modified over past decades. Table 3.13 summarizes research areas related to the accounting system practices of SMEs conducted by previous researchers in the developed economies such as the USA, Canada, the UK, and Australia. Previous research describes characteristics of accounting information system practices but without empirical evidence of links between accounting information system practices and profitability of SMEs. Table 3.13: Summary of research areas related to the accounting system practices of SMEs Researcher(s) and year Country Main research areas Corner (1967) UK Use of cost accounting system Murphy (1973, 1978, 1979) UK Use of cost accounting system Lovett (1980) UK Costing system D Amboise and Gasse (1980) Canada Cost accounting system Cheney (1983) USA The most important applications of computer software Raymond and Magnenat- Thalmann (1982) Canada Computer software applications DeThomas and Fredenberger USA Financial record keeping (1985) Farhoodman & Hryck (1985) USA The most important application of computer software Raymond (1985) Canada Computer software applications Peacock (1985, 1987, 1988) Australia The effects of cost accounting system on business failure Williams (1986) Australia Accounting records Holmes (1987) Australia Double entry system Holmes and Nicholls (1988) Australia Accounting information preparation Gul (1991) Australia The effects of management accounting systems on small business manager s performance Chen (1993) UK Computer software applications in accounting systems Palmer (1994) USA Using computerized accounting systems by small businesses Gorton (1999) UK Use of financial accounting techniques and computerized accounting systems Source: Adapted as indicated above Financial reporting and analysis Recording and organizing the accounting information systems will not meet objectives unless reports from systems are analyzed and used for making managerial decisions. This section provides a review of financial reporting and analysis of SMEs. In the USA and 83

103 Chapter Three: Financial Management and SME Profitability Canada, the key researchers of this issue include Luoma (1967), D Amboise and Gasse (1980), Lindecamp and Rice (1983), DeThomas and Fredenberger (1985), Thomas and Evanson (1987), and Palmer (1994). Louma (1967) conducted a survey of 62 manufacturing SMEs on the use of accounting information in managerial decisionmaking. Eighty-six percent of respondents reported that they used some form of financial statement analysis and interpretation. Of these, 40 percent indicated that the founder of the businesses was actively involved. D Amboise and Gasse (1980) studied the use of financial statement analysis by small manufacturers in Quebec, Canada and found that small manufacturers in shoe and plastic industries formally undertook the analyses based on financial statements as presented in Table Table 3.14: Use of financial statement techniques by small manufacturers in Quebec Technique Shoe industry Plastic industry % use % use Rate of return analysis Financial situation analysis Source: Adapted from D Amboise and Gasse (1980) Lindecamp and Rice (1983) studied familiarity with financial statement analysis of 102 owner-managers of small retail stores in Mississippi. Some 73 percent of respondents reported that they analyzed their cost figures on a frequent or regular basis. Nearly 60 percent indicated that they did not maintain up-to-date figures on the contribution to profit of individual product or product lines. Nearly 50 percent seldom or never compared their concern s performance with industry figures. Over 50 percent of respondents did not appear to understand the meaning of debt/equity ratio and 59 percent did not know the value of this ratio for their business. In their survey, DeThomas and Fredenberger (1985) found that 81 percent of the small enterprises regularly obtained summary financial information. Ninety-one percent of the summary information was in the form of traditional financial statements (balance sheets, profit and loss statements, fund statements), the remainder being bank reconciliation and operating summaries whereas no business was regularly receiving cash-flow information. Regarding responsibility for interpretation of financial statements, DeThomas and Fredenberger s findings are summarized in Table 3.15 (page 85). 84

104 Chapter Three: Financial Management and SME Profitability Table 3.15: Responsibility for financial statement interpretation Responsibility Percentage of response Owner-manager 82 In-house bookkeeper 14 Outside accountant 4 Source: Adapted from DeThomas and Fredenberger (1985) DeThomas and Fredenberger also found that 61 percent of respondents felt the financial statements provided the information they required for planning and decision-making. Nevertheless, only 11 percent of respondents reported that they had used financial statement information formally as part of managerial evaluation, planning and decisionmaking, 2 percent of businesses utilized financial ratio analysis, and few made even simple historical comparisons. Thomas and Evanson (1987) studied 398 small pharmacies (in Michigan, North Carolina, Nebraska, Rhode Island and Washington) to examine the extent to which financial ratios were used in a specific line of small retail business and tested for a relationship between use of financial ratios and business success. The proportion of respondents using financial ratios in Thomas and Evanson s (1987) study of small pharmacies is summarized in Table 3.16 (page 86). Thomas and Evanson (1987) used regression analysis to examine the relationship between financial ratio usage and SME profitability. However, they could not demonstrate any significant relationship between earnings-to-sales and the number of financial ratios used by the owner in operational decision-making. When efforts were made to include the effects of other managerial practices and variations in business environments, no association between use of individual ratios and total earnings or totalto-sales was found. They explained the lack of association between financial ratio usage and either survival or profitability, may also indicate that the level of sophistication in use of ratios has not reached a high enough level among pharmacies to make a discernible difference between those which use and those which do not use financial ratios. However, Thomas and Evanson (1987) s study only examined the association between SME profitability and the number of financial ratios, while the relationship between SME profitability and the efficiency as the result of using the financial ratios was not studied. 85

105 Chapter Three: Financial Management and SME Profitability Table 3.16: Proportion of respondents indicating use of selected financial ratios Percentage of each kind of pharmacies using financial ratios Closed (%) Changes of ownership (%) Ongoing (%) Total (%) Cost of goods sold to sales Inventory turnover Gross margin to sales Net profit to net sales Net profit to inventory Current assets to current liabilities Net sales to inventory Accounts receivable collection period Total liabilities to net worth Return on equity or investment Days accounts receivable outstanding Days accounts payable outstanding Inventory to net working capital Source: Adapted from Thomas and Evanson (1987) Palmer (1994) interviewed 36 small independent retail owners to determined if timely and accurate financial information is really all that important to small businesses and found that the more knowledgeable the owner-managers were about the financial position of these businesses, the more successful the businesses appeared to be. The key researchers of financial reporting practices in the UK include Ray and Hutchinson (1983), Hankinson (1982, 1983), Arnol-McCullock and Lewis (1986), and McMahon and Davies (1994). Ray and Hutchinson (1983) studied the type and frequency of financial reporting in the super-growth enterprises and found that there was a clear tendency towards more frequent financial reporting as the business grew and became public companies. Hankinson (1982, 1983) studied making investment decisions in 52 small engineering businesses in southwest England between 1979 and 1982 and found that only one business in the sample used financial ratio analysis. Conversely, in their survey of 102 growth enterprises operating in the northeast region of England, McMahon and Davies (1991) found that 80 percent or more of the participants employed financial ratio analysis. Related to the kind of financial ratios used, Arnold-McCulloch and Lewis (1986) examined 52 recently established businesses. Their findings are summarized in Table 3.17 (page 87), which revealed that the percentage of use of financial ratios such as debtors/creditors, acid test, sales to debtors and cash, inventory turnover, return on 86

106 Chapter Three: Financial Management and SME Profitability investments, net return on sales, and gross return on sales, is not more than 12 percent respectively. Table 3.17: Percentage of use of financial ratios Kind of financial ratio Percentage of use Debtors/Creditors 10 Acid test 6 Sales to debtors and cash 8 Inventory turnover 10 Return on investments 12 Net return on sales 10 Gross return on sales 10 Source: Adapted from Arnold-McCulloch and Lewis (1986) McMahon and Davies (1994) examined significant associations between financial reporting and analysis and achieved growth rates and financial performance and found the following: Enterprises that had more comprehensive reporting in terms of both the number of statements obtained and their frequency were more likely to employ financial analysis. There is apparently no statistically significant association between rates of growth in turnover and employment achieved by participating enterprises and their historical financial reporting practices. There appears no statistically significant association between achieved rates of growth in turnover, employment, and net profit and use of financial ratio analysis. In Australia, Holmes (1986,1987), Williams (1986), Holmes and Nicholls (1988), and McMahon (1998, 1999) are considered key researchers who studied financial reporting and analysis. Holmes (1986) examined preparing the accounting statements of 60 small enterprises and found that they were both internally and externally prepared but taxation returns were mainly prepared by external accountants (92.7 percent). Similar results were also found from a study conducted by Holmes and Nicholls (1988). With only a minor change in percentage of internal and external taxation return preparation (Table 3.18 page 88). 87

107 Chapter Three: Financial Management and SME Profitability Table 3.18: Percentage of preparing accounting information both internally and externally In 1986 In 1988 Internally prepared (%) Externally prepared (%) Internally prepared (%) Externally prepared (%) Taxation returns Statutory accounts Balance sheet/ profit and loss n.a n.a Manufacturing statements n.a n.a Funds statements Cash-flow statement Production reports Job costing reports Source: Adapted from Holmes (1986), Holmes and Nicholls (1988) A common tendency is that relatively complicated accounting reports such as taxation returns, statutory accounts, balance sheets, and profit and loss statements are usually prepared by external experts. McMahon (1998) examined which enterprises and financial management characteristics seem to most influence financial reporting practices adopted in small and medium-sized manufacturing enterprises in Australia and what impact these financial reporting practices appear to have on achieved business growth and performance. The research results showed that development orientation, extent of owner-management, technological complexity, degree of reliance upon external financial advice, and financial reporting climate significantly influence on the comprehensiveness of financial reporting practices in Australian small manufacturing enterprises. According to McMahon (1998) the relationship between financial reporting practices and business growth and performance is difficult to identify, describe and explain. The reason explained for this is that management is a complex activity affected by a myriad of interacting internal and external factors. Recently, McMahon (1999) reported new empirical evidence on financial reporting to financiers by small and medium-sized enterprises and found a significant relationship exists in the study sample between enterprise size in employment terms and provision to financiers of a business plan or future-oriented financial statements or annual historical financial statements or periodic historical financial statement. However, no statistically significant relationship exists in the study sample 88

108 Chapter Three: Financial Management and SME Profitability between enterprise size in employment terms and the likelihood of being asked to provide more financial information by potential financiers. In summary, researchers reporting in the literature have spent much time studying financial reporting and analysis practices and effects on the performance of SMEs. Table 3.19 (page 89) summarizes the main research areas related to the financial reporting and analysis practices of SMEs conducted by previous researchers in the developed countries. Table 3.19: Summary of the main research areas related to the financial reporting and analysis Researchers Country Main research areas D Amboise & Gasse (1980) Canada Use of financial statement techniques Lindecamp and Rice (1983) USA Familiarity with financial statement analysis Hankinson (1982, 1983) UK Financial ratio analysis Ray & Hutchinson (1983) UK Frequency of financial reporting DeThomas & Fredenberger USA Use and interpretation of financial statement (1985) Holmes (1986, 1987) Australia Preparing accounting statements Arnld-McCulloch & Lewis UK Use of financial ratios (1986) Thomas & Evanson (1987) USA Association between financial ratio and business success Holmes & Nicholls (1988) Australia Preparing accounting statement McMahon & Davies (1994) Australia Association between financial reporting analysis and achieved growth rate McMahon (1998) Australia The impact of financial reporting practices on achieved business growth and performance. McMahon (1999) Australia Financial reporting to financiers by Australian manufacturing SMEs Source: Adapted as indicated above Working capital management This subsection reviews the literature on working capital management practices of SMEs. The context of working capital management includes cash management, receivables and payables management, and inventory management. In the USA and Canada, Luoma (1967), Grablowsky (1978), Grablowsky and Rowell (1980), Cooley and Pullen (1979), D Amboise and Gasse (1980), Anvari and Gopal (1983), Thomas and Evanson (1987), Kathawala (1988), Khoury, Smith and MacKay (1999) are considered the key researchers who studied working capital management practices. In the UK and Australia, Murphy (1978), Arold-McCulloch and Lewis (1986), Williams (1987), and Peel and Wilson (1996) are the main researchers. 89

109 Chapter Three: Financial Management and SME Profitability Regarding cash management practices, Grablowsky (1978) and Grablowsky and Rowell (1980) conducted a questionnaire survey concerned with the cash management practices of 66 small enterprises from a number of industries located in and around Norfolk, Virginia. The results showed that 67 percent of respondents replied they did not do forecasting of cash flows. When asked how they determined the level of cash to be held by the business, less than 10 percent of enterprises reported using any type of quantitative technique. The method most often employed was to hold cash as a fixed ratio of projected expenses, forecasted sales or anticipated purchases. Non-quantitative methods used consisted of meeting compensating balance requirements, maintaining the level considered safe by management or achieving a level recommended by outside advisers. Additionally, seventy-one percent of business in the Virginia survey reported that they had no short-term surpluses of cash in their recent history. Only 23 percent had a long-term surplus. Nearly 30 percent of respondents had invested excess cash in earnings securities or accounts. The most common investments were savings accounts, certificates of deposit, treasury bills, repurchase agreements, commercial papers, shares, bonds and other investments. Based on Cooley and Pullen s (1979) research, cash management was seen as the process of planning and controlling cash flows. It consisted of three basic components: cash forecasting practices, cash surplus investment practices and cash-control practices. Cooley and Pullen (1979) examined cash management practices of 122 small businesses engaged in petroleum marketing and reported that 73 percent of respondents had experienced a cash surplus. Comparison of cash surplus investment practices of businesses in Grablowsky and Rowell s survey and Cooley and Pullen s survey are summarized in Table Table 3.20: Cash surplus investment practices Grablowsky and Rowell s survey (1978) Cooley and Pullen s survey (1979) Outlet Percentage use (%) Percentage use (%) Saving account Cheque account n.a 25 Repurchase agreement 3 n.a Treasury bills 6 15 Common sock n.a 9 Certificate of deposit 11 8 Commercial paper 3 8 Other investments 6 8 Source: Adapted from Grablowsky and Rowell (1978, 1980) and Cooley and Pullen (1979) 90

110 Chapter Three: Financial Management and SME Profitability In contrast to Grablowsky and Rowell s (1978) and Cooley and Pullen s (1979) survey, Murphy s (1973) study indicated that active cash management in small enterprises in the UK was unusual, and that there was little inclination to invest surplus cash on a short-term basis. Evidence on the cash management practices of 123 small enterprises across a variety of industries in the Canadian provinces of Quebec and Ontario was provided by Anvari and Gopal (1983). Generally, 53 percent of the sample businesses indicated that they prepared cash forecasts, substantially higher than the 30 percent figure reported by Grablowsky (1978, 1980). Respondents were also asked the basis for determining the level of their cash balances. Only 26 percent of respondents indicated they used formal techniques, using a fixed percentage of sales or expenses, for determining the level of their cash balances. Fifty-five percent of respondents claimed to have had a short-term surplus of cash and 26 percent of businesses had generated what they considered to be long-term surplus funds in the previous year. The instruments of short-term investment used by these firms are shown in Table Table 3.21: Instruments of short-term investment used Instrument Percentage Checking account 1.5 Saving account 9.1 Treasury bills 3.0 Bankers acceptance 28.8 Term deposits 56.1 Commercial paper 1.5 Source: Adapted from Anvari and Gopal (1983) Regarding accounts receivable management practices, Grablowsky (1976) and Grablowsky and Rowell (1980) found generally low standards. Approximately 95 percent of businesses that sold on credit tended to sell to anyone who wished to buy. Only 30 percent of respondents subscribed to a regular credit reporting service. Most had no credit checking procedures and guidelines, and only 52 percent enforced a late-payment charge. Thirty-four percent of businesses had no formal procedure for aging accounts receivable. Bad debts averaged 1.75 percent of sales, with a high of 10 percent in some concerns. Murphy (1978) revealed a very high level of awareness and utilization of credit control systems in the UK, even in the smallest businesses (Table 3.22, page 92). 91

111 Chapter Three: Financial Management and SME Profitability Table 3.22: Awareness and utilization of credit control systems Size category (Employees) Awareness (%) Utilization (%) Source: Adapted from Murphy (1978) On inventory management practices, D Amboise and Gasse (1980) studied the utilization of management techniques in small shoe and plastic manufacturing industries in Canada and found 64 percent of shoe and 65.4 percent of plastic businesses employed formal inventory control systems. While Grablowsky and Rowell (1980) found that most of the respondents had in excess of 30 percent of their capital invested in inventory, the general standard of inventory management was poor. Only six percent of businesses in their survey used a quantitative technique such as economic order quantity for optimizing inventory and 54 percent had systems which were unable to provide information on inventory turnover, reorder points, ordering costs or carrying costs. Related to the methods used to determine inventory level, Grablowsky (1984) compared methods used by a sample of 94 small enterprises with those used by large enterprises and found the results as in Table Table 3.23: Methods used by small and large enterprises to determine inventory level Small enterprises Large enterprises Method Percentage use (%) Percentage use (%) ABC 2 - Economic order quantity (EOQ) 2 63 Inventory turnover ratio - 55 Linear programming - 24 Statistical methods - 10 Safety stock 7 50 Anticipation stock 32 - Executive judgement 6 66 Sales projections 9 - Past experience 15 - No method 27 - Source: Adapted from Grablowsky (1984) Unlike the researchers mentioned above, Peel and Wilson (1996) studied working capital management practices of small firms based in the North of England without any 92

112 Chapter Three: Financial Management and SME Profitability separation of cash management, receivable, payable and inventory management but dealing with working capital components. In their research, respondents were requested to indicate the frequency with which they used or reviewed various methods or components pertaining to the management of working capital. Table 3.24 reports the research results conducted by Peel and Wilson (1996). Table 3.24: Working capital management: Frequency (%) of using or reviewing Never Sometimes Quite often Often Very often Cash budgeting (use) Debtors credit period (review) Debtors discount policy (review) Bad debt (review) Doubtful debts (review) Customer credit/risk standing (review) Creditors payment period (review) Factoring (use) Working capital financing requirements Stock turnover (review) Stock level (review) Stock re-order levels (review) Economic order quantity model (use) Source: Adapted from Peel and Wilson (1996) In general, depending upon their objectives, in examining working capital management practices, previous researchers emphasized specific aspects of working capital management. Burns and Walker (1991) examined working capital management as a whole. In their survey of working capital policy among small manufacturing firms in the USA, the following aspects of working capital were considered: working capital policy, managing working capital components, including cash, receivable, payable and inventory management, and relationships between working capital management practices and profitability. Probably this survey was one of the most comprehensive surveys of working capital management practices where almost all aspects of working capital management were 93

113 Chapter Three: Financial Management and SME Profitability examined. Burns and Walker s (1991) findings can be summarized into some main points as follows: Thirty-nine percent of the company s total assets were working capital, but only 24 percent of the financial manger s time were spent on working capital. Overall, companies had an informal procedure or no written policy for working capital management. However, those that did have a written policy were probably more profitable than others. For cash management, the typical company used cash budgeting on a weekly basis mainly to plan for shortages and surpluses of cash. Company would determine target cash balances based on needs for transaction balances, and put its idle cash in cash management accounts or certificates of deposit. For accounts receivable, the typical company used both the collection period and aging schedule to monitor the payment behavior of credit customers. With regard to inventory policy, the typical firm used computerized inventory control systems to decide on the appropriate amount to replenish its storage points by using ad hoc decisions. Company mainly considered the availability of parts and materials in deciding on reorder quantities for inventory purchased. As for accounts payable, the typical firm became a net supplier of credit believing that the cost of foregoing trade discounts was only about 13%, yet it always or sometimes took the discounts. In summary, working capital management practices have long attracted the attention of previous researchers. The main research areas related to these practices included cash, receivable and inventory management summarized in Table 3.25 (page 95). This table shows that studies on working capital management practices conducted by previous research provided detailed descriptions of working capital management practices of SMEs. However, relationships between working capital management practices and SME profitability have not been investigated. To date there almost are no tests of associations between working capital management practices and SME profitability. 94

114 Chapter Three: Financial Management and SME Profitability Table 3.25: Summary of working capital management practices Researcher(s) and year Country Main research areas Grablowsky and Rowell (1980) USA Short-term surplus of cash Low standards of receivable management bad debt Cooley and Pullen (1979) USA Cash forecasting Cash surplus investment Cash control Anvari and Gopal (1983) Canada Preparing cash forecasts Techniques used to determine cash balance Short-term cash surplus Investment of short-term investment Mrphy (1973) UK Awareness and utilization of credit control system D Amboise and Gasse (1980) Canada Inventory control system Grablowsky and Rowell (1980) USA Capital invested in inventory Poor standard of inventory management Methods used to determine inventory level Pell and Wilson (1996) UK Frequency of using and reviewing working capital management Source: As indicated above Fixed asset management This subsection reviews research on fixed asset management practices of SMEs. The key researchers in this field include Soldofsky (1964), Corner (1967), Taylor Nelson Investment Services (1970), Scott et al. (1972), Murphy (1978), Hankinson (1979), Grablowsky and Burns (1980), Pattillo (1981), Arnold-McCulloch and Lewis (1986), Williams (1986), Holmes (1986, 1987), Brigham (1992), Proctor and Canada (1992), Ruyon (1993), and Block (1997) in the developed countries such as the USA, Canada, the UK, and Australia. Brigham (1992) suggested that capital budgeting might be more important to a smaller firm than its larger counterparts because of the lack of access to the public markets for funding. Capital budgeting has attracted researchers over the past several decades. McMahon et al. (1993) claimed the earliest study of capital budgeting of SMEs was reported by Soldofsky (1964). During 1961, Soldofsky interviewed 126 owners of small manufacturing businesses in Iowa and the results were published in

115 Chapter Three: Financial Management and SME Profitability Soldofsky (1964) found there was considerable variation in the methods of calculating payback period and in determining payback standards. In many businesses, required payback periods were flexible according to circumstances such as the variability of cash, planned product changes and business outlook. In the smaller enterprises, approvals for capital outlays tended to be given as required, whereas larger concerns were more likely to have annual capital budgets. Only four firms attempted to calculate some variation of the average cost of capital for use as a hurdle rate for capital projects. Most businesses seemed unaware of the link between their financing and investment decisions. On the positive side, it was quite clear that the evaluation of capital projects was heavily cash flow oriented. Regarding capital project selection techniques, there were several surveys conducted by previous researchers such as Soldofsky (1964), Luoma (1967), Taylor Nelson Investment Services (1970), Hankinson (1979), Grablowsky and Burns (1980), Proctor and Canada (1992), and Block (1997). Soldofsky s (1964) study results are summarized in Table 3.26 which shows around 58 percent of respondents used payback period methods whereas only 4.1 percent employed accounting rate of return technique. Table 3.26: Percentage of firms using capital project selection methods Methods Percentage use Payback period 57.7 Accounting rate of return 4.1 No formal criteria 41.5 Source: Adapted from Soldofsky (1964) Domination of payback period methods compared with other techniques in evaluating capital investment projects of SMEs was also found in the study of Louma (1967). Louma (1967) conducted a survey of small and medium-sized manufacturing businesses in the United States and found that more than 22 percent of SMEs used formal methods of capital investment evaluation (Table 3.27). Table 3.27: The extent of use of formal methods of the capital investment evaluation Method SMEs with annual sales SMEs with annual sales > < $5 million (% use) $5 million (% use) Payback period Simple rate of return Discounted cash flow methods Not specified 26 8 Source: Adapted from Louma (1967) 96

116 Chapter Three: Financial Management and SME Profitability Thirty years after the Louma s (1967) study, Block s (1997) survey of 232 small businesses in the USA indicated payback method remains the dominant method of investment selection for small businesses, whereas large corporations widely incorporate discounted cash flow models in financial analysis of capital investment proposals (Proctor and Canada, 1992). This is not evidence of a lack of sophistication as much as it is a reflection of financial pressures put on the small business owner by financial institutions. The question to be answered is not always how profitable the project is, but how quickly a loan can be paid back. Nevertheless, more sophisticated methods using discounted cash flow (IRR and NPV) have increased in use over time (Table 3.28). Table 3.28: Primary method of investment analysis Firms Percentage Payback period (PP) Accounting rate of return (ARR) Internal rate of return (IRR) Net present value (NPV) Others, not specified Total Source: Adapted from Block (1997) The predominance of the payback period method can be attributed to its simplicity, emphasis on liquidity, and response to external financing pressures. While other more complicated methods are not as popular. Similarly, Grablowsky and Burns (1980) found that the level of understanding and use of more advanced capital budgeting polices and techniques were very low. For example only 4.6 and 13.8 percent of respondents in the Grablowsky and Burns (1980) survey indicated they use the net present value and internal rate of return methods respectively. In the UK, Corner (1967) found remarkable differences in methods used for assessing capital projects between smaller and lager enterprises. The percentage use of different methods depending upon business size (Table 3.29) illustrated by Corner (1967). Table 3.29: Percentage use of different methods by small, medium, and large enterprises Size category Payback period Rate of return Discounted cash flow (% use) (% use) (% use) Small Medium Large Source: Adapted from Corner (1967) 97

117 Chapter Three: Financial Management and SME Profitability Scott et al. (1972) examined the capital investment evaluation procedures of 135 small manufacturing enterprises in the USA and the following are some principal findings: Eighty-four percent of respondents indicated that some investments were necessary in the short-run, regardless of their profitability. Payback period was used to evaluate capital projects by 51 percent of respondents, while 30 percent reported use of some variation of accounting rate of return. Only 10 percent reported use of discount cash flow methods such as net present value (5 percent) and internal rate of return (2 percent). This finding is consistent with the Soldofsky (1964), Louma (1967), Corner (1967), and Grablowsky and Burns (1980) findings of a tendency in using simple and complicated methods of capital investment project evaluation. Sixty-one percent of respondents indicated that they screened capital expenditures by comparing the expected rate of return on investment with the cost of capital or some cost of financing. Regarding the screening rates used to evaluate the capital projects, the respondents indicated the percentages in Table Table 3.30: Percentage of kinds of screening rate used to evaluate the capital projects Percentage use Cost of some specific source of fund (e.g., cost of borrowing) 37 Some mix of financing cost (e.g., average cost of capital) 13 Some other hurdle rate (e.g., historic rate of return n investment) 9 Others 1 No response 40 Source: Adapted from Scott et al. (1972) Similarly, Block (1997) found that, of the 64 firms using discounted cash flow as the primary method of investment analysis, only 9 used a concept closely related to weighted average cost of capital as the discount or hurdle rate. The majority of firms used the cost of funding the specific project as the cut-off point. Others relied on such concepts as an arbitrarily determined cut-off point or historical rate of return (Table 3.31, page 99). The reason for not using weighted average cost of capital is that smaller firms have difficulty in estimating the cost of equity capital. They were accustomed to relating cost to 98

118 Chapter Three: Financial Management and SME Profitability contractual obligations, and not other concepts such as opportunity cost related to retained earnings. Furthermore, smaller firms have less access to the public capital markets and fewer alternatives overall than larger firms and feel a less compelling need to measure the relative cost of each. Table 3.31: Methods of determining the required rate of return as using discounted cash flow Firms Percent Cost of funding a specific project Arbitrary cut-off point Weighted average cost of capital Historical rate of return Non-specified or other Source: Adapted from Block (1997) In summary, subsection shows the previous findings related to fixed asset management practices. Payback period method continues keeping its dominant position in evaluating capital investment projects of SMEs as shown in Table Table 3.32: Summary of fixed asset management practices Researcher Country Research areas Main findings Soldofsky (1964) USA Capital project Domination of payback period method selection Most businesses seemed unaware of the techniques link between their financing and investment decisions Luoma (1967) USA Methods of Domination of payback period method capital Percentage of using discounted cash investment flow methods was risen when the firm evaluation size increases Scott et al. USA Capital Domination of payback period method (1972) investment Cost of some specific source of funding evaluation is mainly used as the screening rate to evaluate the capital projects Block (1997) USA Methods of Payback period method remains investment dominant method analysis More sophisticated methods have increased in use over time Cost of funding a specific project used as the required rate of return Grablowsky and USA Capital Level of understanding and use of more Rowell (1980) budgeting advanced capital budgeting polices and policy and techniques ere very low techniques Corner (1967) UK Methods used There are the significant differences for assessing between larger and smaller enterprises capital projects Source: As indicated above 99

119 Chapter Three: Financial Management and SME Profitability Capital structure management Subsection examined financial management practices related to capital investment decisions. The current subsection reviews capital structure management or financial management practices related to the decisions of sources of financing. It includes examining what factors affect capital structure decisions and how capital structure impact on SME profitability. Small companies frequently suffer from a particular financial problem lack of a capital base. Small businesses are usually managed by their owners and available capital is limited to access to equity markets, and in the early stages of their existence owners find it difficult in building up revenue reserves if the owner-managers are to survive. A question concerns how small businesses determine sources of finance in such difficult circumstance. According to Brigham (1995, p. 447), modern capital structure theory began in 1958, when Modigliani and Miller s (1958) seminal article on capital structure was published. Since that point of time, researchers have attempted to explain how firms choose their capital structure. Myers (1984, p. 575) stated: How do firms choose their capital structure? The answer is we don t know we do not know how firms choose the debt, equity, or hybrid securities they issue. Though some theoretical work focuses on small business capital structure (Day et al. 1985; McConnell and Pettit, 1984; Pettit and Singer, 1985; and Walker, 1988), empirical work on small business and capital structure is minimal (Norton, 1991). Literature of the 1980 s has attempted to explain small firm financing decisions by using modern financial theories. McConnell and Pettit (1984) suggested that small businesses generally have proportionally less debt than large firms because: (1) small firms generally have lower marginal tax rates than larger firms, thereby, less tax deduction benefit of debt, (2) small firms may have higher bankruptcy costs than large firms, and (3) small firms may find it more difficult to express their business health to creditors. Another attempt to explain small firm financing behaviour relied on agency theory. Agency theory holds that investors who have equity or debt in a firm require costs 100

120 Chapter Three: Financial Management and SME Profitability to monitor the investment of their funds by management or the small business owner (agency costs). This view suggests that financing is based on the owner-manager being able to assess these agency costs for each type of financing, and then select the lowest cost method of financing the firm s activities. One weakness of this explanation is that no one has yet been able to measure agency costs, even in large firms (Myers, 1984). In contrast, more recent theoretical and empirical work suggests that a strategic perspective may have promise in explaining the financing decisions. Barton and Gordon (1988) suggest that the following characteristics must be accounted for in any explanation of firm financing decisions: behavior at the firm level fact that the capital structure decision is made in an open systems context by top management, and decisions reflects multiple objectives and environmental factors, not all of which are financial in nature. The firm s financing decision, then, appears to be a product of many internal and external factors, as well as managerial values and goals. The arguments of Barton and Gordon (1988) for the management choice perspective on large-firm financing decisions may have even more relevance and validity for small firms. First of all, because most small firms are not actively traded on a financial market as large, public firms are, they are unconcerned with the financial market s assessment of their capital structure. As a result, modern financial leverage theory, which is based on the market s assessment of total stock valuation, does not always apply. Second, as Levin and Travis (1987) pointed out the owners attitudes toward personal risk not the capital structuring policies public companies use determine what amounts of debt and equity are acceptable. In effect, the authors argue that small firms choose debt based on personal, managerial preference. While the classic strategy paradigm is not explicitly theoretical in nature, it does identify key decision categories, which are affected by top managers, when they make strategic decisions. Based on dimensions of the strategy paradigm, Barton and Matthews 101

121 Chapter Three: Financial Management and SME Profitability (1989) suggested five propositions to explain how small firms determine their capital structure listed as follows: (1) top management s risk-taking propensity affects the firm s capital structure; (2) top management s goal for the firm will affect the firm s capital structure; (3) top managers would prefer to finance firm needs from internally generated funds rather than from external creditors or even new stockholders; (4) the risk propensity of top management and financial characteristics of the firm affect on the amount of debt lenders are willing to offer and on what terms; and (5) financial characteristics moderate the ability of top management to select a capital structure for the firm. However, the authors mentioned above and Barton and Matthews (1989) have not provided empirical evidence to support their propositions. Conversely, Norton (1991) provided empirical evidence on capital structure selection by conducting a survey of 400 small, high-growth corporations. In his survey, respondents were asked to describe the underlying firm philosophy in making debt and equity decisions. There were 261 respondents answering this question and the results are shown in Table Table 3.33: Viewpoint guiding firms financing decisions Response percentage a. Raise/use money in the following order: Use internal funds as much as possible 2. Issue short-term debt, long-term debt 3. Issue convertible securities 4. Issue common stock b. Consider market response to new issues of debt and equity 16.9 c. Alternate between debt and equity issues 4.6 d. Choice depends on the existence of any differences in firm value between management and the marketplace 7.7 e. Try to balance present value of the tax shield of debt with the present value of possible bankruptcy costs 0.0 f. Issue debt and equity to stay close to a target debt: equity ratio 6.1 g. Use no long-term debt 5.4 h. Borrow the maximum available 1.9 i. Borrow the maximum available with an A rating 1.9 j. Maintain a given coverage ratio 5.0 k. Careful firm evaluation of cash flow variation and bankruptcy given financing choice 1.1 l. Issue debt when interest rates are low, issue stock when prices are high, to finance capital budgeting projects 10.0 m. Issue debt when interest rates are low, issue stock when prices are high, even though present needs are not great in order to build up a long-term funds cushion 7.7 Source: Adapted from Norton (1991) 102

122 Chapter Three: Financial Management and SME Profitability Other empirical evidence on capital structure was provided by Peterson and Shulman (1987). Peterson and Shulman (1987) analyzed the empirical data collected for 1984 International Small Business Congress. Approximately 130 questions were asked in 4,000 interviews conducted in 12 countries including Brazil, Colombia, Spain, Kenya, Cameroon, Indonesia, USA, Canada, West Germany, United Kingdom, Netherlands, and Japan. The survey questionnaire contains information regarding the source of funds, including traditional debt, internal equity, friends/relatives, and trade suppliers. The actual percentage of each source that a firm employs varies depending on such factors as (1) age of firm, (2) location of the firm, (3) cost of the source, (4) availability of the source, (5) profitability of the firm, (6) growth level of the firm, and (7) information flows. The results of the study show that a life cycle of capital structure among small growing firms depend on age, size, and economic development. Most firms appear to be initially dependent on relatives/friends and personal equity for expansion/working capital needs and over time are able to rely on more heavily on traditional source of bank debt for financial support. Since firm managers/owners will attempt to minimize the overall cost of capital, the firm is seen as having a rising level of debt as it becomes available. Using debt finance seems to be dependent on size, profitability of the firm and the development of the economy. This conclusion is supported by the evidence shown in Table Table 3.34: Factors influencing percentage of bank debt usage Percentage of bank debt use Number of employees Under Over Firm profitability Profitable firms 71 Unprofitable firms 43 Development of the economy Developed countries 68 Developing countries 42 Source: Adapted from Peterson and Shulman (1987) 103

123 Chapter Three: Financial Management and SME Profitability Section 3.4 reviewed the literature of financial management practices of SMEs in the developed countries. Most previous researchers in the literature concentrated on examining, investigating and describing the behavior of SMEs in implementing financial management. Specific areas of financial management practices including accounting information system, financial reporting and analysis, working capital management, fixed asset management and capital structure management, have attracted the attention of many researchers. However, their findings are mainly related to exploring and describing behavior of SMEs in financial management practices. As a result, they provided many descriptive findings but seem to lack the associative findings of the relationship between financial management practices and financial performance of SMEs. 3.5 FINANCIAL CHARACTERISTICS OF SMEs This section reviews the literature on financial characteristics of SMEs. Its objectives are (1) to examine how previous researchers identify and measure financial, characteristics, (2) to review the findings related to financial characteristics that were found by previous researchers, and (3) to identify gaps in knowledge of financial characteristics of SMEs. This section is structured into three subsections. Subsection examines the variables of financial characteristics identified by previous researchers. Subsection discusses measuring these variables. Lastly, subsection summarizes all the previous findings related to financial characteristics of SMEs Identifying financial characteristics This subsection mainly discusses the concept of financial characteristics of SMEs. It reviews definitions of financial characteristics that were mentioned and used by previous researchers. Stevens (1973), Burns (1985), Hutchinson, Meric and Meric (1988), Jaggi and Considine (1990), Davidson and Dutia (1991), Laitinen (1992), Hutchinson and Mengersen (1993), McMahon et al. (1993), and Meric et al. (1997) are viewed as the key researchers who study financial characteristics. In defining financial characteristics, McMahon et al. (1993, p. 177) states: 104

124 Chapter Three: Financial Management and SME Profitability Financial characteristics of enterprise, often in the form of accounting ratios, derived from financial statements provide useful information for numerous purposes. This information can be used to quantify the position of small business in terms of their profitability, liquidity, and leverage and to compare them with other or large enterprises. Stevens (1973), who studied financial characteristics of acquired firms, conducted factor analysis on several ratios and reduced the number of ratios into the following six factors: leverage, profitability, activity, liquidity, dividend policy and earning ratio identifying financial characteristics. Burns (1985) analyzed financial characteristics and profitability of small companies in the UK. He used the following ratios: quick ratio, current ratio, gearing, long-term debt ratio, and interest cover ratio to define financial characteristics of the companies. Hutchinson, Meric and Meric (1988) studied financial characteristics of small firms, which achieved quotation on the United Kingdom Unlisted Securities Market. They used financial ratios including liquidity ratios, leverage ratios, activity ratios, profitability ratios and growth ratios to identify financial characteristics of the firm. In another study, Hutchinson and Mengersen (1993) examined the effect of growth on financial characteristics. The variables used to define financial characteristics were profitability, liquidity, and leverage. Jaggi and Considine (1990) examined whether financial characteristics of ownercontrolled acquired firms differ from those of the non-owner-controlled acquired firms. Four variables: profitability, liquidity, leverage, and dividend payment capability were used to identify financial characteristics of the firm. To reduce the large number of ratios produced, some researchers such as Stevens (1973), Laitinen (1992) used factor analysis. According to Laitinen (1992) factor analysis is a useful statistical tool reducing a large set of correlated variables to fewer unrelated dimensions and identifying a typology. Laitinen (1992) studied financial characteristics of newly-founded firms and used the following variables: profitability, dynamic liquidity, quick ratio, indebtedness or static solidity, dynamic solidity, logarithmic net sales, and capital intensiveness to identify financial characteristics. 105

125 Chapter Three: Financial Management and SME Profitability Davidson and Dutia (1991) explored whether small firms have distinctively different financial characteristics from larger firms and determined the extent of the under-capitalization problem. In their study, four variables: liquidity, profitability, debt and solvency, and turnover are viewed as the variables to determine financial characteristics of SMEs. Meric et al. (1997) conducted a comparative study on financial characteristics of 87 Japanese and 87 USA chemical firms. In their study, they compared financial characteristics between the USA and Japanese chemical firms by using ten financial ratios. Financial ratios used to define financial characteristics in their study included: (1) operating profit margin, (2) total asset turnover, (3) return on assets, (4) return on equity, (5) fixed charge coverage, (6) common equity ratio, (7) long-term debt ratio, (8) current ratio, (9) quick ratio and (10) inventory turnover. In summary, depending upon the purpose of each study, previous researchers selected appropriate variables to identify financial characteristics of the small firms. The following variables: liquidity, leverage, profitability, and activity were most popularly used by most researchers to describe financial characteristics of the firms. Table 3.35 summarizes the variables used by previous researchers to define financial characteristics. Table 3.35: Summary of literature review of financial characteristic variables Researcher(s) Business type Variables for identifying financial characteristics Stevens (1973) 40 acquired and 40 Leverage, profitability, activity, liquidity, dividend non-acquired firms policy, price and earning ratio Burns (1985) General Current ratio, quick ratio, gearing, long-term debt ratio and interest cover ratio. Hutchinson, The UK Unlisted Liquidity ratios, leverage ratios, activity ratios, Meric and Meric Securities Market profitability ratios and growth ratios (1988) small firms Jaggi and 73 owner controlled Profitability, liquidity, leverage and dividend Considine (1990) acquired firm payment capability Laitinen (1992) Newly-founded Profitability, dynamic liquidity, quick ratio, firms indebtedness or static solidity, dynamic solidity, logarithmic net sales, and capital intensiveness. McMahon et al. General Profitability, liquidity and leverage (1993) Hutchinson and Growth small firm Profitability, liquidity, and leverage Mengersen (1993) Meric et al. 87 Japanese and 87 Operating profit margin, total asset turnover, return (1997) US chemical firms on assets, return on equity, fixed charge coverage, common equity ratio, long-term debt ratio, current ratio, quick ratio, inventory turnover Source: As indicated above 106

126 3.5.2 Measuring financial characteristics Chapter Three: Financial Management and SME Profitability Subsection discussed financial characteristic identified by previous researchers in their studies. Subsection examines how to measure financial characteristics. However, the purpose of this study is not to examine all variables but only discusses measuring four variables: liquidity, leverage, activity and profitability, which are the most popularly used to identify financial characteristics and meet the objectives of the study Liquidity Most researchers view liquidity as one of the variables to define financial characteristics. Liquidity refers to the overall level of cash and near cash assets (such as debtors and stock) held and cash inflows and outflows that add to and subtract from the sum of these assets (McMahon and Stanger, 1995, p.24). When used for determining financial characteristics, liquidity is often measured as ratios. There are two kinds of ratios used by most researchers such as Stevens (1973), Burns (1985), Jaggi and Considine (1990), Hutchinson and Mengersen (1993), Meric et al (1997): 1. Current ratio = Current assets / Current liabilities 2. Quick ratio = (Current assets Inventory) / Current liabilities In general, previous researchers strongly agreed in the use of these two ratios as measures of liquidity and to determine financial characteristics of small enterprises Financial leverage Leverage is the next variable often used by most researchers to determine financial characteristics of the small enterprises. Walker and Petty (1978, p.145) defined financial leverage to be the process of using senior (debt or equity capital with a fixed return) capital to increase the rate of return on junior securities. Brigham (1995, p. 429) indicated that financial leverage is the extent to which fixed-income securities (debt and preferred 107

127 Chapter Three: Financial Management and SME Profitability stock) are used in a firm s capital structure. Similarly, Ross, Westerfield and Jaffe (1999, p.33) said that financial leverage is related to the extent to which a firm relies on debt financing rather than equity. When financial leverage is used to identify financial characteristics of the firm, it is often measured by the following ratios: 1. Equity ratio = Equity/Total asset: used by Hutchinson, Meric and Meric (1988), Meric et al (1997) 2. Long-term debt ratio = Long-term debt/total capital: used by Burns (1985), Meric et al (1997) 3. Lon-term debt to equity ratio = Long-term debt/common stock equity: used by Jaggi and Considine (1990) 4. Debt ratio = Total debt/total assets: used by Brigham (1995) and Ross, Westerfield, and Jaffe (1999). 5. Debt-to-equity ratio = Total debt/total equity: used by Brigham (1995) and Ross, Westerfield, and Jaffe (1999) Activity A ratio of activity is considered the third variable to determine financial characteristics of the firm. Hutchinson, Meric and Meric (1988) measure activity by the following ratios: 1. Inventory ratio = Inventory/Sales 2. Receivables ratio = Accounts receivable/sales 3. Fixed assets ratio = Fixed assets/sales 4. Total asset turnover = Sales/Total assets Meric et al (1997) only used two ratios of activity: total asset turnover (Sales/Total assets) and inventory turnover. Noticeably, Ross, Westerfield, and Jaffe (1999) and Meric et al. (1997) used inventory turnover instead of inventory ratio. Inventory ratio is 108

128 Chapter Three: Financial Management and SME Profitability calculated by dividing the cost of goods sold by average inventory while inventory ratio is calculated by dividing inventory by sales Profitability Profitability ratios are viewed as another variables to identify and measure financial characteristics of SMEs. According to Jaggi and Considine (1990), profitability is a crucial indicator for determining the financial position of the firm. The firm is considered financially weak when its profitability is sliding or the profitability is weak compared to other firms in the industry. In their study, they also used return on assets as the indicator to reflect profitability. Burns (1985) and Meric et al. (1997) measured profitability by three ratios: return on total assets, return on net assets, and return on equity. According to Burns (1985) return on total assets is the best measure of a firm s efficient use of assets because it is independent of financing methods. While return on equity is a measure of the profit return to shareholders. In summary, depending on the purpose of their study the researchers in the literature use different ratios to measure financial characteristics of a firm. Table 3.36 (page 110) summarizes ratios used by previous researchers in measuring financial characteristics. Table 3.36 reveals that previous researchers have used many different variables and ratios to identify and measure financial characteristics of a firm. However, the variables most popularly used by most previous researchers included (Table 3.36, page 110): liquidity measured by current and/or quick ratios, financial leverage measured by debt (long-term and short-term) ratio, debt-toequity ratio, and/or equity-to-total asset ratio, activity measured by total asset turnover, receivables turnover, and/or inventory turnover, and profitability measured by return on sales, return on assets and/or return on equity 109

129 Chapter Three: Financial Management and SME Profitability Table 3.36: Summary of measurement of financial characteristic variables Researcher(s) Financial Measurement and year characteristic variables Burns (1985) Liquidity Current ratio and quick ratio Profitability Return on total assets, return on net assets and return on equity Leverage Gearing ratio and long-term debt ratio Liquidity ratios Current assets/current liabilities (Current assets Inventory)/Current liabilities Current assets/total assets (Current assets current liabilities)/total assets Hutchinson, Leverage ratios Owners equity/total assets Current liabilities/total asset Meric and Meric (1988) Activity ratios Inventories/Sales Sales/Total assets Profitability ratios Net profit after tax/sales Earnings before interest and tax/total assets Net profit after tax/owners equity Growth ratios Average annual assets growth rate Average annual sales growth rate Profitability Operating profit/total assets Jaggi and Considine (1990) Liquidity Cash/Current liabilities (Cash + accounts receivable)/current liabilities current assets/current liability Leverage Long term debt/common stock equity Dividend payment Cash dividend/net income capability Profitability Return on investment ratio Dynamic liquidity Cash flow to net sales Static liquidity Quick ratio Laitinen (1992) Static solidity Shareholders capital to total capital Dynamic solidity Cash flow to total debt Capital Net sales to total capital ratio intensiveness Operating profit/sales Profitability Net income/total assets Meric et al. (1997) Activity Leverage Liquidity Source: As indicated above Net income/common equity Sales/Total assets Income before fixed charges/fixed charges Cost of goods sold/inventory Common equity/total assets Long-term debt/total capital Current assets/current liabilities (Current assets Inventory)/Current liabilities 110

130 Chapter Three: Financial Management and SME Profitability Previous findings related to financial characteristics This subsection reviews findings of previous researchers, related to financial characteristics. Its objective is to identify the gap in knowledge of financial characteristics of SMEs. During the three decades of 1960 s, 1970 s and 1980 s, Anderson (1967), Singh and Whittington (1968), Gupta (1969), Bolton (1971), Bates (1971), Elliott (1972), Stevens (1973), Walker and Petty (1978), Wilson (1979), Chen and Balke (1979), Tamari (1980), the US Small Business Administration (1984), Burns (1985), Storey et al. (1987), and Hutchinson, Meric and Meric (1988) are the well-known researchers who completed numerous studies related to financial characteristics of SMEs. In recent years, the key researchers who have contributed to studying financial characteristics of SMEs include Jaggi and Considine (1990), Davidson and Dutia (1991), Laitinen (1992), Hutchison and Mengersen (1993) and Meric et al. (1997). The findings and contribution of researchers as mentioned above can be classified into three categories: findings of factors influencing financial characteristics of SMEs findings of comparisons (large versus small enterprises, owner versus non-owner controlled acquired firms, quoted versus unquoted firms, floated versus nonfloated firms, country versus another country) of financial characteristics of SMEs, and findings of the impact of financial characteristics on SME performance. The next subsections will review details of these findings. Its objective is to identify a gap in the literature on financial characteristics of SMEs Findings of factors influencing financial characteristics of SMEs Researchers in the literature found many factors influencing financial characteristics of SMEs in which growth and size are two of these factors. According to McMahon et al. 111

131 Chapter Three: Financial Management and SME Profitability (1993), the effects of growth are likely to manifest themselves in financial characteristics and performance of small enterprises. Weston and Brigham (1981) consider the financial implications of five stages of development: formation, rapid growth, growth to maturity, maturity, and decline, and found that major sources of finance at formation are the owners personal resources. However, according to McMahon et al. (1993) the major financial problems likely to arise at this stage are that these resources are insufficient and that the small enterprise is thereby under-capitalized. Growth beyond formation is likely to be financed by retained earnings, trade credit and bank borrowing. As a result, growth may have the following effects: Growth may outstrip financial resources, leading to over-trading and liquidity crises. Growth may also cause a financial gap where the small enterprise is forced to rely too much on short-term finance because of a lack of long-term finance. Further growth may require a stock market flotation in order to overcome the finance gap. The effect of growth and size on financial characteristics and performance were examined by Elliott (1972). Size was found to affect performance in two ways. Belowaverage sized enterprises were found to have higher growth in cash flow and to have undertaken higher rates of capital spending than above-average enterprises. Growth affected on enterprise s debt position, with both debt equity ratios and the proportion of non-equity financed assets being higher for slowly growing enterprises than for rapidly growing ones. Additionally, below-average growth enterprises had significantly higher rates of capital spending than above-average growth enterprises. In contrast, Chen and Balke (1979) reported that the size of enterprises did not seem to have a significant effect on most financial ratios. Only the current ratio was found to have significantly negative effects by different sizes of enterprise. When studying the effect of growth and size on financial characteristics, Gupta (1969) looked at variations in asset utilization, leverage, liquidity and profitability 112

132 Chapter Three: Financial Management and SME Profitability between manufacturing enterprises operating at different size levels and with different growth rates. Gupta s (1969) findings are summarized as follows: Activity ratios and leverage ratios decrease with an increase in the size of the enterprise but increase with the growth of the enterprise. Liquidity ratios rise with an increase in the size of the enterprise but fall with growth rates. Larger enterprises tend to have higher profit margins on sales than small enterprises. In contrast, Whittington s (1971) conclusions regarding size and profitability, derived from regression analysis using cross-sectional data, are that the average profitability of enterprises is independent of their initial size during the period studied. These conclusions are largely in line with those of an earlier study by Samuel and Smyth (1968), and thus tend to confirm the law of proportionate effect which asserts that the profitability of an enterprise growing at a given rate during any specific period of time is independent of the initial size of the enterprise. In addition to growth and size, financial characteristics were also found to be affected by contingent factors. McMahon et al. (1993, p.179) comment on the importance of keeping in mind that there are many other factors, in addition to stage of development, growth rate, and stock market flotation, which affect financial characteristics and performance of small enterprises. However, according to Neck (1977), these factors can be grouped into three categories: host, agent and environment. The host is taken to be the owner-manager of the small enterprise. Financial skills of small enterprise owner-managers can have a direct impact on the financial profile of the business in terms of its profitability, financial leverage and liquidity management. The agent is taken to be various financial environmental institutions. Financial characteristics of small enterprises will be affected by the availability of finance from institutions. If the finance gap does exist so that small enterprises cannot 113

133 Chapter Three: Financial Management and SME Profitability raise long-term finance in the same way as large enterprises, then this will directly affect their financial structure. The environment is taken to be that created by legislation, taxation, and economic conditions Comparative studies of financial characteristics Small versus large enterprises Comparative studies of financial characteristics between small and large enterprises have long attracted the attention of several researchers. There are many findings, which report or describe differences of financial characteristics between small and large enterprises. McMahon et al. (1993) made an important contribution to reviewing the literature on financial characteristic differences between small and large enterprises. According to McMahon et al. (1993, p. 189) these differences can be summarized and classified into three basic groups: Differences in liquidity Liquidity in small enterprises has been found to be lower for small enterprises than for large by Bates (1971), Gupta (1969), Walker and Petty (1978), Wilson (1979) and Burns (1985). In contrast, Chen and Balke (1979) and Elliott (1972) found small enterprises to be more liquid than large enterprises whilst the Bolton Committee (1971) and the US Small Business Administration (1984) found no significant differences between the two groups. In recent years, Davidson and Dutia (1991) found that whilst small enterprises had higher levels of current liabilities they also had higher cash balances. Based on the current and quick ratio, Davidson and Dutia (1991) also found that small firms are less liquid than large firms. Conversely, Osteryoung, Constand and Nast (1992) found that the liquidity ratios, including current and quick ratio, are not different across the large and small firms. 114

134 Chapter Three: Financial Management and SME Profitability Differences in financial leverage Financial leverage in small enterprises is not significantly different from large enterprises, as reported by Bolton (1971), Chen and Balke (1979), Elliott (1972), Tamari (1980), and Wilson (1979). Only Bates (1971) found that total debt levels to be lower for small enterprises, whilst Davidson and Dutia (1991), Gupta (1969), the US Small Business Administration (1984), and Walker and Petty (1978) and Burns (1985) found small enterprises to be more highly leveraged than large firms. Small growth enterprises have higher leverage than large enterprises or other small enterprises according to Bolton (1971). Recently, Davidson and Dutia (1991) also found that small firms use more short-term debt than larger firms. Differences in profitability Profitability has generally been found to be lower for small enterprises than large in USA studies such as Anderson (1967), Gupta (1969), and the USA Small Business Administration (1984). Only Tamari (1980) and Walker and Petty (1978) found small enterprises to be more profitable than large enterprises. In the UK, only Bates (1971) found small enterprises to be less profitable than large enterprises. Both Bolton (1971) and Wilson (1979) found that small enterprises were more profitable than large. The Bolton (1971) Committee also found that growth small enterprises were more profitable than either large enterprises or other small enterprises. In more recent, Davidson and Dutia (1991) also found smaller firms in their study tend to have lower profit margins than large firms. However, small firms did not have lower ROA ratios. Conversely, Osteryoung, Constand and Nast s (1992) results of studying indicated that two profitability ratios, return on sales and return on net worth, are not different across the large and small firms. Owner controlled versus non-owner controlled acquired firms Jaggi and Considine (1990) examined whether financial characteristics of owner controlled acquired firms differ from those of the non-owner controlled acquired firms. Their study was based on 73 firms from each group and the results indicated that the financial position of owner controlled acquired firms was significantly different compared to that of the non-owner controlled acquired firms. The financial position, as 115

135 Chapter Three: Financial Management and SME Profitability reflected by four financial characteristics: profitability; liquidity; leverage and dividend payment capability was weak for non-owner controlled firms and it was strong for owner-controlled firms. Quoted versus unquoted small firms Differences in financial characteristics of quoted and unquoted small firms were examined by Hutchinson, Meric and Meric (1988). In their study, they examined whether financial characteristics of small firms, which are quoted on the Unlisted Securities Market (USM) in the UK, are different from small firms not listed. Based on multivariate variance analysis, they indicated that the overall financial characteristics of these firms are significantly different from those which have not achieved USM quotation. The most important differences between these two groups of firms are in terms of sales growth rates, the use of debt financing, and the level of liquid assets. Small firms, which had achieved USM quotation, appeared to have higher growth rates, use more debt financing, and invest less in current assets than small firms, which have not achieved USM quotation. Floated versus non-floated small firms While Hutchinson et al. (1988) provided an analysis of financial characteristics of small firms which achieved quotation on the USM, Hall and Hutchinson (1995) examined how financial characteristics of small firms entering the USM between 1980 and 1983 inclusive differed from those that remained non-floated. Their results provide useful insights into some aspects of the operation of the USM with respect to small firms. Those small firms, which did seek flotation, are not necessarily the fastest growing; and the establishment of the USM would not appear to have made any difference to the relationship between the growth of a small firm and its profitability in achieving flotation. Similarly, whilst small firms that were floated on the USM in 1980 to 1983 were clearly usually more profitable than those that were not, profitability would not appear to have 116

136 Chapter Three: Financial Management and SME Profitability any greater impact on the probability of flotation by a small firm than would have been the case during the 1970s. These conclusions are not consistent with Walker and Petty s (1978) findings. Walker and Petty (1978) found that small firms preparing to enter the USA public stock market had a significantly different financial profile from that of large corporations. The differences for small firms entering the stock market were lower dividend payout, lower liquidity and higher profitability. Internationally comparative studies of financial characteristics of SMEs In addition to comparative studies of financial characteristics as indicated above, a review of literature also provides many international comparisons of financial characteristics of SMEs. McMahon et al. (1993) provides the best review of these international comparisons based on the study conducted by Tamari (1980). From Tamari s (1980) analysis, levels of equity, measured either as a percentage of total funds or as a percentage of long-term finance, are very similar for USA and UK small enterprises which are, in turn, very much higher than those for Japanese and French small enterprises, with Israeli small enterprises being in between. Meric and Meric (1994) compared the overall financial characteristics of 562 USA and Japanese firms from 28 different industries. However, their study did not compare financial characteristics of USA and Japanese firms in an individual industry. Meric and Meric (1997) followed with a comparison of financial characteristics of Japanese chemical firms and those of the USA chemical firms by using ten well-known financial ratios (Table 3.37) Table 3.37: Financial ratios used in the study of Meric and Meric (1997) Operating profit margin = Operating profit/sales Total assets turnover = Sales/Total assets Return on assets = Net income/total assets Return on equity = Net income/common equity Fixed charge coverage = Income before fixed charges/fixed charges Common equity ratio = Common equity/total assets Long-term debt ratio = Long-term debt/total capital Current ratio = Current assets/current liabilities Quick ratio = (Current assets Inventory)/Current liabilities Inventory turnover = Cost of goods sold/inventory Source: Adapted from Meric and Meric (1997) 117

137 Chapter Three: Financial Management and SME Profitability By using the multivariate analysis of variance method to compare financial characteristics of Japanese chemical firms, and USA chemical firms, Meric and Meric (1997) found that the overall financial characteristics of these two groups are significantly different. Particularly, the differences in financial characteristics of two groups of firms included: All profitability ratios were higher in USA chemical firms compared with Japanese chemical firms. Japanese firms were able to use a significantly higher level of financial leverage compared with USA firms to boost their return on equity. The liquidity level as measured by the quick ratio was not significantly different for USA and Japanese chemical firms; however, the current ratio was significantly higher for USA chemical firms than for Japanese chemical firms. The inventory turnover ratio was also significantly lower for USA chemical firms than for Japanese chemical firms. Another international comparison of financial characteristics was a financial comparison between Korean and USA firms provided by Van Auken, Doran and Yoon (1993). By using canonical correlation analysis, they found the differences in financial characteristics between Korean and USA firms to be as follows: The Korean firms were shown to have greater relative level of cash and fixed assets and small levels of inventory than USA small and large firms. Korean firms were less liquid compared to USA businesses. A comparison of the current and quick ratios of two groups is given in Table Another difference between Korean and USA businesses was that Korean businesses depend heavily on the use of current debt. Table 3.38: Comparison of liquid ratios between Korean and USA firms Korean firms USA firms Small Large Current ratio Quick ratio Source: Adapted from Van Auken, Doran and Yoon (1993) 118

138 Chapter Three: Financial Management and SME Profitability Findings of impact of financial characteristics on performance Subsection provided a review of the factors influencing financial characteristics of SMEs. Subsection reviews the findings related to the impact of financial characteristics on SME performance. Unfortunately, studies on these effects are few in the literature. While there is much research on factors affecting financial characteristics and many comparative studies of financial characteristics of SMEs, it appears there is little research on the impact of financial characteristics on SME profitability. This is a gap in previous studies, which needs to be met by this research. 3.6 SME PROFITABILITY Sections 4 and 5 review the literature of financial management practices and financial characteristics of SMEs, two of three main issues in this research. Section 3.6 reviews the literature on profitability of SMEs. This section is structured into three subsections. Subsection examines the importance of profitability to survival and development of SMEs. Subsection reviews measures of profitability. Lastly, subsection analyses factors influencing SME profitability Importance of profitability Profitability is one of the most important objectives of financial management because one goal of financial management is to maximize the owner s wealth (McMahon, 1995). Thus, profitability is very important in determining the success or failure of a business. At the establishment stage, a business may not be profitable because of investment and expenses for establishing the business. When the business becomes mature, profits have to be produced. Due to the importance of profitability, Edmister (1970) among other researchers have suggested that small firms need to concentrate on profitability. Jen (1963) found profitability to be a significant determinant of a small firm s credit risk. Thomas and Evanson (1987) stress the aim of a business is not only the generation of sales, but also 119

139 Chapter Three: Financial Management and SME Profitability generation of profits. Profit is especially important because it is necessary for the survival of a business. Low profitability contributes to under-capitalization problems because it leads to fewer dollars as retained earnings and therefore to a reliance on external capital (Davidson and Dutia, 1991) Defining and measuring profitability One of the most difficult attributes of a firm to conceptualize and measure is profitability (Ross, Westerfield and Jaffe, 1999). In a general sense, accounting profits are the difference between revenues and costs. However, the problem with accounting-based measures of profitability is that they ignore risk. In the economic sense, a firm is profitable only if its profitability is greater than investors can achieve independently in the capital market. In their text, Ross et al. (1999) suggest some methods to measure profitability including profit margin or return on sales, return on assets, and return on equity. Profit margins are computed by dividing profits by total operating revenue and thus express profits as a percentage of total operating revenue. Return on assets is the ratio of income to average total assets, both before tax and after tax, and measures managerial performance. Return on equity is defined as net income divided by average stockholders equity, and shows profit available for stockholders. Cohen (1989) stated measures of profitability are essential in any business. In his text, he indicated many different ratios to measure profitability of the business. They included asset-earning power, return on the owner s equity, net profit on sales, and return on investment. Asset earning power is determined by the ratio of earnings before interest and tax to total assets. It indicates how much operating profit each dollar of total assets earns. 120

140 Chapter Three: Financial Management and SME Profitability Return on the owner s equity is computed by dividing net profit by average equity, and shows return that the business received in exchange for investment. Net profit on sales is determined by the ratio between net profit and net sales, and measures the difference between what the business takes in and what it spends in the process of doing business. Return on investment is simply computed by dividing net profit by total assets. This measure is very useful for measuring profitability. There are several different ways of calculating return on investment depending upon the purpose of measure: 1. A measure of earning power in operating efficiency (Cohen, 1989) Rate of earning on total capital employed = Net income + Interest + Tax Total liabilities and capital 2. A measure of earning power of the borrowed invested capital (Cohen, 1989) Rate of earnings on invested capital = Net income + Income taxes Proprietary equity and fixed liabilities 3. A measure of the yield on the power s investment (Cohen, 1989) Rate of earnings on proprietary capital = Net income Total capital including surplus reserves 4. A measure of the attractiveness of common stock as a source of income (Cohen, 1989) Rate of earnings on stock equity = Net income Stock equity 5. To indicate the desirability of common stock as a source of income (Cohen, 1989) Rate of dividends on common stock equity = Common stock dividends Common stock equity 121

141 Chapter Three: Financial Management and SME Profitability 6. A measure of the current yield on investment in a particular stock (Cohen, 1989) Rate of dividends on common stock equity = Common stock dividends per share Market value per share of common stock Some researchers, who have studied financial characteristics of SMEs, also mentioned measuring profitability. For example, Burns (1985) used three ratios: return on total assets, return on net assets and return on equity to measures SME profitability while Hutchinson, Meric and Meric (1988) measured profitability by the following ratios: net profit after tax/sales, earnings before interest and tax/total assets, and net profit after tax/owners equity. Altman (1968), in a study of financial ratios, discriminant analysis and the prediction of corporate failure, measured profitability by two ratios: retained earnings/total assets (RE/TA) and earning before interest and taxes/total assets (EBIT/TA). According to Altman (1968), retained earnings to total asset ratio is the measure of cumulative profitability over time and the age of a firm is implicitly considered in this ratio. A relatively young firm will probably show a low RE/TA ratio because it had not had time to build up its cumulative profits. EBIT/TA ratio is calculated by dividing the total assets of a firm into its earning before interest and tax reductions. In essence, it is a measure of the true productivity of the firm s assets, abstracting from any tax or leverage factors. In summary, previous researchers in the literature have used several different ratios to measure profitability of SMEs depending on their research purposes. Table 3.39 (page 123) summarizes the ratios used by previous researchers to measure profitability of SMEs. Of the ratios summarized in table 3.39 (page 123), three ratios: return on sales, return on assets and return on equity are the most popularly used as the measurement of SME profitability. 122

142 Chapter Three: Financial Management and SME Profitability Table 3.39: Summary of measurement of SME profitability Researcher(s) and year Ratio Measurement or computation Return on total assets Measure of firm s efficient use of assets Burns (1985) Return on net asset The key measure of performance Return on equity A measure of the profit return to the shareholders Hutchinson, Return on sales Net profit after tax/sales Meric and Meric (1988) Return on assets Earnings before interest and tax/total assets Return on equity Net profit after tax/owners equity Jaggi and Considine (1990) Return on assets Operating profit/total assets Laitinen (1992) Return on investment Return on investment ratio Meric et al. (1997) Return on sales Operating profit/sales Return on assets Net income/total assets Return on equity Net income/common equity Source: As indicated above Factors influencing profitability This subsection reviews the factors affecting SME profitability. Its objectives are (1) to identify which factors affect SME profitability and (2) to isolate those factors that are caused by financial management practices and financial characteristics. Based on the profitability measures presented by Westerfield and Jaffe (1999) and by Cohen (1989), the main factors influencing profitability include revenue, costs and capital. In general, revenue is determined or influenced by marketing, sales management and new product development, whereas cost and capital are mainly affected the financial management practices. When analyzing factors affecting profitability, Burns (1985) found that profitability could be affected by many different economic factors. Lev (1983) found that variability of profit measures over time is affected by type of product, degree of competition, degree of capital intensity as well as firm size. The effect of size on SME profitability was also discussed by Gupta (1969), Whittington (1971), Bates (1971), Walker and Petty (1978), Tamari (1980), and Storey et al. (1987). Kirchhoff and Kirchhoff (1987) examined family contributions to productivity and profitability in small businesses. The evidence showed that family members are more 123

143 Chapter Three: Financial Management and SME Profitability productive than other employees. However, in his study family member s productivity did not increase profitability. Results showed the opposite, as paid family labor increases, profitability decreases. As family member participation increases, wage and salary expense increase as a percentage of revenue, thereby causing profit as a percentage of sales to decline. McDonald (1999) provided new evidence on the determinants of profitability of Australian manufacturing firms by analyzing an unique firm level data-set of firm performance over the period Determinants of firm profitability were found to be generally consistent with previous Australian industry-level results and overseas studies. Firm profitability was found to be negatively affected by union density and by import penetration, and positively affected by industry concentration. In addition, there was a strong degree of persistence in firm profit margins over time. Real wage inflation was negatively related to profit margins, which suggests that firms do not immediately pass on increases in real wages by raising current prices. Firm market share was generally not found to be a significant determinant of profit margins, although this result is sensitive to the econometric method used. Generally, there are many factors affecting SME profitability. However, from the viewpoint of financial management, DuPont analysis is considered a standard model to analyze the factors affecting on SME profitability. According to Eisemann (1997), a virtue of DuPont analysis is its simplicity. Three fundamental ratios derive one summary ratio: return on equity (ROE). Their relationships are illustrated by the following equations: Return on equity = (Net profit margin) x (Total asset turnover) x (Leverage) (Eq. 6.1) Net income/equity = (Net income/sales) x (Sales/assets) x (Assets/equity) (Eq. 6.2) The ratios that determine ROE reflect three major performance dimensions of interest to all loan analysts: income statement management, or how much profit a company can generate per sales dollar; and two aspects of balance sheet management, how well assets can generate sales and the amount of solvency risk. The ratios also indicate that there are several paths that a business can use to gain a return for its owners: 124

144 Chapter Three: Financial Management and SME Profitability margin, volume, and leverage. All represent areas of financial management and are affected by financial management practices. While DuPont analysis technically only includes the three ratios discussed above, the framework can be extended to incorporate most major financial ratios (Eisemann, 1997). It helps to think of the ratios as analogous to parts of a tree. The trunk is ROE and there are three major branches: profit margin, total asset turnover, and assets to equity. Each of these three branches in turn further divides to include more ratios, as illustrated by the figure 3.6. Figure 3.6: Financial ratios linked to return on equity Return on equity Profit margin Asset turnover Asset/equity Gross margin Operating expense Interest Taxes Accounts receivable days Debt/equity Inventory days Coverage Fixed-asset turnover Source: Adapted from DuPont analysis (Eisemann, 1997) Figure 3.6 provides a quick insight into factors affecting SME profitability including gross margin, operating expenses, interest, taxes, accounts receivable days, inventory days, fixed-asset turnover, leverage and coverage. From the equation 6.1, it appears that as leverage increases, ROE will also rise. The problem with this thinking is that another effect of an increase in leverage is larger interest expense, which, in turn, causes a decrease in the profit margin and ROE. Thus leverage spreads its effects over two ratios, making it hard to disentangle the impact of leverage and operations. Moreover, profit margin is not really an accurate measure of operations, since it combines operations with financial leverage. To overcome this problem, the number of ratios is broken-down into smaller groups while permitting a more complete separation of operations and financial leverage (Eq. 6.3). 125

145 Chapter Three: Financial Management and SME Profitability Net income/equity = (operating income/sales) x (EBT/operating income) x (Net income/ebt) x (sales/assets) x (assets/equity) (Eq.6.3) Equation 6.3 provides new insights into profit margin and leverage. The first of the three new ratios, operating margin, relates operating income to sales. Because operating income is before any deduction for interest, this ratio measures the underlying profitability of the business and, except for the impact of leasing, is independent of how the firm is financed. The second ratio divides earnings before taxes by operating income. This ratio measures the income statement effect of financial leverage. As financial leverage and interest expense increase, this ratio decreases. To see this, consider a situation where there is no interest expenses or non-operating income. Earnings before taxes and operating income would be identical and the value of the ratio would be one. The last new ratio is net income divided by earnings before taxes. This measures the effect of taxes and is actually equivalent to one minus the effective tax rate. 3.7 RELATIONSHIPS BETWEEN FINANCIAL MANAGEMENT AND SME PROFITABILITY This section reviews the relationships between financial management and SME profitability based on the literature by reviewing findings that were investigated by previous researchers. Unfortunately, these findings are not clear because most previous researchers only focus on examining and describing financial management practices and financial characteristics but do not focus on examining the impact of financial management practices on SME profitability. Concerned with the relationships between working capital management practices and SME profitability, only Burns and Walker (1991) provide some relevant findings as follows: profitable firms reviewed their working capital policies on monthly and quarterly bases profitable firms used an ROI (return on investment) criterion in looking at changes in the management of certain working capital components 126

146 Chapter Three: Financial Management and SME Profitability profitable firms always or sometimes take discounts on payables whereas aggressive firms and those with written working capital policies were net users of trade credit. Some theoretical researchers do indicate the relationships between financial management and profitability. For example, Van Horne (1986, p. 145) indicated the relationship between liquidity and profitability: The greater the relative proportion of liquid assets, the less risk of running out of cash profitability unfortunately, also will be less resolution of the trade-off between risk and profitability with respect to these decisions depends upon the risk preferences of management. According to Van Horne (1986), if the firm maintains a relatively large proportion of liquid assets, its profitability probably will decrease. Regarding the relationship between financial leverage and profitability, Edwards and Cooley (1979) indicated that the effects of financial leverage on returns available to equity holders are typically analysed in either one of two contexts. In many financial management books, financial leverage is examined in a net-operating-income (NOI) or equivalent context for its effects on rates of return available to stockholders. In the literature of real estate finance, the effects of leverage on equity return are evaluated in a cash flow (CF) context. In both settings, the evaluation of leverage effect reduces to a convenient rule exemplified by the following statement (Edward and Cooley, 1979): In general, whenever the return on assets exceeds the cost of debt, leverage is favourable, and the higher leverage factor, the higher the rate of return on common equity. The statements mentioned above should be tested by the empirical data. In doing so, this research will contribute to filling a gap and building up a model of the impact of financial management on SME profitability. The next section will consider the possibility of such a model. 127

147 Chapter Three: Financial Management and SME Profitability 3.8 MODEL OF THE IMPACT OF FINANCIAL MANAGEMENT ON SME PROFITABILITY Based on the literature, this research chapter was seeking to provide an overview of the findings of financial management practices, financial characteristics and SME profitability. Related to financial management practices, most previous researchers from the literature concentrated on examining, investigating and describing the behaviour of SMEs in implementing financial management. The specific areas of financial management practices including accounting information system, financial reporting and analysis, working capital management, fixed asset management and capital structure management have attracted the attention of many researchers. Their findings are mainly related to exploring and describing behaviour of SMEs in financial management practices. Although they provided much descriptive statistical data and empirical evidence on SME financial management practices, it appears that there are some limitations in past research, which need to be addressed. Firstly, most empirical evidence comes from developed economies such as the USA, UK, Canada and Australia. Evidence seems to lack evidence from emerging economies, especially from the transiting economies such as Vietnam and China. Secondly, most researchers in the literature only focus on investigating and describing financial management practices, whereas few examine the impact of financial management practices on SME profitability. It will be difficult to convince financial management practitioners of the importance of financial management until evidence on the impact of financial management practices on SME profitability is provided and the relationship between the two variables are discovered. In addition to financial management practices, the literature also provided the valuable findings related to financial characteristics of SMEs. Four variables including 128

148 Chapter Three: Financial Management and SME Profitability liquidity, financial leverage, activity and profitability are popularly used by previous researchers to identify and measure financial characteristics of SMEs. Many studies on financial characteristics of SMEs have been conducted by researchers over several decades. Subsection (page 114) concerned with the comparative studies of SME financial characteristics indicated that most researchers focused on examining whether or not there exist differences in financial characteristics between different groups of SMEs. However, there still exist gaps in the literature on financial characteristics of SMEs, which need to be examined. Firstly, it appears that financial characteristics of SMEs in developing countries, especially in the transiting economies such Vietnam and China have not been investigated with empirical data Secondly, to date there is no study, which examines the relationship or the impact of three variables: liquidity, financial leverage, and activity on profitability. As such, the lack of empirical evidence from the emerging economies and the absence of examination of the impact of financial management practices and financial characteristics on SME profitability, are gaps that this review found from the literature. Based on these findings provided by previous researchers and these gaps, a model of the impact of financial management on SME is developed. Such a model is presented in Figures 3.7 (page 130). The model needs to be tested by the empirical data and this will be demonstrated in chapters 4 and 5. Figure 3.7 (a) describes the general model of the simultaneous impact of financial management including the impact of financial management practices and the impact of financial characteristics on SME profitability. Figure 3.7 (b) describes the detailed model of the impact of financial management practices on SME profitability in which the components measuring financial management practices such as accounting information system, financial reporting and analysis, working capital management, fixed asset management, capital structure management and financial planning, and components measuring financial characteristics such as liquidity, financial leverage, and business activity are identified. 129

149 Chapter Three: Financial Management and SME Profitability Figure 3.7: Model of the impact of financial management on SME profitability Financial management practices Financial management SME profitability Financial characteristic a) General model Financial management practices: Accounting information system Financial reporting and analysis Working capital management Fixed asset management Capital structure management Financial planning Efficient financial management SME profitability: Return on sales Return on assets Return on equity Financial characteristics: Liquidity ratios Financial leverage ratios Activity ratios b) Detailed model Source: Developed for this study 130

150 3.9 CONCLUSIONS Chapter Three: Financial Management and SME Profitability As indicated in the introduction, the objectives of this chapter were to review the literature, find gaps and build a model of the impact of financial management on SME profitability based on this review. These objectives could not be separated as different activities, and all are fulfilled when a model of the impact of financial management on SME profitability was created (Figure 3.7, page 130). Sections 3.2, 3.3, 3.4, 3.5 and 3.6 respectively reviewed literature on definitions of SMEs, definition of financial management, financial management practices, financial characteristics, and profitability of SMEs. Generally, previous researchers provided valuable and detailed insights into financial management, financial management practices and financial characteristics. However, it appears that no investigation has been undertaken of the relationship between financial management including financial management practices and financial characteristics, especially the simultaneous impact of many variables such as accounting information system, financial reporting and analysis, working capital management, fixed asset management, financial planning practices, liquidity, financial leverage and activity ratios on SME profitability. Finally in this chapter, a model of the impact of financial management on SME profitability was developed. This model indicates that the objectives of this chapter have been satisfied. Collecting data for testing the model will be examined in chapter 4, which is designed to discuss aspects of research methodology, while chapter 5 will present the results of data analysis applied in this study. 131

151 Chapter Four: Research Methodology 4.1 INTRODUCTION Chapter 3 reviewed relevant literature on financial management practices, financial characteristics, SME profitability and the relationships between financial management practices and SME profitability. At the end of chapter 3, a model of the impact of financial management practices and financial characteristics on SME profitability was created based on the literature. Chapter 4 discusses aspects of the research methodology including research design, data collection and data analysis methods, and hypothesis testing to support the model. The objectives of this chapter are: (1) to justify the study s research methodology, (2) to explain the research methodology used in the study, and (3) to demonstrate how research design, and data collection and analysis can be utilized in this study to answer the research questions outlined in the chapter 1. This chapter is structured into eight sections. Section 4.1 generally introduces the chapter including the main contents, objectives and structure of the chapter. Section 4.2 provides a brief review of research methods used by prior researchers. The objective of this section is to justify the research methodology applied in this study. Section 4.3 discusses and explains how the research design can be appropriately utilized in this study to answer the research questions. Section 4.4 concentrates on defining and measuring the variables, and developing the model, which will be tested by empirical data. Section 4.5, 4.6 and 4.7 respectively present methods of data collection, data transformation, and data analysis, which will be conducted in chapter 5 of the study. Finally, section 4.8 summarizes the conclusions drawn from the chapter and Figure 4.1 (page 133) provides a visual picture of the chapter outline and the links among sections as indicated earlier.

152 Chapter Four: Research Methodology Figure 4.1: Structure of chapter Introduction 4.2 Appraisal of prior research methodologies 4.3 Research design 4.4 Variable definition, survey instrument and model development 4.5 Data collection methods 4.6 Raw data transformation methods 4.7 Data analysis methods 4.8 Conclusions Source: Developed for this thesis 133

153 Chapter Four: Research Methodology 4.2 APPRAISAL OF PRIOR RESEARCH METHODOLOGIES The purpose of this section is to provide an initial appraisal of prior SME research undertaken internationally from a methodological viewpoint. Reviews and surveys of SME research related to financial management practices and financial characteristics, which has been reflected in this and earlier chapters, include those of D Amboise and Gasse (1980), Raymond and Magnenat-Thalmann (1982), Cheney (1983), Raymond (1985), DeThomas and Fredenberger (1985), and Farhoodman and Hryck (1985), Corner (1967), Murphy (1978 and 1979), Lovett (1980), Arnold-McCulloch and Lewis (1985, 1986) and Gorton (1996) Peacock (1985, 1987, and 1988), Williams (1986, 1987), Holmes (1987) and Holmes and Nicholls (1988), Luoma (1967), Lindecamp and Rice (1983), Thomas and Evanson (1987), Ray and Hutchinson (1983), Hankinson (1982, 1983), McMahon and Davies (1994), McMahon (1998, 1999), Grablowsky (1978), Grablowsky and Rowell (1980), Cooley and Pullen (1979), Anvari and Gopal (1983), Khoury, Smith and MacKay (1999), Peel and Wilson (1996), Soldofsky (1964), Scott et al. (1972), Grablowsky and Burns (1980), Pattillo (1981), Block (1997), Corner (1967), Taylor Nelson Investment Services (1970), Stevens (1973), Burns (1985), Hutchinson, Meric and Meric (1988), Jaggi and Considine (1990), Davidson and Dutia (1991), Laitinen (1992), Hutchinson and Mengersen (1993), McMahon et al. (1993), and Meric et al. (1997). In methodology, studies and surveys conducted by previous researchers have the features drawn from the review of literature in chapter 3 as follows: 1. Examining the variables of financial management practices including accounting information system, financial reporting and analysis, working capital management, fixed-asset management, and capital structure management was often conducted in separate studies. While prior studies provide interesting insights into each separate aspect of financial management practices, very few attempts have been made to link all variables to performance. As a result, the simultaneous impact of many variables (accounting information system, financial reporting and analysis, working capital management, fixed asset management, 134

154 Chapter Four: Research Methodology capital structure management and financial planning) on SME profitability have not been examined and investigated. 2. These studies and surveys provided largely descriptive but little evidence. For example, regarding financial reporting and analysis, the Bureau of Economic and Business Research (1961) of Temple University, Philadelphia, was the first to study the use of financial ratios in small businesses. Unfortunately, this Bureau report was largely descriptive and provided very little associative evidence. In other research, Ray and Hutchinson (1983) investigated financial reporting and analysis practices in small growth enterprises but the provision of historical financial reports did not differ markedly between growth enterprises and a matched sample of non-growth enterprises. However, there was a tendency towards more frequent financial reporting as growth enterprises developed and became public companies. Thomas and Evanson (1987) examined possible associations between financial reporting and analysis practices and performance characteristics. The results of a study of 398 small pharmacies located in Michigan, North Carolina, Nebraska, Rhode Island, and Washington revealed that there was no significant difference in frequency of obtaining financial statements between continuing enterprises, those which eventually closed, and those which changed hands. Using regression analysis, Thomas and Evanson (1987) were unable to demonstrate a significant association between the number and frequency of use of financial ratios and enterprise profitability or survival. They hypothesized that this may have been due to a lack of sophistication in financial interpretation that prevented usage from making a discernible difference to performance. 3. Previous research focused on examining performance of SMEs in general without any emphasis on SME profitability whereas profitability is the final and survival goal of the business. Peel and Wilson (1996) found that increasing profitability was ranked higher than other objectives such as increasing sales growth or increasing employment. 4. Regarding financial characteristics of SMEs, previous researchers only emphasized differences in financial characteristics between groups of SMEs by 135

155 Chapter Four: Research Methodology conducting comparative studies but did not consider the impact of financial characteristics on SME performance in general and SME profitability in particular. In terms of methodology, McMahon (1998) summarized criticism of the most significant methodological problems identified in published reviews and surveys of prior SME research as follows: too much focus on exploratory research a narrow focus with reliance on a single paradigm or disciplinary frameworks and insufficient learning from other fields in terms of both content and process too many cross-sectional surveys, and far too few longitudinal and field research studies use of small and/or non-representative and/or poorly selected samples reliance on data from surveys with poor response rates, and failure to adequately test for response and non-response bias thus creating serious misgivings about the external validity or generalization ability of findings poor reporting of definitions used, sampling frames and samples employed, and other methodological details so that it becomes difficult to validly compare research findings and/or replicate them reporting with largely descriptive but statistically simplistic and with limited use of more sophisticated techniques of statistical analysis, and widespread disregard for the circumstances in which particular forms of analysis may be validly employed. In this study, the limitations, as indicated earlier, in terms of research methodology will be overcome by selecting research designs, incorporating variable definitions and measurements, developing models, and using appropriate data collection and analysis methods. These will be examined in the next sections. 136

156 Chapter Four: Research Methodology 4.3 RESEARCH DESIGN This section, firstly, examines the types of business research in terms of classification, purpose and technique and then, explains how the research design is selected as most appropriate for the study. Many definitions of research design have been advanced, but no one definition imparts the full range of important aspects (Emory, 1985). Emory (1985) did not define but reviewed a definition of research design from Kerlinger (1973): Research design is the plan, structure, and strategy of investigation conceived so as to obtain answers to research questions and to control variance. The plan is the overall scheme or program of research. It includes an outline of what the investigator will do from writing the hypotheses and their operational implications to the final analysis of the data Classification of research design According to Emory (1985) research design is a complex concept that may be viewed from different perspectives. McMahon (1998) reviewed classifications of research conducted by Gay and Diehl (1992) in which classifications of research designs are based on the broad strategy, orientation, emphasis and approach of research. In their classifications, research designs consisted of the following: Historical research which involves studying, understanding and explaining past events Descriptive research which involves collecting and examining data in order to answer questions concerning the status or condition of the research subject at some point of time. Associative research which attempts to determine whether, and to what degree, a relationship exist between the status or condition of the research subjects at some point of time and other factors which cannot be manipulated by the researchers. 137

157 Chapter Four: Research Methodology Causal-comparative (or ex post facto) research which attempts to establish the cause of the status or condition of the research subjects at some point of time on the basis of knowledge of factors which cannot be manipulated by the researchers. Experimental research which attempts to establish the cause of the status or condition of the research subjects at some point of time on the basis of knowledge of factors that can be manipulated by the researchers. Based on the manipulation of independent variables, Davis and Cosenza (1988) classified research into ex post facto design and experimental design. In ex post facto design, the researchers cannot manipulate the independent variables or factors whereas in experimental design they can. Based on the degree of understanding, ex post facto design can be classified into two subtypes, field study and survey, whereas experimental design can be classified into field experiment and laboratory experiment. Based on the degree of problem crystallization, Emory (1985) classified research as exploratory or formal. Exploratory studies tend to be loosely structured with an objective of learning what the major research tasks are to be whereas the goal of a formal research design is to test the hypotheses or answer the research questions posed. Because there are a variety of different research approaches, it is helpful to categorize types of research. This thesis is concerned with types of research applied in business. Business research can be classified on the basis of either technique or function (Zikmund, 1997, p. 37). Based on technique, business research can be classified into three main types: experiments, surveys, and observational studies. Based on the purpose or function, the business research can be classified into (1) exploratory, (2) descriptive, or (3) causal research. Exploratory research is conducted with the expectation that subsequent research will be required to provide conclusive evidence. Exploratory research could be used for clarifying ambiguous problems. Descriptive research seeks to determine the answers to who, what, when, where and how questions. Its major purpose, as designed, is to describe characteristics of a population or a phenomenon. 138

158 Chapter Four: Research Methodology Causal research is conducted to identify cause-and-effect relationships among variables where the research problem has already been defined. Its major objective is to identify the cause-and-effect relationships between variables (Zikmund, 1997). In summary, there are a number of different design approaches, but unfortunately there is no simple classification system that defines all the variations to be considered (Emory, 1985). Table 4.1 summarizes classification of research designs based on seven different perspectives, indicated by Emory (1985), in which (*) represents the type of research design selected in this study. Table 4.1: Classification of research designs Classification criteria Types of research designs Degree of problem Exploratory research to develop hypotheses or questions for crystallization further research Formal research * to test the hypotheses or answer the research The method of data collection Researcher s control of variables The purpose of the study questions posed Observation The researcher monitors and records information about subjects without questioning them. Survey * The researcher interrogates subjects and collects their responses. Experimental design The researcher attempts to control or manipulate the variables in the study. Ex post facto design * Investigators have no control over the variables in sense of being able to manipulate them. Descriptive research * concerned with answering who, what, where, when or how much questions Casual research * concerned with learning why, i.e., how one variable affects another The time dimension Cross-sectional research* carried out once Longitudinal research repeated and studied changes over time The topical scope Statistical study* emphasis on breadth of coverage and interested in the frequency of certain characteristics or instances Case study emphasis on the detailed analysis a limited number of events or conditions and their relationships The research Field study* environment Laboratory study Source: Adapted from Emory (1985) (*) Selected for this research 139

159 Chapter Four: Research Methodology Based on the summary of research classifications as presented in Table 4.1 (page 139), subsection explains how the most appropriate research design was selected for this study Selecting research design or paradigm Subsection reviewed the classification of research types. This subsection explains how the research paradigms are appropriately selected and utilized in this study. There are two main research paradigms labeled positivist and phenomenological (Hussey and Hussey, 1997). Selection of research type or paradigm is based on the theoretical framework of research design and methodological appraisal of prior research examined in subsection and section 4.2 (page 134) As indicated by Zikmund (1997), descriptive research seeks to determine the answers to who, what, when, where and how questions. Its major purpose, as designed, is to describe characteristics of a population or a phenomenon. According to Emory (1985), the essential difference between descriptive and causal studies lies in their objectives. If the research is concerned with finding out who, what, where, when, or how much, then the study is descriptive. If it is concerned with learning why, that is, how one variable affects another, it is causal. Chapter 1 states the main research questions that this study is seeking to answer include: How important are financial management practices and financial characteristics to SME profitability? What are the relationships between financial management practices, financial characteristics and SME profitability in Vietnam? How do financial management practices and financial characteristics affect on SMEs profitability? In seeking answer to these questions, the characteristics of financial management practices and financial characteristics of SMEs in Vietnam has been investigated and described. As such, descriptive research is more appropriate than exploratory research 140

160 Chapter Four: Research Methodology because exploratory research is usually conducted to clarify and define the nature of a problem whereas descriptive research is designed to describe characteristics of a population or phenomenon. This study is also seeking to explain how financial management practices and financial characteristics affect SME profitability. Thus this study is concerned with learning why, that is, how financial management practices and financial characteristics variables affect the SME profitability variable. This concern required a causal design to identify the cause-and-effect relationships between efficient financial management practices and profitability of SMEs. Thus causal research is implemented in combination with descriptive research in this study Selecting research methods or techniques Based on the methods of data collection, Emory (1985) classified research into two types: observation and surveys. However, Zikmund (1997) expands this classification into four basic types: surveys, experiments, observation and secondary data studies. Survey is a research technique in which information is gathered from a sample of people by use of a questionnaire (Zikmund, 1997, p. 49). Experiment holds the greatest potential for establishing cause-and-effect relationships. The use of experimentation allows investigation of changes in one variable while manipulating other variables under controlled conditions (Zikmund, 1997, p. 49). Observation allows the researcher to monitor and record information about subjects without questioning them (Emory, 1985). Secondary data study is a research technique by using previously collected data or secondary data. Secondary data are data gathered and recorded by someone else prior to the current needs of the researcher (Zikmund, 1997, p.143). In terms of research technique, this research utilizes both survey and secondary data methods. Survey was chosen as a research technique in this study to investigate and describe financial management practices of SMEs in Vietnam. The argument for 141

161 Chapter Four: Research Methodology choosing survey was based on two major reasons. Firstly, survey provides a quick, efficient and accurate means of assessing information about the population. Secondly, survey is more appropriate where there is a lack of secondary data. In this case, secondary data of financial management practices of SMEs in Vietnam is not available; thus, conducting a survey to gain information about financial management practices was necessary. Surveys may be further classified by the communication medium used into mail, telephone survey and personal interview (Emory, 1985, Zikmund, 1997). Mail survey is a self-administered questionnaire sent to respondents through the mail. Telephone survey is a method of survey in which respondents are contacted by telephone to gather responses to survey questions. Personal interview are direct communications wherein interviewers in face-toface situations ask respondents questions. In Vietnam, there are difficulties in collecting data, especially data regarding financial information. Therefore, selection of appropriate methods to communicate with respondents was very important in the surveys. This selection may be based on (1) the possibility of communicating with respondents, (2) the advantages and disadvantages of the most typical surveys as summarized in Table 4.2, and (3) the budget allocated for the research. Table 4.2 (page 143) shows that each of survey methods (personal interview, telephone interview and mail survey) has both advantages and disadvantages in terms of different perspectives. However, item non-response, possibility for respondent misunderstanding, and respondent cooperation or participation are probably the most important factors for success of a survey. Therefore, this study used personal interview as a technique to obtain information about financial management practices from the respondents key managers or owner-managers. 142

162 Chapter Four: Research Methodology Table 4.2: Summary of advantages and disadvantages of the most typical surveys Personal interview Telephone Mail survey interview Speed of data collection Moderate to fast Very fast Slow, researcher has no control over questionnaire return Geographic flexibility Limited to moderate High High Respondent Excellent Good Moderate cooperation Versatility Quite versatile Moderate Highly standardized format Questionnaire length Long Moderate Varies depending on incentive Item non-response Low Medium High Possibility for to be Lowest Average Highest respondents misunderstood Degree of interview High Moderate None influence on answer Supervision of Moderate High Not applicable interviewers Anonymity of Low Moderate High respondent Ease of call-back or Difficult Easy Easy, but take time follow-up Cost Highest Low to Lowest moderate Special features Visual materials may be shown or demonstrated, Simplified fieldwork and supervision of Respondent may answer questions at own convenience; has time to reflect on answer extended; probing possible data collection Source: Adopted from Zikmund (1997) Arguments for selection of personal interview as a mean of communicating with respondents in this study are based on the following advantages of personal interview compared with other survey methods: Item non-response Social interaction between interviewer and respondent increase the likelihood that a response will be given to all items on the questionnaire. As a result, item non-response is lowest for personal interview. Possibility for respondent misunderstanding Personal interview provides an opportunity to probe. If a respondent s answer is brief or unclear, the interviewer may be able to probe for a clearer or more comprehensive explanation. As a result, the possibility for respondent misunderstanding is lowest. 143

163 Chapter Four: Research Methodology High participation The presence of an interviewer generally increases the percentage of people willing to complete the interview. As a result, response rate is high. In addition to using personal interview to obtain primary data related to financial management practices, the secondary data method was used to examine the financial characteristics of SMEs. The variables such as liquidity ratios, financial leverage ratios, activity ratios, and profitability ratios were derived from financial statements. These financial statements were available from taxation departments of Vietnam and sometimes from businesses. 4.4 VARIABLE DEFINITION, SURVEY INSTRUMENT, AND MODEL DEVELOPMENT This section discusses variable definitions and measurements, and develops a model representing the relationships between variables Variable measurements and survey instrument This study is designed to develop a model and test the hypotheses of association between financial management practices, financial characteristics and SME profitability. Before developing the hypotheses to test these associations, variables had to be defined and measured clearly. Pedharzur and Schmelkin (1991, p. 177) defined a variable as any attribute or property in which organisms (objects, events, people) vary. In developing a causal model and testing the hypotheses of association, there are two kinds of variables involved: dependent and independent variables. An independent variable is the presumed cause, whereas a dependent variable is the presumed effect (Pedharzur and Schmelkin, 1992, p.177). Following is a more detail consideration of the dependent and independent variables, which are defined and utilized in this study. 144

164 Chapter Four: Research Methodology Dependent variables Zikmund (1997, p.87) defines a dependent variable as a criterion or a variable that is to be expected or explained. This study examines the impact of financial management practices and financial characteristics on SME profitability. Generally, profitability is viewed as the dependent variable. However, profitability is an abstract concept and a latent variable, it cannot be measured directly. To overcome this obstacle, researchers often use indicated variables to indirectly measure profitability. Chapter 3 discussed variables used by previous researchers to measure profitability. For example, Burns (1985) measured profitability using three indicated variables: return on total assets, return on net assets and return on equity. Hutchinson, Meric and Meric (1988) used two indicated variables: return on sales and return on equity to measure profitability, while Cohen (1989) suggested four variables: asset earning power, return on equity, net profit on sales and return on investment. Generally, depending upon their own purpose, researchers in the literature review used different indicated variables to measure profitability. However, three variables: return on sales (ROS), return on assets (ROA) and return on equity (ROE) were the most popularly used by the researchers and authors such as Ross, Westerfield, and Jaffe (1999), Meric et al. (1997), and Burns (1985) to measure profitability. In this study, profitability of SMEs was also indirectly measured by three indicated variables including return on sales (ROS), return on assets (ROA), and return on equity (ROE). Return on sales (ROS) is computed by dividing profits by total operating revenue and thus it expresses profits as a percentage of total operating revenue or sales. Return on assets (ROA) is the ratio of income to average total assets, both before tax and after tax. It measures managerial performance. Return on equity (ROE) is defined as net income divided by average stockholders equity. It shows the profit available to share for the stockholders. 145

165 Chapter Four: Research Methodology As such in this study, profitability of SMEs was measured by three ratios: ROS, ROA, and ROE. These measurements are frequently used in developed economies and Vietnam Independent variables Zikmund (1997, p.87) defined an independent variable as a variable that is expected to influence the dependent variable. In this study, the independent variables involved include variables used to define the efficiency of financial management practices and variables used to define financial characteristics of SMEs. 1. Independent variables related to financial management practices As indicated in chapter 3, in reviewing the context of financial management practices, McMahon (1998) defined concepts of financial management practices including accounting information system, financial reporting and analysis, working capital management, fixed-asset management, financial structure management, financial planning and control. However, McMahon (1998) study and most previous studies were designed with an emphasis on descriptive rather than explanatory research. Thus, only descriptive perspectives of these concepts were considered, while measuring perspectives have not been considered. This study emphasizes the relationships between the efficiency of financial management practices and SME profitability in which the efficiency of financial management is viewed as an independent variable. In such circumstances, measuring this variable is very important. However, the efficiency of financial management practices is a complex and multi-dimension construct. In term of context, financial management practices consists of the following components (McMahon, 1998). Accounting information systems DeThomas and Fredenberger (1985) measured the efficiency of an accounting information systems with three indicators: (1) extent to which financial information is prepared, (2) extent of owner/manager involvement in the interpretation and use of 146

166 Chapter Four: Research Methodology financial information, and (3) suitability of the information and services provided by outside accountants. Gul (1991) used a modified version of a 20-item scale developed by Chenhall and Moris (1986) to measure management accountant systems. This instrument requested participants to state their perception of the usefulness of each of characteristics of information. Perception of usefulness of information represented the extent to which these characteristics of information were available that would have a direct impact on performance. In this study, accounting information systems included all systems of recording transactions, bookkeeping, cost accounting, and use of computers in financial record keeping for management decision-making. However, this study was concerned with not only the context but also measurement of efficiency of accounting information systems. The efficiency of an accounting information system was measured by 8 items on the nine-point scales on which the respondents were asked to rate where the positions of their businesses were for each item as described below: attitude of owner/manager to accounting information systems frequency of accounting information preparation promptness of accounting information system in reflecting business transactions owner/manager involvement in preparing accounting information owner/manager involvement in the interpretation and use of accounting information reasonableness of accounting information systems usefulness of accounting information in decision-making extent of computerization of accounting information Figure 4.2 lists questions related to accounting information systems that owners or managers were asked to answer. Based on their ratings, interviewers circled the appropriate number on the scale corresponding to each of 8 items. 147

167 Chapter Four: Research Methodology Figure 4.2: Survey instrument for measuring accounting information system 1. How does your business regard its accounting information system? 2. How frequent does your business prepare its accounting reports? 3. How does accounting information system in your business update the business transactions? 4. What is the owner/manager involved in preparing accounting information? 5. What is the owner/manager involved in interpreting and using accounting information? 6. How acceptable is your business s accounting information system? 7. How useful is your business s accounting information in making decisions? Low regard High regard Not frequent at all Very frequent Not updated at all Very updated Low involvement High involvement Low involvement High involvement Very unacceptable Very acceptable Not useful at all Very useful Low Computerization High computerization 8. How computerized is your business s accounting information system? Source: Developed for this study The extent of efficiency of an accounting information system was measured by the sum of the values of eight of these indicated variables, which have a possible range of 8 to 72. The more points a business recorded, the higher the efficiency of its accounting information system, and the accounting information system of a business was said to be efficient if its sum of points of 8 items as mentioned above is greater than the average point of 40. Financial reporting and analysis McMahon (1998) stated financial reporting and analysis includes the nature, frequency and purpose of financial reporting, audit, analysis and interpretation of financial statements, and use of physical and financial performance benchmarks. For the purpose of this study, financial reporting and analysis included the preparation, interpretation, 148

168 Chapter Four: Research Methodology analysis and use of financial statements to serve for making decisions of business and management. McMahon and Davies (1994), firstly, ascertained the relationship between financial reporting and financial analysis, then, examined significant associations between these practices and achieved growth rates and financial performance. In their study, financial reporting and analysis practices were derived from the three following questions, which the respondents were asked to answer: Which financial statements do you use regularly to monitor financial position and performance? How frequently do you prepare your financial statements? Do you use financial ratios when reading your financial statements? Their study first employed a simple index of the historical financial reporting practices of the participating enterprises based on responses to the first of three questions mentioned above. The starting point was five dichotomous variables indicating preparation of particular financial statements (balance sheet, profit and loss statement, funds statement, cash-flow statement and other statements; Yes = 1, No = 0). The simple financial index was the sum of the values of these variables, which had a possible range of 0 to 5. Their study also employed a further historical financial reporting index, based on responses to the second question presented earlier, asking for the usual frequency of preparation (annually, semi-annually, quarterly, monthly, weekly, daily, and never) of historical financial reports. Taken as a whole, responses reflected the perceived financial information needs of participation of small enterprises from the experienced viewpoint of their owner-managers. The starting point was 35 dichotomous variables five financial reports by seven reporting frequencies indicating the preparation of particular historical reports and their frequency of preparation (for each report and frequency combination, Yes = 1, No = 0). Unlike McMahon and Davie (1994) study, this study emphasized efficiency of financial reporting and analysis practices rather than context. The efficiency of financial reporting and analysis practices was measured by the following indicators: 149

169 attitude of owner/manager to financial reporting and analysis frequency of financial statement preparation owner/manager involvement in preparing financial statements Chapter Four: Research Methodology owner/manager involvement in the interpretation and use of financial statements usefulness of financial statements in managing financial position of the business frequency of financial statement analysis number of financial ratios (current ratios, debt ratios, activity ratios and profitability ratios) used for financial statement analysis computerization of financial reporting and analysis practices. Respondents were asked to rate the position of their businesses on nine-point scales corresponding to each item as listed by Figure 4.3. Figure 4.3: Survey instrument for measuring financial reporting and analysis Low regard High regard 1. How does your business regard financial reporting and analysis? Not frequent at all Very frequent 2. How frequent does your business prepare financial statements (balance sheet, income statements, statements of cash flows)? Low involvement High involvement 3. How involved is the owner/manager in preparing financial statements? Low involvement High involvement 4. How involved the owner/manager in interpreting and using financial statements? Not useful at all Very useful 5. How useful are the financial statements of your business in providing information for making decisions? Not frequent at all Very frequent 6. How frequent does your business analyze financial statements (balance sheet, income statements, statements of cash flows)? Not useful at all Very useful 7. How useful are financial ratios applied in financial analysis of your business? Low High computerization computerization 8. How computerized are the financial reporting and analysis practices in your business? Source: Developed for this study 150

170 Chapter Four: Research Methodology The extent of efficiency of financial reporting and analysis was measured by the sum of values of eight of indicators as presented in Figure 4.3. This sum had a possible range from 8 to 72 points, and the more points a business recorded, the higher its efficiency of financial reporting and analysis. The financial reporting and analysis practices of a business were said to be efficient if the sum of points is greater than the average point of 40. Conversely, if the sum of points is less than the average point of 40, the business was said to be inefficient in practising financial report and analysis. Working capital management Firstly, components of working capital management are clarified. Most researchers, for example, Burns and Walker (1991), Belt and Smith (1992), Khoury, Smith, and MacKay (1999) agreed that working capital management includes three components: cash management, receivable management, and inventory management. a) Cash management practices In their survey, Cooley and Pullen (1979) reported on the cash management practices of 122 small businesses in petroleum marketing. Cash management, in their survey, consisted of three basic components: cash forecasting, investing temporary cash surplus, and controlling cash inflows and outflows. Anvari and Gopal (1983) conducted a study to gain insights into how small Canadian firms manage their cash resources. They used five indicators: cash forecasts, cash balance, basis for determining cash balance, and cash surplus investment to measure cash management practices. Burns and Walker (1991) used the following indicators to measure practices of cash management: (1) the interval of time for cash budgeting (daily, weekly, monthly, quarterly, semi-annually, annually or never), (2) techniques used to determine the target balance, and (3) the forms of idle cash investment for profitable purpose. In this study, the efficiency of cash management practices was considered in terms of cash forecasting or budgeting, target cash balance determining, and cash surplus investing. The extent of efficiency of cash management practices was measured by the following indicators: 151

171 attitude of owner/manger to cash management Chapter Four: Research Methodology frequency (weekly, monthly, quarterly, annually or never) of preparing cash budget owner/manager involvement in preparing cash budget owner/manager involvement in interpreting and using cash budget usefulness of cash budget in providing information for making decisions application of cash management theories to determine cash balance reasonability of target cash balance determination computerization of cash budget preparation Respondents were asked to rate the position of their businesses on the nine-point scale corresponding to each item as presented by Figure 4.4. Figure 4.4: Survey instrument for measuring cash management practices Low regard High regard 1. How does your business regard its cash management practices? Not frequent at all Very frequent 2. How frequent does your business prepare its cash budgets? Low involvement High involvement 3. How involved is the owner/manager in preparing cash budgets? Low involvement High involvement 4. How involved is the owner/manager in interpreting and using cash budgets? Not useful at all Very useful 5. How useful are cash budgets of your business in providing information for making decisions? Very poorly Very well 6. How does your business apply theories of cash management in determining the target cash balance? Very unacceptable Very acceptable 7. How acceptable is the target cash balance determined in your business? Low High computerization computerization 8. How computerized are cash management practices in your business? Source: Developed for this study 152

172 Chapter Four: Research Methodology The extent of efficiency of cash management practices was measured by the sum of values of eight indicators, which had a possible range from 8 to 72 and are measured by the survey instrument as designed in Figure 4.4. The more points a business recorded the higher its efficiency of cash management practices, and the cash management practices of a business were said to be efficient, if the sum of points is greater than the average point of 40. Conversely, if the sum of points is less than the average point of 40, the business was said to be inefficient in practising cash management practices. b) Receivable management practices Peel and Wilson (1996) examined the working capital management and capital budgeting practices of a sample of small firms based in the North of England. In their survey, respondents were requested to indicate (on a scale 1= never use/review, to 5 = use/review very often ) the frequency with which they reviewed their debtors credit period, debtors discount policy, bad debts and doubtful debts. In this research, the efficiency of receivable management was defined and measured by the frequency of review and extent of reasonability of debtors credit period, debtors discount policy, bad debts and doubtful debts. Respondents were requested to indicate on nine-point scales (1 = never review/very unacceptable, to 9 = very often/ very acceptable) the frequency of review and extent of acceptability of debtors credit period, debtors discount policy, bad debts and doubtful debts based on the following items: attitude of owner/manger to receivable management frequency of reviewing debtors credit period reasonability of debtors credit period frequency of reviewing debtors discount policy reasonability of debtors discount policy frequency of reviewing bad debts reasonability of bad debts utilizing receivable management theories 153

173 computerization of receivable management Chapter Four: Research Methodology Respondents were asked to rate the position of their businesses on the nine-point scale corresponding to each item listed by Figure 4.5 and the interviewer circled the appropriate number depending on their answers. Figure 4.5: Survey instrument for measuring receivable management practices Low regard High regard 1. How does your business regard receivables management practices? Not regularly at all Very regularly 2. How regularly does your business review debtors credit period? Not reasonable at all Very reasonable 3. How reasonable is debtors credit period in your business? Not regular at all Very regular 4. How regular does your business review debtors discount policy? Not reasonable at all Very reasonable 5. How reasonable is debtors discount policy in your business Not regular at all Very regular 6. How regular does your business review percentage of bad debts? Not reasonable at all Very reasonable 7. How reasonable is the percentage of bad debts in your business Not frequent at all Very frequent 8. How frequent does your business implement theories of receivables management? Low High computerization computerization 9. How computerized are receivable management practices in your business? Source: Developed for this study The extent of efficiency of receivable management practices was measured by the sum of values of nine of indicators as described in Figure 4.5. This sum had a possible range from 9 to 81 and the more points a business recorded, the higher its efficiency of receivable management practices. Receivable management practices of a business were said to be efficient if the sum of points was greater than the average points of 45 (9 x 5 point average) and conversely. 154

174 Chapter Four: Research Methodology c) Inventory management practices In examining inventory management practices, Peel and Wilson (1996) focused on reviewing stock turnover, stock levels, stock re-order levels and using the economic order quantity model. They used five-point scales to measure the degree of frequency of reviewing/using these indicators. This research used nine-point scales, which is similar to the scales developed by Peel and Wilson (1996), to measure the efficiency of inventory management practices via the following indicators: attitude of owner/manager to inventory management frequency of reviewing inventory turnover frequency of reviewing inventory level reasonableness of inventory turnover reasonableness of inventory level usefulness of inventory budget in providing information for making decisions utilizing inventory management theories computerization of inventory management Respondents were asked to answer the questions listed in Figure 4.6 (page 156) and based on their ratings the interviewer circled the appropriate number on the scale corresponding to each item. The extent of efficiency of inventory management was measured by the sum of values of eight indicators designed as in Figure 4.6. This sum had a possible range from 8 to 72 and the more points a business recorded, the higher its efficiency of inventory management practices. In this way, inventory management practices of a business were said to be efficient if its sum of points is greater than the average point of 40. Conversely, if its sum of points was lower than the average point, the business was said to be not efficient or inefficient in practising inventory management. 155

175 Chapter Four: Research Methodology Figure 4.6: Survey instrument for measuring inventory management practices 1. How does your business regard inventory management practices? 2. How regularly does your business review inventory turnover? 3. How regularly does your business review inventory level? Low regard High regard Not regularly at all Very regularly Not regularly at all Very regularly Very slow Very fast 4. How fast is inventory turnover of your business? Very unacceptable Very acceptable 5. How acceptable is inventory level of your business? Not useful at all Very useful 6. How are inventory budgets of your business useful in providing information for making decisions? How does your business apply theories of inventory management in determining the inventory level? Very poorly Very well Low High computerization computerization 8. How computerized are inventory management practices in your business? Source: Developed for this study Fixed-asset management practices McMahon (1998) defined fixed-asset management including non-financial and financial considerations in fixed-asset acquisition, quantitative techniques for capital project evaluation, investment hurdle rate determination, and handling risk and uncertainty in this context. This research examined the efficiency of fixed-asset management in terms of financial management. In this study, the efficiency of fixed-asset management was defined as the efficiency of capital budgeting practices and fixed-asset utility after acquisition. This was considered before and after making investment decisions. Before making investment decisions, the efficiency of fixed-asset management was evaluated via the efficiency of capital-budgeting practices. After making investment decisions, the efficiency of fixed-asset management was evaluated via the efficiency of fixed-asset utility. Particularly, the efficiency of fixed-asset management was measured by the following indicators on nine-point scales: 156

176 Chapter Four: Research Methodology attitude of owner/manager to fixed-asset management practices attitude of owner/manager to assessing capital project before making investment decisions frequency of using capital budgeting techniques before making investment decision reasonability of capital budgeting used sophisticated extent (payback period, discounted payback period, net present value, internal rate of return or modified internal rate of return) of capital budgeting techniques used reasonability of utilizing fixed assets usefulness of fixed assets acquired computerization of fixed asset management practices. Respondents were asked to rate the position of their businesses on the scale corresponding to each item listed by Figure 4.7. Figure 4.7: Survey instrument for measuring fixed asset management Low regard High regard 1. How does your business regard fixed asset management practices? Low regard High regard 2. How does your business regard assessing capital project before making investment decisions? Not regularly at all Very regularly 3. How regularly does your business review capital projects? Very unacceptable Very acceptable 4. How acceptable is capital budgeting utilized in your business? Not advanced at all Very advanced 5. How advanced does your business apply techniques of capital budgeting in determining capital investment projects? Very unreasonable Very reasonable 6. How reasonable are fixed assets of your business utilized? Not useful at all Very useful 7. How useful are fixed assets acquired in your business? Low High computerization computerization 8. How computerized are fixed asset management practices in your business? Source: Developed for the study 157

177 Chapter Four: Research Methodology The extent of efficiency of fixed asset management was measured by the sum of values of eight indicators designed as in Figure 4.7 (page 157). This sum had a possible range from 8 to 72 and the more points a business recorded, the higher its efficiency of fixed asset management practices. Fixed asset management practices of a business were said to be efficient if its sum of points was greater than the average point of 40. Conversely, if its sum of points is not greater than the average point, the business was said to be not efficient or inefficient in fixed asset management practices. Financial planning practices McMahon (1998) examined financial planning and control including financial objectives and targets, cost-volume-profit analysis, pricing, financial budgeting and control, and managerial responsibility centers. These were the main contexts of financial planning. The current study was concerned with not only the context but also efficiency of financial planning practices. The efficiency of financial planning was defined as its quality and benefit and measured by the following indicators on nine-point scales: attitude of owner/manager to financial planning frequency of preparing master budgets involvement of owner/manager in preparing master budgets involvement of owner/manager in interpreting and using master budgets usefulness of master budgets in providing information for making decisions frequency of comparing budgeted and actual results reasonability of financial planning techniques applied in financial analysis computerization of financial planning. Respondents were asked to rate the position of their businesses on the scale corresponding to each item as designed in Figure 4.8 (page 159). The extent of efficiency of financial planning practices was measured by the sum of values of eight indicators designed as in Figure 4.8. This sum had a possible range from 8 to 72, and the more points a business obtained, the higher its efficiency of financial planning practices. 158

178 Chapter Four: Research Methodology Financial planning practices of a business were said to be efficient if its sum of points was greater than the average point of 40 and conversely. Figure 4.8: Survey instrument for measuring financial planning Low regard High regard 1. How does your business regard financial planning? Not regularly at all Very regularly 2. How regularly does your business prepare its financial budgets? Low involvement High involvement 3. How involved is the owner/manager in preparing financial budgets? Low involvement High involvement 4. How involved is the owner/manager in interpreting and using financial budgets? Not useful at all Very useful 5. How useful are the financial budgets of your business useful in providing information for making decisions? Not regularly at all Very regularly 6. How regularly does your business compare between actual and budgeted results? Very unreasonable Very reasonable 7. How reasonable are financial planning techniques applied in financial analysis of your business? Low High computerization computerization 8. How computerized are the financial reporting and analysis practices in your business? Source: Developed for the study Based on the measurements of each component of financial management practices as indicated earlier, the efficiency of financial management practices of SMEs was measured by 57 items consisting of 8 items of accounting information system, 8 items of financial reporting and analysis, 8 items of cash management practices, 9 items of receivable management practices, 8 items of inventory management practices, 8 items of fixed asset management practices, and 8 items of financial planning practices. These components were strongly correlated. To avoid multicollinearity phenomena, factor analysis was applied to extract the strongly correlated items and group them into the main components, which were finally used as independent variables that defined the efficiency of financial management practices in the regression model. 159

179 2. Independent variable related to financial characteristics Chapter Four: Research Methodology Current ratio (CUR) Liquidity refers to the overall level of cash and near cash assets (such as debtors and stock) held and to cash inflows and outflows that add to and subtract from the sum of these assets (McMahon and Stanger, 1995, p.24). When used for determining the financial characteristics, liquidity is often measured in the form of ratios. Two kinds of ratios: current ratio and quick ratio were used by several previous researchers such as Stevens (1973), Burns (1985), Jaggi and Considine (1990), Hutchinson and Mengersen (1993), Meric et al (1997). In the current study, liquidity was viewed as an independent variable and measured by current ratio, which was derived from financial statements by dividing current assets by current liabilities. Debt ratio (DER) Walker and Petty (1978, p.145) defined financial leverage to be the process of using senior (debt or equity capital with a fixed return) capital to increase the rate of return on junior securities. Brigham (1995, p. 429) indicated that financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm s capital structure. Similarly, Ross, Westerfield and Jaffe (1999, p.33) said that financial leverage is related to the extent to which a firm relies on debt financing rather than equity. When financial leverage is used to identify the financial characteristics of the firm, it is often measured by the following ratios: Equity ratio = equity/total asset, used by Hutchinson, Meric and Meric (1988), Meric et al (1997) Long-term debt ratio = long-term debt/total capital, used by Burns (1985), Meric et al (1997) Long-term debt to equity ratio = long-term debt/common stock equity, used by Jaggi and Considine (1990) 160

180 Debt ratio = total debt /total assets, and Chapter Four: Research Methodology Debt-to-equity ratio = total debt /total equity, used by Brigham (1995) and Ross, Westerfield, and Jaffe (1999). This study examined the impact of financial leverage ratio on profitability in which financial leverage ratio was considered an independent variable and measured by the debt ratio, which was derived from financial statements by dividing total debt by total equity. Total asset turnover (TAT) Activity ratio is considered the variable to determine the financial characteristics of the firm. Hutchinson, Meric and Meric (1988) measured activity by the following ratios: Inventory ratio = Inventory/sales Receivables ratio = Accounts receivable/sales Fixed assets ratio = Fixed assets/sales Total asset turnover = Sales /total assets Meric et al (1997) only used two ratios of activity: total asset turnover (sales/total assets) and inventory turnover. Noticeably, Ross, Westerfield, and Jaffe (1999) and Meric et al. (1997) use inventory turnover in lieu of inventory ratio. Inventory ratio is calculated by dividing the cost of goods sold by average inventory whereas inventory ratio is calculated by dividing inventory by sales. This study examined the impact of activity ratio on profitability in which activity ratio was measured by total asset turnover, which was derived form financial statement by dividing sales by total assets. In summary, in this research study, profitability measured by ROS, ROA and ROE was defined as the dependent variable whereas the efficiency of financial management practices, current ratio, debt ratio and total asset turnover were defined as the independent variables. These variables were used to test the model of the impact of financial management practices and financial characteristics on SME profitability. This model was developed in section

181 Chapter Four: Research Methodology Model development This subsection discusses the basic concepts of models and develops a model for this research. Objectives are to review types of models and to build a model for this study based on the literature reviewed in chapter 3 and variables defined in subsection Model classification According to Pattillo (1980), in general, a model is a representation of real-world phenomena as they exist (descriptive models) or as they ought to exist (normative models). A model is defined as any highly formalized representation of a theoretical system, usually designated through the use of symbols (Davis, 1996, p.300). Davis (1996, p. 301) emphasized the importance of models to decision-makers as follows: Models are extremely important to decisions-makers because they form the basis for the development of decision support system. There are a variety of ways to classify models. According to Davis (1996) all useful classification schemes have three elements in common: (1) level of aggregation, (2) time dimension, and (3) degree of uncertainty in the process being modeled. Based on these elements, Davis (1996) provided a model classification as summarized in Table 4.3 (page 163). Based on the basic forms of decision models, Davis (1996) classified models into two types: verbal and mathematical models. Each can be used to transform a complex real-world process into a more manageable representation of that process. The verbal model has broad appeal in that it is more easily understood by decision makers but it is quite difficult to implement, since many implied variables and relationships that affect the objective are omitted (Davis, 1996, p. 302). 162

182 Chapter Four: Research Methodology Table 4.3: Model classification Element Type Characteristics Examples Level of Dis-aggregate Models individual Consumer choice models, aggregation (micro) processes with outcomes forecasting model for demand of one firm Aggregate Models a system, or firms Economic models of an industry (macro) interacting in environment with outcomes, or outcomes is Time dimension Degree of uncertainty group-related Dynamic Changes in the process Multiple-period inventory due to time models, time series forecasting Changes in variable models specification Static Outcome static in nature One-period inventory model, due to static one-period mathematical measurements of programming models specified variables Deterministic All parameters are known Linear programming productwith certainty mix model, inventory model with known demand Probabilistic Parameters vary Risk analysis for capital according to an assumed budgeting, inventory model with known probability random demand levels described distribution by a probability distribution Source: Adapted from Davis (1996, p. 306) follows: The generalized mathematical model form can symbolically be represented as OI = f(a i, B j ) (Eq. 4.1) where: OI = outcome information or objective from the model to be used by the decision maker or the dependent variable A i = controllable independent decision variables in the process being modeled BBj = uncontrollable independent variables influencing the process being modeled, or the environment variables f = functional relationship between the outcome information variable (the dependent variable) and the independent variables A i and BBj (Davis, 1996, p. 303). 163

183 Chapter Four: Research Methodology Model development for this study Based on the generalized mathematical model form as indicated by Davis (1996) and the variables defined in subsection 4.4.1, the model of the impact of financial management practices and financial characteristics on SME profitability was developed as follows: PRO = f(cur, DER, TAT, EFF) (Eq. 4.2) where: PRO = Profitability = Average (ROS, ROA, and ROE) ROS = Return on sales = Net profit/sales ROA = Return on assets = Net profit/total assets ROE = Return on equity = Net profit/equity CUR = Current ratio (= Current assets/current liabilities) DER = Debt ratio (= Total debt/total assets) TAT = Total asset turnover (= Sales/Total assets) EFF = The efficiency of financial management practices In this model, by making some standard assumptions, equation 4.2 can be restructured into linear multiple regression equation (Eq.4.3) as follows: PRO = b 0 + b 1 CUR + b 2 DER + b 3 TAT + b 4 EFF + ε (Eq. 4.3) where: b i (i = 0, 1, 2...) are the coefficients, ε is the error variable, CUR, DER and TAT are the independent variables measured by ratio scale, and EFF is a multi-dimension construct measured by 57 items related to financial management practices on the 9-point scales. Factor analysis was used as a tool to extract and group items that are strongly correlated into the main components defined the efficiency of financial management practices. The required assumptions of this multiple regression model are that (1) the error variable (ε) is normally distributed, (2) the mean value of the error variable is zero, (3) 164

184 Chapter Four: Research Methodology the variance of the error variable is a fixed but unknown value, (4) the values of the error variable are independent of one another, and (5) relationship between profitability and variables of financial management practices is linear. Chapter 5 will discuss how the research recognized whether or not these assumptions were satisfied and how to overcome the problem if these assumptions were not satisfied. The mathematical model mentioned earlier may be described by the visual model as in Figure 4.9 below. Figure 4.9: Analytical model for the research study The efficiency of financial management practices (EFF): Accounting information system Financial reporting and analysis Cash management practices Receivable management practices Inventory management practices Fixed asset management practices Financial planning practices Current ratio (CUR) SME profitability: (PRO) Return on sales Return on assets Return on equity Total asset turnover (TAT) Debt ratio (D E R) Source: Developed for the study Hypothesis statements A hypothesis is a proposition that is empirically testable. It is an empirical statement concerned with the relationship among variables (Zikmund, 1997, p. 25). Hypotheses to test the relationships SME profitability and current ratio, debt ratio, total asset turnover, 165

185 Chapter Four: Research Methodology and the efficiency of financial management practices as described in the model illustrated by Figure 4.9 were respectively stated in this subsection. Van Horne (1986, p. 145) indicated the relationship between liquidity and profitability: The greater the relative proportion of liquid assets, the less risk of running out of cash profitability unfortunately, also will be less resolution of the trade-off between risk and profitability with respect to these decisions depends upon the risk preferences of management. Based on the exploratory research conducted by Kack and Lindgren (1999) and findings of Vuong Quan Hoang (1998), it was found that SMEs in Vietnam seem likely to maintain excessively high current ratios and the financial management practices might adversely affect SME profitability. As reviewed in the literature, liquidity is measured by current and quick ratio and the two ratios are high correlated each other. Thus, this study only used current ratio as a measure to define liquidity and the hypothesis to test the relationship between profitability and current ratio is stated as follows: Hypothesis 1: Profitability of SMEs is negatively related to the current ratio. Regarding the relationship between financial leverage and profitability, Edwards and Cooley (1979) indicated that the effects of financial leverage on return available to equity holders are typically analyzed in either one of two contexts. In many financial management books, financial leverage was examined in a net-operating-income (NOI) or equivalent context for its effects on rates of return available to stockholders. In the literature of real estate finance, the effects of leverage on equity return were evaluated in cash flow (CF) context. In both settings, the evaluation of leverage effect reduced to a convenient rule exemplified by the following statement (Edward and Cooley, 1979, p.12): In general, whenever the return on assets exceeds the cost of debt, leverage is favorable, and the higher leverage factor, the higher the rate of return on common equity. 166

186 Chapter Four: Research Methodology Additionally, in many financial management books, debt is viewed as deductible factors, which helps the firm to save its income tax, and thus, to increase net profit (Brigham, 1995, Ross, Westerfield and Jaffe, 1999). These conclusions are the basis for the hypothesis to test the relationship between profitability and financial leverage, which was measured by the debt ratio in this study. Thus, the second hypothesis in this study is as follows: Hypothesis 2: Profitability of SMEs is positively related to the debt ratio. Profitability of SMEs was assumed to relate to activity ratios. Hutchinson, Meric and Meric (1988) measured activity by inventory ratios, receivable ratios, fixed asset ratios, and total asset turnover whereas Meric et al (1997) only used two ratios: total asset turnover and inventory turnover. For simplicity purpose, this research study used total asset turnover as a ratio to measure activity characteristics. Total asset turnover is the ratio between sales and total assets. It measures the efficiency of total asset utility by representing how many sales are produced by one unit of total asset value. The higher total asset turnover, the higher sales are produced by one unit of total asset value. On the other hand, high sales produce high profits for the business. As a result, profitability was assumed to positively relate to total asset turnover and the hypothesis to test the relationship between profitability and total asset turnover is stated as follows: Hypothesis 3: Profitability of SMEs is positively related to total asset turnover. From the literature, the final goal of financial management is to maximize the financial wealth of the business owner and this general goal can be viewed in terms of two specific objectives: profitability and liquidity (McMahon, 1995). DuPont analysis reviewed in chapter 3 provided a quick insight of factors affecting SME profitability including gross margin, operating expenses, interest, taxes, accounts receivable days, inventory days, fixed-asset turnover, leverage and coverage. These factors negatively or positively affect SME profitability depending on the efficiency of financial management 167

187 Chapter Four: Research Methodology practices. Therefore, the hypothesis to test the relationship between profitability and the efficiency of financial management practices is as follows: Hypothesis 4: Profitability of SMEs is positively related to the efficiency of financial management practices. As indicated in subsection the efficiency of a specific area of financial management practices such as accounting information systems, financial reporting and analysis, cash management, receivable management, inventory management, fixed asset management, and financial planning was measured by the sum of points of 8 or 9 items. A specific area of financial management practices was said to be efficient if its sum of points is greater than the average points and conversely. In generalization, a business was said to be efficient in financial management practices if all specific areas of financial management practices are efficient. Based on this criterion, SMEs in the sample were divided into two groups. The first group consists of SMEs that are efficient and the second group consists of SMEs that are inefficient in financial management practices. This study was also designed to test the hypothesis of differences in average profits of two groups of SMEs. Hypothesis 5: The average profit of efficient financial management SMEs differs from that of inefficient financial management SMEs. In summary, there are five hypotheses that were tested in this study. The first four hypotheses were to test the relationship between financial characteristics, financial management practices and SME profitability. The last hypothesis was to test the difference in average profits of two groups of SMEs. 4.5 DATA COLLECTION METHODS This section discusses how relevant data was collected for testing the model developed in section 4.4. According to Hussey and Hussey (1997), data refers to known facts or things 168

188 Chapter Four: Research Methodology used as a basic for inference or reckoning. Data can be described as qualitative or quantitative. Qualitative data is concerned with qualities and non-numerical characteristics, whilst quantitative data is all data that is collected in numerical form. Hussey and Hussey (1997, p. 150) indicated that there will always be a combination of quantitative and qualitative data in a research study no matter what paradigm is being followed. Whether you are following a broadly positivist or phenomenological paradigm, there will always be a combination of quantitative and qualitative inputs into your data generating activities. In terms of data sources, there are two main sources of data: primary data and secondary data. As mentioned in section 4.3, this study used both types of data: secondary and primary data. Secondary data collection is examined in subsection and primary data collection will be examined in subsection Secondary data collection Zikmund (1997, p.143) defined secondary data as data gathered and recorded by someone else prior to the current needs of the researchers. Secondary data are usually historical, already assembled, and do not require access to respondents or subjects. In this study, major secondary data were mainly used to derive the financial ratios measuring liquidity, financial leverage, activity and profitability of SMEs. This method has been popularly used by previous researchers in examining the financial characteristics of SMEs. For example, Osteryoung, Constand, and Nast (1992) used two sources of secondary data for their study of financial ratios in large public and small private firms. The small firm data sample was drawn from the Financial Studies of the Small Business (FSSB) published by Financial Research Associates and the raw data for the large firm sample was collected from the COMPUSTAT PC PLUS database. Meric et al. (1997) used secondary data drawn from the DISCLOSURE Worldscope/Global data file in a comparative study of the financial characteristics of U.S.A and Japanese chemical firms. Van Auken, Doran, and Yoon (1993) used financial 169

189 Chapter Four: Research Methodology position statement data for the year 1988 obtained from An Annual Report of Korean Companies, published by the Korean Productivity Center in 1990 in their study of financial comparison between Korean and USA firms. To date, a database of financial performances of SMEs has not been available in Vietnam. However, the possibility of financial statement collection from which financial ratios can be derived was feasible. In Ho Chi Minh City, these financial statements can be obtained from the following organizations: Ho Chi Minh City Department of Taxation Vietnam Bank for Non-state Enterprises (VP Bank) Faculty of Accounting, Finance and Banking Ho Chi Minh City University of Economics Primary data collection Section explained how secondary data could be collected to reflect financial characteristic variables. However, in Vietnam, such sources of data have not been available for collecting data that reflects the variables of financial management practices. In this case primary data is viewed as an appropriate source. Zikmund (1997, p. 46) defined primary data as data gathered and assembled specifically for the project at hand. Section 4.3, explained why this study used survey as a method of data collection to answer the research questions outlined in chapter 1. This section further explains how primary data was collected in the survey Target population Target population is the complete group of specific population elements relevant to the research (Zikmund, 1997). Due to limitations of time and funds, the target population in this research could not cover all SMEs in Vietnam. Moreover, this research was not designed to study all SMEs in Vietnam but was only designed to study the impact of financial management on SME profitability with evidence from Vietnam. It is not 170

190 Chapter Four: Research Methodology therefore necessary to define the target population as the whole of SMEs in Vietnam. Vietnam has four large cities (Ho Chi Minh City, Hanoi, Hai Phong and Da Nang) and 57 provinces. Ho Chi Minh City is the biggest city in term of numbers of SMEs, labor force, industrial outputs, trading and service volumes (Statistical Yearbook, 1998). Typically, SMEs in Ho Chi Minh City may be viewed as representative of SMEs in the country. Therefore, in this research, SMEs in Ho Chi Minh City were defined as the target population from where the sample was drawn for research. Figure 4.10: Structure of SMEs in Vietnam and the target population SMEs in Vietnam SMEs located in Ho Chi Minh City + SMEs not located in Ho Chi Minh City Private enterprises Limited companies Joint stock companies State enterprises The target population Source: Developed for this research As examined chapter 2, in Vietnam SMEs include many forms of business such as state enterprises, private enterprises, limited liability companies (or limited companies), joint stock companies, cooperatives and business households or family business. However, this study examined the impact of financial management practices on profitability of private SMEs. Therefore, only forms of private businesses that have set up a relatively complete system of financial management practices including practices of accounting information system, financial reporting and analysis, working capital management, fixed-asset management, capital structure management, and financial 171

191 Chapter Four: Research Methodology planning were included in this study. As indicated in chapter 2, only private enterprises, limited companies, and joint stock companies satisfy this criterion were, therefore, viewed as the target population (Figure 4.10, page 171) whereas other businesses including cooperatives and family business were beyond the limits of this study Sampling frame Selecting a sampling frame was the next step after determining the target population. A sampling frame is the list of elements from which the sample may be drawn (Zikmund, 1997, p.420). In this research, the List of Businesses provided by Ho Chi Minh City Department of Investment and Planning in 2000 was chosen as the sampling frame from which the sample of SMEs was drawn for interviewing. Generally, it was not feasible to compile a list that did not exclude some members of the population (Zikmund, 1997, p. 420). Thus, sampling frame error was unavoidable. For example, the List of Businesses in 2000 may exclude SMEs, which registered late, did not register or exist due to other reasons Sampling methods There are several alternative methods of selecting a sample. In general, these methods may be grouped into two: probability and non-probability techniques. A probability sample is one in which each element (person or company) in the population has an equal, or at least a known, chance of being selected while in a non-probability sample some elements have a greater, but unknown, chance than others of selection (De Vaus, 1985, p.60). All probability samples are based on chance selection procedures. This eliminates the bias inherent in the non-probability sampling procedures because the probability sampling process is random (Zikmund, 1997). This research used probability-sampling method. Based on the probability sampling method, there are four main sampling techniques: simple random sampling, systematic sampling, stratified sampling, and cluster sampling (Zikmund, 1997). Simple random sampling A sampling procedure that assures each element in the population an equal chance of being included in the sample. For simple random 172

192 Chapter Four: Research Methodology sampling, the sampling process is straight forward (Zikmund, 1997, p.431) but is most appropriate when a good sampling frame exists and when the population is geographically concentrated or the data collection technique does not involve travelling (De Vaus, 1985, p. 64). Because of these limitations, simple random sampling is not appropriate in this study. Systematic sampling A sampling procedure in which an initial starting point is selected by a random process, and then every nth number on the list is selected (Zikmund, 1997, p.432). Systematic sampling is similar to simple random sampling and has the same limitations (De Vaus, 1985, p.65). Stratified sampling A probability sampling procedure in which sub-samples are drawn from samples within different strata that are more or less equal on some characteristics. The reasons for taking a stratified sample are (1) to have a more efficient sample than could be taken on the basis of simple random sampling, and (2) to assure that the sample will accurately reflect the population on the basis of the criterion or criteria used for stratification (Zikmund, 1997, p. 433). Stratified sampling is a modification of simple random and systematic sampling designed to produce more representative and thus more accurate samples (De Vaus, 1985, p. 65). Cluster sampling An economically efficient sampling technique in which the primary sampling unit is not the individual element in the population but a large cluster of elements (Zikmund, 1997, p. 435). The problem of cluster sampling is that travel costs are likely to be enormous because the amount of time spent travelling will be substantially greater than the time spent in the interviewing process (Zikmund, 1997). In selection for sampling techniques, this study was concerned with two important principles. The first was that the sample had to reflect the population. The second was that the sampling technique did not cause an increase in travelling costs. Based on these principles and characteristics of sampling techniques as discussed above, stratified sampling was seen as most appropriate in this study. Moreover, as examined in chapter 1 and subsection (page 170) this study was only concerned with private enterprises, 173

193 Chapter Four: Research Methodology limited liability companies and joint stock companies. Stratified sampling can help to assure the proportions of these groups of SMEs in a sample being the same in the population Sampling units The sampling unit is a simple element or group of elements subject to selection in the sample (Zikmund, 1997, p. 23). This research used the stratified sampling technique with the fraction of 90 to select the sample. The plan procedure for selecting sampling units is presented in Table 4.4. Table 4.4: Number and percentage of SME sample and population Business type Population Sample Number Percentage Fraction Number Percentage Manufacturing 5, % 1/ % Stock companies % 1/ % Limited companies 4, % 1/ % Private enterprises % 1/ % Trading 9, % 1/ % Stock companies % 1/ % Limited companies 5, % 1/ % Private enterprises 3, % 1/ % Total 14, % % Source: Ho Chi Minh City Department of Investment and Planning (2000) 4.6 DATA TRANSFORMATION This section examines aspects of data transformation including purpose and methods of data transformation. Zikmund (1997, p.540) defined data transformation as the process of changing data s original form to a format that is more suitable to perform a data analysis that will achieve research objectives. Zikmund s (1997) definition indicated the purpose of data transformation was to create a more suitable format for data analysis. Section introduced variable definitions and measurements in which the ninepoint numerical scales were applied. These scales were constructed to collect raw data from the respondents, however, these data need to be transformed into a suitable format before analysis. For example, because scales, as constructed above, only provide the 174

194 Chapter Four: Research Methodology values of indicated variables, these values were transformed into the values of the latent variables through a summative score (Zikmund, 1997, p.541). Summative score = Sum (indicated variable 1, 2, 3, n) As indicated in section (page 162) the resumed model was based on assumptions of normal distributions and linear relations of variables. Chapter 5 will test whether these assumptions are satisfied. Otherwise, data transformation will be applied to create more suitable data for analysis. In addition, this study used the ratios: return on sales, return on assets, return on equity as dependent variables, and liquidity ratio, financial leverage, ratio and activity ratio as the independent variables. These ratios are derived from financial statements collected from SMEs directly or indirectly. The process of deriving these ratios required a transformation of raw data into more suitable data for analysis. Computer package (Excel) will help this data transformation easily and quickly. 4.7 DATA ANALYSIS This section briefly discusses data analysis methods whereas details of techniques used and results of data analysis will be reported in chapter 5. Objectives of this section are (1) to outline the data analysis techniques that will be particularly applied in chapter 5 and (2) to appropriately match selected data analysis methods to types of data collected General consideration The purpose of analytic methods is to convert data into information needed to make decisions (Davis, 1996, p. 356). According to Zikmund (1997), the choice of the methods of statistical analysis depends on (1) the type of question to be answered, (2) the number of variables, and (3) the scale of measurement. 175

195 Chapter Four: Research Methodology Type of question the researcher is attempting to answer is a consideration in choice of statistical technique. Based on this factor, the researcher may be concerned about the central tendency of a variable or the distribution of that variable. Numbers of variables are also considered to determine whether the statistical techniques applied should be univariate data analysis, bivariate data analysis or multivariate data analysis. Scale of measurement on which the data are based or the type of measurement reflected in the data determines the permissible statistical technique and whether the appropriate empirical operation may be performed. This study was concerned with two main research questions. The first is how to describe the financial management practices and financial characteristics of SMEs in Vietnam. The second is to determine whether efficient financial management practices positively affect on SME profitability and how to explain the relationships between efficient financial management practices and SME profitability. Descriptive statistics and hypothesis testing were two main methods of data analysis that are suitable to these research questions. In terms of number of variables and scale of measurements, this study was concerned with simultaneous investigation of the impact of several independent variables, measured by nine-point numerical scales and ratios, on the dependent variable, measured by the ratios. Multivariate data analysis is the appropriate match for this study (Zikmund, 1997). Specifically, multiple linear regression was developed and tested to explain the relationships between the financial management practices and SME profitability Descriptive statistics As indicated in section 4.3 (page 137), this study was designed as a combination of descriptive and explanatory research. Descriptive statistics were applied to investigate and describe characteristics of financial management practices of SMEs in the sample. 176

196 Chapter Four: Research Methodology Descriptive analysis refers to the transformation of the raw data into a form that will make them easy to understand and interpret. Describing responses or observations is typically the first form of analysis (Zikmund, 1997, p.533). In this study, the following statistical techniques were used (in chapter 5) as the tools of descriptive analysis: calculation of averages, frequency distribution, and percentage distribution used as a form of summarizing data tabulation used as the orderly arrangement of data in a table or summary format cross-tabulation used to allow the inspection of differences and to make comparisons between two groups of SMEs, with and without efficient financial management Bivariate data analysis Zikmund (1997, p.567) defined bivariate data analysis as data analysis and hypothesis testing when the investigation concerns simultaneous investigation of two variables using tests of differences or measures of association between two variables at a time. This section examines how bivariate data analysis can be used in this study Measures of association Measures of association are statistical values designed to represent co-variation between variables (Zikmund, 1997). As indicated in section 4.5 (page 162), the measurement levels used in this study included interval and ratio measures. This allows the use of Pearson s correlation coefficient for measuring association among variables. The results of correlation coefficients were presented by under standard form of reporting correlation results the correlation matrix. The correlation matrix would be used to present the measures of association among the variables as outlined in section 4.5 (page 168). 177

197 Chapter Four: Research Methodology This correlation matrix was also used as a tool to recognize whether multicollinearity occurs in the multiple regression equation (Eq. 4.3). Murphy (1989, p. 504) indicated how the correlation matrix can be used to recognize multicollinearity. The correlation matrix should be examined on the computer printout to determine which, if any, independent variables are substantially related. A general rule is that if a correlation between any two independent variables is greater than or equal 0.70, then a high degree of interrelationship can be inferred, and the possibility of multicollinearity exists Test of differences Zikmund (1997, p. 586) defined test of differences as an investigation of hypotheses that state that two or more groups differ with respect to measures of a variable. This study was also concerned with examining whether the average profitability of SEMs achieved the efficient financial management practices differs that of SMEs which do not. The t-test may be used to test this hypothesis. The t-test for differences in two means is a technique used to test the hypothesis that the mean scores on some interval-scaled variable will be significantly different for two independent samples or groups (Zikmund, 1997, p.591) Multivariate analysis Overview Like most other business problems, profitability is inherently multidimensional. It can be simultaneously influenced by many dimensions. In term of management, profitability can be influenced by the efficiency of marketing management, financial management, production management, and quality management. By assuming other things hold equal, this study concentrated on examining the effect of financial management on SME profitability. Even though this assumption is held, the effect of financial management on SME profitability still has a multidimensional characteristic since profitability can be influenced by the efficiency of accounting information system, financial reporting and analysis, working capital management practices, fixed-asset management practices, 178

198 Chapter Four: Research Methodology financial planning practices, liquidity, financial leverage and business industry. Therefore, multivariate analysis was utilized in this research (Davis, 1996). When problems are multidimensional and three or more are involved, we utilize multivariate analysis. Multivariate statistical methods allow the effects of more than one variable to be considered at one time (Zikmund, 1997, p. 656). There are many multivariate techniques, however, two basic groups of multivariate techniques are classified: dependence methods and interdependence methods. Figure 4.11 adapted from Zikmund (1997, p.657) presents a classification and selection of multivariate methods. Figure 4.11: A classification of multivariate methods All multivariate methods Are some of the variables dependent on others? Yes No Dependence methods Interdependence methods Source: Adapted from Zikmund (1996, p.657) This study was concerned with investigating and explaining the effects of a large number of variables of financial management practices and financial characteristics on profitability. Multivariate dependence analysis was appropriate to be selected in this study. Zikmund (1997, p.657) defined dependence analysis as a multivariate statistical 179

199 Chapter Four: Research Methodology technique that attempts to explain or predict the dependent variable on the basis of two or more independent variables. Dependence analysis consists of multiple regression analysis, multiple discriminant analysis, multivariate analysis of variance, and canonical correlation analysis. Multiple regression analysis is an analysis of association that simultaneously investigates the effect of two or more independent variables on a single, intervalscaled or ratio-scaled dependent variable (Zikmund, 1997, p. 659). Multiple discriminant analysis is a statistical technique for predicting the probability of objects belonging in two or more mutually exclusive categories based on several independent variables (Zikmund, 1997, p. 662). Multivariate analysis of variance is a statistical technique that provides a simultaneous significance test of mean difference between groups, made for two or more dependent variables (Zikmund, 1997, p. 668). Canonical correlation analysis is a technique used to determine the degree of linear association between two sets of variables, each consisting of several variables (Zikmund, 1997, p. 667). In summary, there are many multivariate analysis techniques and each is appropriate with a specific purpose of investigation. Table 4. 5 (page 181) adapted from Zikmund (1997, p. 669) summarizes multivariate techniques for the analysis of dependence and indicates how to select the appropriate technique for utility. This study investigates the simultaneous effect of several independent variables (CUR, DER, TAT and EFF) on a dependent variable (PRO). Multiple regression is appropriate to be selected in this study. However, as presented in subsection 4.4.1, because the efficiency of financial management practices (EFF) is a multi-dimension construct measured by 57 items related to financial management, factor analysis was applied to group strongly correlated items into some main components or factors. This assisted the researcher to reduce a large number of variables into few factors and avoid multicollinearity phenomena in multiple regression analysis (Lehmann, Gupta, and Steckel, 1998, Laitinen, 1991, Murphy III, 1989). 180

200 Chapter Four: Research Methodology Table 4.5: Summary of multivariate techniques for the analysis of dependence Number of Number of Technique Purpose dependent independent Type of measurement variables variables Dependent Independent Multiple To simultaneously 1 2 or more Interval or Interval or regression investigate the effect of ratios ratio several independent variables on a dependent variable Discriminant To predict the probability 1 2 or more Nominal Interval or analysis of objects or individual ratio belonging in two or more mutually exclusive categories based on several independent Canonical correlation Multi analysis of variance variables To determine the degree of linear association between two sets of variables, each consisting of several variables To determine if statistically significant differences of means of several variables occur simultaneously between two levels of a variable Source: Adapted from Zikmund (1997, p.669) 2 or more 2 or more Interval or Interval or ratio ratio 2 or more 1 Interval or Nominal ratio Factor analysis Zikmund (1997, p. 669) defined factor analysis as a type of analysis used to discern the underlying dimensions or regularity in phenomena. Its purpose is to summarize the information contained in a large number of variables into a smaller number of factors. In this study, factor analysis would be utilized before testing the multiple regression models. Its objectives are as follows: to determine linear combinations of variables that aid in investigating the interrelationships (Zikmund, 1997, p. 669) to reduce the problem of multicollinearity in multiple regression model (Zikmund, P. 672). 181

201 Chapter Four: Research Methodology Chapter 5 will detail the aspects of factor analysis techniques, which are applied to extract and group the high correlation items into the principal components of financial management practices Multiple regression analysis As indicated in chapter 1 (page 4), the research problem in this study is to determine whether a relationship exists between financial management practices, financial characteristic ratios and profitability. Multiple regression analysis is an appropriate statistical technique for examining this research problem. Murphy III (1989) indicated multiple regression analysis allows the appraiser to determine whether a relationship exists between several independent variables and a dependent variable. This study used multiple regression analysis to investigate simultaneous effects of (1) current ratio (CUR), debt ratio (DER), total asset turnover (TAT) and efficiency of financial management practice (EFF) on SME profitability (PRO). As indicated in section 4.4.2, the multiple regression equation in this study was as follows: PRO = b 0 + b 1 CUR + b 2 DER + b 3 TAT + b 4 EFF + ε where: b i (i = 0, 1, 2...) are the coefficients and ε is the error variable. Chapter 5 will discuss testing this model with empirical data to explain and determine the degree of association between financial management and profitability of SMEs. In summary, descriptive statistical techniques such as frequencies, descriptive statistics and cross tabulation, bivariate analysis including test of association and test of differences, and multivariate analysis including factor and multiple regression analysis were the main techniques of analysis applied in this study. Chapter 5 will present, in more detail, how these techniques are applied to analyze the data collected. 182

202 Chapter Four: Research Methodology 4.8 CONCLUSIONS This chapter examined aspects of research methodology for this study, including research designs, variable definitions and measurements, model development, data collection methods, and data analysis. As respectively indicated by sections, this study was a combination of descriptive and explanatory research in which the stratified sampling technique was used to draw a sample of 160 SMEs located in Ho Chi Minh City for data collection via personal interview. Personal interview provided information of financial management practices of SMEs in the sample. In addition, secondary data was used to derive financial ratios such as liquidity, financial leverage, activity ratios from financial statements (balance sheets and income statements) collected directly and indirectly from SMEs. Data collected was transformed into more suitable format for analysis by utilizing Excel software. After data processing, the Statistic Package for Social Science (SPSS) was utilized for data analysis. Statistical techniques used in this study included descriptive and inference statistics. Descriptive statistics such as means, frequency, tabulation, cross-tabulation were used to summarize and describe characteristics of financial management practices of SMEs in sample. More complicated statistical analysis techniques such as bivariate analysis, multivariate analysis, factor analysis were used to determine whether a relationship exists between efficient financial management and SME profitability, and to explain this relationship. Results of the survey and findings of the relationships between financial management practices, financial characteristics and SME profitability will be presented in chapter 5: Data Analysis and Findings. 183

203 Chapter Five: Data Analysis And Findings 5.1 INTRODUCTION Chapter 4 presented aspects of research methodology including research design, data collection and data analysis methods, and hypothesis testing as support for the model. A model of the impact of financial characteristics and financial management practices on SME profitability was created at the end of chapter 4 (page 165). Chapter 5 presents descriptive findings of financial management practices, financial characteristics and SME profitability and findings of the research study related to testing the model of SME profitability. Objectives of this chapter are (1) to systematically present the descriptive findings of the research study, (2) to interpret significance of these findings as results of data analysis, (3) to present the results of testing the model for SME profitability, and (4) to explain how the model developed from a literature review, was supported by data analysis. Chapter 5 is structured into 5 main sections. Section 5.1 and 5.2 respectively introduce the chapter and links between research objectives and data analysis. Section 5.3 presents descriptive findings of financial management practices, financial characteristics, and findings of SME profitability. Section 5.4 presents the findings of relationships between financial management practices, financial characteristics and SME profitability based on bivariate analysis and findings of simultaneous impact of financial management practices and financial characteristics on SME profitability based on multivariate analysis. Section 5.5 ends the chapter with conclusions drawn from descriptive findings of financial management practices, financial characteristics and their impact on SME profitability. Figure 5.1 (page 185) provides a visual picture of the chapter outline and the links among sections as indicated earlier.

204 Chapter Five: Data Analysis and Findings Figure 5.1: Structure of chapter Introduction 5.2 Links between data analysis and research objectives 5.3 Descriptive findings of the research study Sample descriptions and SME characteristics Descriptive findings of financial management practices Descriptive findings of financial characteristics Descriptive findings of profitability 5.4 Associative analysis and findings of the research study Factor analysis and findings Bivariate analysis and findings Multi regression analysis and findings Test for difference in average profits between efficient and inefficient financial management groups of SMEs 5.5 Conclusions Source: Developed for this thesis 185

205 Chapter Five: Data Analysis and Findings 5.2 LINKS BETWEEN DATA ANALYSIS AND RESEARCH OBJECTIVES AND QUESTIONS As indicated in chapter 1, the objectives of this research study are (1) to collect the descriptive evidence on financial management practices, financial characteristics and profitability of SMEs in Vietnam, and (2) to develop the model of the simultaneous impact of financial management practices and financial characteristics on SME profitability. Additionally, this research study is designed to answer two main questions as follows: What are the relationships between financial management practices, financial characteristics and SME profitability? How do financial management practices and financial characteristics simultaneously affect SME profitability? The results of data analysis and findings presented in this chapter are linked to the research questions and objectives as mentioned above. Firstly, descriptive findings of the research study including findings of sample and SME characteristics, financial management practices, financial characteristics and findings of SME profitability will be presented respectively in section 5.3, particularly from subsections to Findings presented in these subsections are linked to the objective of descriptive evidence collection of financial management practices, financial characteristics and profitability of SMEs in Vietnam. Associative findings of the research study will be presented in section 5.4, in which bivariate analysis, factor analysis and multiple regression analysis are applied to investigate the relationships between financial characteristics, financial management practices and SME profitability. These findings are linked to the objective of developing and testing the model of the simultaneous impact of financial management practices and financial characteristics on profitability. Finally, the hypothesis of difference between mean profitability of SMEs that were efficient in financial management practices and that of SMEs that were not efficient in financial management practices, will be tested to provide further evidence of supporting the model. Following in this chapter is a report of findings linked to the objectives of the research study. 186

206 Chapter Five: Data Analysis and Findings 5.3 DESCRIPTIVE FINDINGS OF THE RESEARCH STUDY Investigating financial management practices and financial characteristics of SMEs is one of the objectives of this research study. This section presents descriptive findings of the research study, which are linked to the objective of describing financial management practices and financial characteristics of SMEs in Vietnam Sample descriptions and SME characteristics Sample descriptions As indicated in chapter 4, this research study used the stratified sampling technique with the fraction of 90 to select the sample and the plan procedure for selecting sampling units was presented in Table 4.4 (page 174). Based on the list of businesses provided by the Ho Chi Minh City Department of Investment and Planning, 14,424 SMEs operating in Ho Chi Minh City consisting of 5,170 manufacturing (accounting for 35.8%) and 9,254 trading (accounting for 64.2%) SMEs were defined as the target population. Using a random digit table, a sample of 400 SMEs was randomly selected from the list for personal interview aiming at obtaining a sample size of 160 SMEs as described by Table 4.4 (page 174). Thirty interviewers were recruited and trained to contact and interview SMEs selected. One hundred sixty-two of 400 SMEs contacted (a response rate of 40 percent) participated in the survey. After data editing, twelve cases were not usable because of important data omission, and thus eliminated from the data set. As a result, a sample of 150 SMEs was used for data analysis in this study. Structure of SMEs by type of industry and form of ownership in the sample is described in Table 5.1. Table 5.1: Structure of SMEs in the sample by type of industry and form of ownership Number of firms Percentage Type of industry Trading % Manufacturing % Total % The form of ownership Private enterprise % Limited company % Joint stock company 5 3.3% Total % Source: Data analysis for the study 187

207 Chapter Five: Data Analysis and Findings Table 5.1 (page 187) reports the distribution of the sample of responding firms in terms of type of industry and form of ownership. Sixty-six percent of businesses in the study sample are trading enterprises, 34 percent are manufacturing, while other industries are beyond the research study. Compared with the planned structure as indicated in the sampling procedure (chapter 4, page 174), the actual relationship between trading (66%) and manufacturing (34%) was not considerably changed. Figure 5.2 and 5.3 provide a visual distribution of sample in term of business structure. Figure 5.2: Distribution of sample by industry Figure 5.3: Distribution of sample by ownership Manufacturing 34.0% Joint stock company 3.3% Private enterprise 26.7% Trading 66.0% Limited company 70.0% Figure 5.3 represents the business structure of SMEs by form of ownership by which 70 percent of businesses in the sample are limited liability companies and 30 percent are private enterprises (26.7%) and joint stock companies (3.3%). These proportions were not significantly changed in comparing with the fractions planned in the sampling procedure. Therefore, they provide assurance that the sample accurately reflected the target population on the basis of the criteria used for the stratified sampling technique. Table 5.2 (page 189) provides the number and percentage of firms by form of ownership within each industry. For both manufacturing and trading industries, the percentage of limited companies is highest (65.7% and 78.4% respectively) whereas the percentage of joint stock companies is lowest (3.0 and 3.9% respectively) compared within each industry. These percentages are consistent with the proportion of each form of ownership in the target population as presented in the sample-selecting procedure in chapter

208 Chapter Five: Data Analysis and Findings Table 5.2: Sample distribution by form of ownership within industry Type of industry Trading Manufacturing The form of ownership Number of firms Percentage Number of firms Percentage Private enterprise % % Limited company % % Joint stock company 3 3.0% 2 3.9% Total % % Source: Data analysis for the study SME characteristics Table 5.3 provides an insight/review of business characteristics of SMEs in the sample. Ninety-six percent of SMEs reported the age of the business as less than 10 years, only 4 percent operating for more than 10 years. In term of size, 92 percent of businesses had not more than 100 employees and 95 percent had total assets less than VND10 billion 1. These businesses satisfy the criteria of SME definitions in Vietnam. Additionally, 73.3 percent of SMEs had annual sales less than VND5 billion, 22 percent had annual sales Table 5.3: Business characteristics of SMEs in the sample No. of firms Percentage Age of business Less than 2 years % 2-5 years % 6-10 years % More than 10 years 6 4.0% Total % Annual sales Less than 5 billion dong % 5 to 30 billion dong % 31 to 50 billion dong 2 1.3% More than 50 billion dong 5 3.3% Total % Total assets Less than 5 billion dong % 5 To 10 billion dong 8 5.3% More than 10 billion dong 7 4.7% Total % Labour 1 to 10 employees % 11 to 30 employees % 31 to 50 employees 8 5.4% 51 to 100 employees % 101 to 250 employees % More than 250 employees 2 1.4% from 5 to VND30 billion, and less than 5 percent had Total annual sales 148 over VND % billion. Source: Data analysis for the study 1 At the current rate of exchange, USD1 = VND14,

209 Chapter Five: Data Analysis and Findings In summary, Table 5.3 (page 189) indicates that most SMEs in Vietnam are very young in term of number of business operating years and small in terms of total assets, number of employees, and annual sales compared with SMEs in other countries. The next section will consider whether these business characteristics of SMEs affect financial characteristics and financial management practices Descriptive findings of financial management practices Accounting information system practices This section respectively presents descriptive findings of accounting information system practices of SMEs in the sample. All SMEs are found to have accounting information systems organized formally (Table 5.4). This is a legal requirement for SMEs that are organized in the form of private enterprises, limited liability companies or joint stock companies because these SMEs are required to prepare and submit financial statements to departments of taxation frequently and regularly. Table 5.4: Characteristics of accounting system organization No. of firms Percentage Characteristics of accounting system organization Formal % Informal 0 0.0% Total % Source: Data analysis for the study Regarding the responsibility for accounting information systems, Table 5.5 (page 191) reveals that 88 percent of SMEs in the sample used an employed or in-house accountant to record business transactions whereas less than 2 percent used an external accountant or the owner himself or herself. Chief-accountant was often used for the more complicated responsibilities, for example, 15.3 percent of SMEs required the chiefaccountant to prepare accounting reports whereas only 6.7 percent used the chiefaccountant in recording business transactions. For enterprise reporting, up to 41.3 percent of SMEs used the chief-accountant in interpreting and using the accounting information for decision-making. 190

210 Chapter Five: Data Analysis and Findings Additionally, less than 2 percent of respondents answered that they used external (or outside) accountants to record business transactions, prepare accounting reports or interpret accounting information. SMEs in Vietnam appear to be unfamiliar with using external accountants in their accounting information systems. This finding is similar to DeThomas and Fredenberger s (1985) findings in a survey of over 360 SMEs in Georgia (USA), which revealed that only 4 percent of responding firms used external accountants. Table 5.5: Responsibility accounting information system No. of firms Percentage Recording business transactions Owner 3 2.0% Manager 3 2.0% Chief-accountant % Employed accountant % External accountant 2 1.3% Total % Preparing accounting reports Owner 2 1.3% Manager 1 0.7% Chief-accountant % Employed accountant % External accountant 3 2.0% Total % Interpreting and using accounting Owner 5 3.3% information Manager 3 2.0% Chief-accountant % Employed accountant % External accountant 2 1.3% Total % Source: Data analysis for the study In examining the application of computers in accounting information system, Table 5.6 (page 192) shows that 50 percent of respondents often, 37 percent always, and only 0.7 percent never use computers in their accounting systems. However, while about 91% apply computers to the production of accounting reports, only a small percentage of SMEs in the sample apply computers to related fields such as payroll, cash flows, asset management and business transaction recording. 191

211 Chapter Five: Data Analysis and Findings Table 5.6: Using computer in accounting information system No. of firms Percentage Frequency of computer Never 1 0.7% application Rarely 7 4.7% Sometimes % Often % Always % Total % Computer application fields Recording business transactions 8 5.3% Preparing accounting reports % Managing assets 1 0.7% Controlling payroll 2 1.3% Controlling cash flows 1 0.7% Others 1 0.7% No answer 1 0.7% Total % Source: Data analysis for the study After analyzing the results of respondents questions concerning accounting information system practices, the typical characteristics of accounting information systems of SMEs in the sample are summarized as follows: 100 percent of SMEs have systems of accounting information organized formally. Employed accountants and chief-accountant still play an important role in carrying out most accounting responsibilities whereas external accountants have not frequently been used. Most SMEs have applied computers to their accounting information systems and the most frequent application of computers is to prepare accounting reports Financial reporting and analysis practices Financial reporting and analysis practices of SMEs in the sample are respectively analyzed and presented in this subsection. The first finding is that over 93 percent of SMEs focus on two traditionally main types of financial statements, balance sheets and income statements, which are prepared regularly (Table 5.7, page 193). This demonstrates that SMEs strongly favour organizing financial information systems, which 192

212 Chapter Five: Data Analysis and Findings produce reports to help the owner/managers control financial position and performance of the business. Table 5.7: Kinds of financial statements prepared No. of firms Percentage Balance sheet % Income statement (Profit and loss statement) % Statement of cash flows % Statement of funds % Others % Total cases 150 Source: Data analysis for the study Secondly, preparing and analyzing financial statements are frequently conducted with SMEs. About 70 percent of respondents have financial statements prepared and analyzed monthly, while only 3 percent of SMEs have never analyzed financial statements (Table 5.8). Table 5.8: Frequency of preparing and analyzing financial statements No. of firms Percentage Preparing financial statements Monthly % Quarterly % Semiannually 4 2.7% Annually 3 2.0% Total % Analyzing financial statements Monthly % Quarterly % Semiannually 6 4.0% Annually 7 4.7% Never 5 3.3% Total % Source: Data analysis for the study Thirdly, like accounting information system practices, responsibility for preparing and analyzing financial statements is often left to the chief-accountant and/or employed accountants (Table 5.9, page 154). One hundred and fourteen of 150 respondents (76%) reported that employed accountants were in charge of preparing financial statements compared with nearly 2 percent of respondents who said that the owner or external accountants were responsible (Table 5.9, page 194). This finding is similar to DeThomas and Fredenberger s (1985) finding in that SMEs have rarely asked the external accountants to analyze and interpret financial statements. 193

213 Chapter Five: Data Analysis and Findings Table 5.9: Responsibility preparing and analyzing financial statements No. of firms Percentage Preparing financial statements Owner 2 1.3% Manager 1 0.7% Chief-accountant % Employed accountant % External accountant 2 1.3% Analyzing financial statements Owner 3 2.0% Manager 4 2.7% Chief-accountant % Employed accountant % External accountant 2 1.3% Never do it 5 3.3% Total % Source: Data analysis for the study When conducting financial analysis, more than half of the SMEs in the sample apply two types of financial analysis techniques (trend and ratio analysis), while only 5 percent answered that they have never applied any analysis technique. When asked what kinds of financial ratio they have ever used, about half of respondents replied they have used the short-term debt ratio, current ratio, total asset turnover, and fixed asset turnover whereas only 10 percent used the long-term debt ratio (Table 5.10). This may be consistent with the current difficulty of Vietnam SMEs in obtaining long-term loans and the uncertainty of Vietnam s business environment, which cause investors and bankers to hesitate in offering long-term debts. Table 5.10: Kinds of financial analysis and ratios used No. of firms Percentage Kinds of financial analysis used Ratio analysis % Trend analysis 8 5.3% Both ratio and trend analysis % Never 8 5.3% Kinds of financial ratios used Current ratio % Quick ratio % Debt ratio % Debt-to-equity ratio % Short-term debt ratio % Long-term debt ratio % Receivable turnover % Inventory turnover % Fixed asset turnover % Total asset turnover % Return on sales % Return on assets % Return on equity % Source: Data analysis for the study 194

214 Chapter Five: Data Analysis and Findings In summary, after conducting the survey and data analysis, this study has provided insight into financial reporting and analysis practices of SMEs with empirical evidence from Vietnam. Descriptive findings of financial reporting and analysis are summarized as follows: Near 100 percent of SMEs have frequently and regularly prepared and analyzed financial statements including balance sheets and income (profit and loss) statements. Most SMEs (about 70 percent) have prepared and analyzed their financial statements based on monthly periods. Nevertheless, about 2 percent of SMEs have never analyzed financial statements. In financial analysis, about a half of SMEs in the sample have frequently applied both trend and ratio analyses. Ratios of activity such as receivable turnover, inventory turnover, and total asset turnover are most frequently used, followed by ratios of liquidity and the least used are ratios of long-term debt, and profitability of sales, assets and equity Cash management practices As indicated in chapter 3, examination of cash management practices by previous researchers have mainly focussed on examining areas such as cash budgets, cash balance and cash surplus or shortage. This subsection presents descriptive findings of cash management practices of the sample of 99 trading and 51 manufacturing SMEs in Vietnam. Table 5.11 (page 196) indicates 38 percent of respondents always prepare cash budgets, whereas about 5 percent never prepare the budgets. On the other hand, Table 5.11 (page 196) reveals that 76 percent of SMEs prepare cash budgets monthly, 11 percent weekly, about 5 percent by quarterly periods and the balance prepares cash budgets by semiannually and annually periods. As such, the monthly period is most frequently used by SMEs in preparing cash budgets. 195

215 Chapter Five: Data Analysis and Findings Table 5.11: Preparing cash budgets No. of firms Percentage Frequency of preparing cash budgets Never 8 5.4% Rarely 7 4.7% Sometimes % Often % Always % Total % Period for preparing cash budget Never 9 6.0% Weekly % Monthly % Quarterly 7 4.7% Semiannually 2 1.3% Annually 2 1.3% Total % Source: Data analysis for the study On cash balance determination, Table 5.12 reveals that only 12.6 percent of responding firms often or always, while about 40 percent rarely or never determine the target cash balance. This finding is consistent with the common trend that SMEs rarely pay attention to setting up a cash-balance policy. Most SMEs simply consider cash-balance as the result of differences in cash inflows and outflows without any policies. Table 5.12: Cash balance determination No. of firms Percentage Determining the target cash balance Never % Rarely % Sometimes % Often % Always 5 3.3% Total % Cash balance determination Based on theories of cash 1 0.7% management Based on historical data % Based on owner/manager 's % experience Others 2 1.3% No answer 2 1.3% Total % Source: Data analysis for the study Additionally, Table 5.12 indicates that 83 percent of SMEs that often or always set up their cash balance policy were based on the owner/manger s experience in determining the target cash balance. Percentage of SMEs applying theories of cash 196

216 Chapter Five: Data Analysis and Findings management in determining the target cash balance is not significant. This reveals that theories of cash management have not been popularly implemented in practices in Vietnam. For cash shortage phenomena, 20 percent of enterprises never or rarely have been short of cash, only 2.7 percent of responding SMEs often or always have insufficient cash for expenditure (Table 5.13). Conversely, about 40 percent of SMEs in the sample reported that they have a surplus of cash sometimes or often or always (Table 5.13). This finding is consistent with Kack and Lindgren (1999), and Vuong Quan Hoang (1998) findings, which indicated SMEs in Vietnam seems likely to reserve cash and maintain relatively high current ratios (chapter 2, page 55). Table 5.13: Cash surplus or shortage Number of firms Percentage Occurring cash shortage Never % Rarely % Sometimes % Often 3 2.0% Always 1 0.7% Total % Occurring cash surplus Never 7 4.7% Rarely % Sometimes % Often 6 4.0% Always 4 2.7% Total % Cash surplus investment Bank deposit % Treasury bill purchase 1 0.7% No investment % Others 1 0.7% Not cash surplus 7 4.7% Total % Source: Data analysis for the study Regarding cash surplus investment, it is surprising that up to 75 percent of responding SMEs did not invest cash surplus for profit purposes. About 19 percent deposit cash surplus in bank accounts for interest and almost no firms used the cash surplus to buy money-market instruments such as treasury bills, commercial papers or others (Table 5.13). This can be explained, because the money market in Vietnam has not developed, therefore, firms could not use cash surplus to purchase short-term investment instruments for profit purposes. 197

217 Chapter Five: Data Analysis and Findings Below is a summary of descriptive findings related to cash management practices that SMEs in the sample: In general, about 80 percent of SMEs always or often prepare cash budgets, and preparing and reviewing cash budgets are frequently based on monthly periods. Only 2.7 percent of responding SMEs always or often have shortage of cash while about 40 percent always or often have a surplus of cash. Nevertheless, only 19 percent of SMEs deposit their cash surplus into bank accounts while up to 75 percent did not invest the temporarily cash surplus for profitable purposes Receivable management practices On receivable management practices, respondents were asked questions concerned with credit sales and policies, reviewing levels of receivables and bad debts, and percentage of bad debts compared with sales. Below are descriptive findings of receivable management practices of SMEs in the sample. Table 5.14 demonstrates 80 percent of respondents always or often sell their products or services on credit, only 2 percent never use credit sales. However, only 63 percent of SMEs which always or often sell products on credit, answered that they always or often set up a credit policy for the customers. Seven percent never have credit policies for the customers but they tend to sell on credit to anyone who wishes to buy. Table 5.14: Sales on credit and credit polices No. of firms Percentage Sell products or services on credit Never 3 2.0% Rarely 7 4.7% Sometimes % Often % Always % Total % Set up credit policy to the customers Never % Rarely % Sometimes % Often % Always % Total % Source: Data analysis for the study 198

218 Chapter Five: Data Analysis and Findings In reviewing receivable levels and bad debts, a relatively high percentage of SMEs (about 80%) in the sample review their receivable levels and bad debts based on monthly periods. However, 4.7 percent answered that they never review their bad debts (Table 5.15). As such, like cash management practices, monthly periods are still popularly used by SMEs in reviewing receivable levels and bad debts. Table 5.15: Frequency of reviewing receivable levels and bad debts No. of firms Percentage Review levels of receivables Weekly % Monthly % Quarterly 8 5.3% Annually 1 0.7% No answer 1 0.7% Total % Review bad debts Never 7 4.7% Weekly 9 6.0% Monthly % Quarterly 7 4.7% Semiannually 3 2.0% Annually 3 2.0% No answer 1 0.7% Total % Source: Data analysis for the study When analyzing the percentage of bad debts to sales, 89 percent of responding firms indicated that their bad debts have not exceeded 10 percent of sales (Table 5.16). This figure is not high under given conditions of financing source shortages and shows that SMEs are relatively good in managing receivables. However, a few SMEs answered that they did not know their percentage of bad debts to sales, and others did not answer this question. Table 5.16: Percentage of bad debts compared to sales No. of firms Percentage Bad debt percentages Less than 5 % of sales % 5-10% of sales % 10-20% of sales % More than 20% of sales 1 0.7% Don't know 2 1.3% No answer 2 1.3% Total % Source: Data analysis for the study 199

219 Chapter Five: Data Analysis and Findings In general, descriptive findings of receivable management practices of SMEs in the sample revealed the following: Eighty percent of SMEs always or often sell their products or services on credit and 63 percent always or often set up credit polices for the customers. However, there are still 7 percent of SMEs that tend to sell on credit to anyone who wishes to buy. Most SMEs review their levels of receivables and bad debts monthly. As a result, the percentage of bad debts is controllable and maintained at a relatively low level Inventory management practices On inventory management practices, respondents were asked questions related to preparing and reviewing inventory budgets, determining inventory levels, and using the economic order quantity (EOQ) model. Below are descriptive findings of inventory management practices of SMEs in the sample. Table 5.17 shows a relatively high percentage (86%) of SMEs in the sample always or often review inventory levels and 80.7 percent always or often prepare inventory budgets. Only about 5 percent never prepare inventory budgets. Table 5.17: Frequency of reviewing inventory levels and preparing inventory budgets No. of firms Percentage Review inventory levels Never 2 1.3% Rarely 8 5.3% Sometimes % Often % Always % Total % Prepare inventory budgets Never 7 4.7% Rarely 9 6.0% Sometimes % Often % Always % Total % Source: Data analysis for the study 200

220 Chapter Five: Data Analysis and Findings When asked how they determined the level of inventory in preparing inventory budgets, 94 percent of responding firms answered they determine inventory level based on owner/manager s experience, only 2 percent used theories of inventory management (Table 5.18). On the other hand, SMEs very rarely use the Economic Order Quantity Model in inventory management. About 90 percent of SMEs revealed that they had never known of the model, 6 percent know of it but never use it, while only 1.3 percent often used the model. Table 5.18: Basis of determining inventory levels and using EOQ Model No. of firms Percentage Inventory level Based on theories of inventory determination management 3 2.0% Based on historical data 3 2.0% Based on owner/management's experience % Others 3 2.0% Economic Order Quantity Model application Source: Data analysis for the study Total % Do not know this model % Know but never use 9 6.0% Sometimes use 5 3.3% Often use 2 1.3% Total % Practices of inventory management as reviewed above demonstrate that SMEs have a very low level of management expertise regarding inventory. They often review inventory levels and prepare inventory budgets but the ability to applying theories of inventory management to inventory budgeting is very limited Fixed asset management practices On fixed asset management practices, respondents were asked questions related to frequency of evaluating investment projects and reviewing efficiency in use of fixed assets after investing, and methods used to evaluate an investment project. Below are the descriptive findings of fixed asset management practices of SMEs in the sample. Seventy-nine percent of respondents claimed that they always or often evaluated projects before making capital investment decisions. However, there were also 201

221 Chapter Five: Data Analysis and Findings 6 percent respondents who claimed that they had made decisions on capital investment without project evaluation (Table 5.19). For these firms, it seems that they are not concerned about evaluating projects but are willing to buy fixed assets whenever needed. On the quality of utilizing fixed assets after investing, 78.8 percent of responding firms stated that they always or often review the efficiency of utilizing fixed assets after investing. Only about 5 percent have never reviewed fixed assets utilization after making decisions of investment (Table 5.19). Table 5.19: Frequency of evaluating investment projects and reviewing efficiency of using fixed assets after investing No. of firms Percentage Evaluate projects before making Never 9 6.0% capital investment decisions Rarely % Sometimes % Often % Always % Review efficiency of using fixed assets after investing Source: Data analysis for the study Total % Never 8 5.3% Rarely % Sometimes % Often % Always % Total % Regarding methods used to evaluate investment projects or capital budgeting techniques used by the firms in the sample, Table 5.20 (page 203) shows the proportion of firms using the various techniques. Table 5.20 reveals that 86.7 percent of firms in the sample claimed to use the payback method, falling to 33.3 percent for discounted payback period. Only 27.3 percent stated that they use the more sophisticated discounted cash flows; that is, the net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR). These results are similar to those of the studies conducted by Luama (1967), and Peel and Wilson (1996) in that payback period method are the most popular technique used by small firms while more sophisticated techniques such as NPV, IRR or MIRR seem to be less frequently used. 202

222 Chapter Five: Data Analysis and Findings Table 5.20: Methods used to evaluate investment projects No. of firms Percentage Methods used to evaluate Payback period % investment projects Discounted payback period % Net present value % Internal rate of return 5 3.3% Modified internal rate of return 2 1.3% No answer 4 2.7% Source: Data analysis for the study Descriptive findings of fixed asset management practices of a sample of 99 trading and 51 manufacturing SMEs in Vietnam are summarized as follows: Near 80 percent of SMEs always or often evaluate capital projects before making decisions on investment and review the efficiency of utilizing fixed assets after acquisitions. 87 percent of SMEs stated that they use payback period technique in capital budgeting, only 27.3 percent use the more sophisticated discounted cash flows; that is, the net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR). These findings reveal that SMEs have a relatively strong regard for fixed asset management Financial planning practices To investigate financial planning practices, respondents were asked questions related to frequency of preparing and reviewing financial budgets, kinds of financial budgets prepared, responsibility for preparing financial budgets, and frequency of comparing budgeted and actual results. Listed below are the results of response to the questions that interviewers raised with SMEs in the sample. Table 5.21 (page 204) reports the frequency of preparing financial budgets. In line with prior expectations, only 5.3 percent of SMEs in the sample never prepare any kind of financial budgets. A majority of SMEs in the sample (76.6%) always or often 203

223 Chapter Five: Data Analysis and Findings prepared financial budgets during business operations. The remainder rarely or sometimes prepared budgets. Table 5.21: Frequency of preparing and reviewing financial budgets No. of firms Percentage Preparing financial budgets Never 8 5.3% Rarely 7 4.7% Sometimes % Often % Always % Total % Source: Data analysis for the study Table 5.22 reports the percentages of SMEs in the sample that prepared types of budgets. One hundred thirty-one of 150 SMEs asked (87.3%) had prepared sales budgets, representing the highest percentage, while only 34 and 41 percent had ever prepared budget balance sheets and budget profit and loss statements respectively. This is consistent with the reported situation that SMEs in Vietnam rarely prepare budget balance sheets and income statements though they frequently prepared actual balance sheets and income statements (Table 5.7, page 192). Table 5.22: Kinds of financial budgets prepared No. of firms Percentage Kinds of budget prepared Sales budget % Manufacturing budget % Purchase budget % Labour budget % Overhead cost budget % Selling and administration expense budget % Cash budget % Budgeted profit and loss account % Budgeted balance sheet % Source: Data analysis for the study It may be explained that SMEs in Vietnam are unfamiliar with preparing budget balance sheets and income statements. In contrast, they are relatively familiar with preparing other kinds of budgets such as sales budgets, selling and administration expense budgets, labour budgets, overhead cost budgets, and cash budgets. 204

224 Chapter Five: Data Analysis and Findings Regarding the responsibility for preparing financial budgets, Table 5.23 reveals that 62 percent of responding SMEs have employed or internal accountants prepare financial budgets, falling to 34.7 percent using chief-accountants and 20.6 percent using owners or managers. Once again, employed accountants are recognized as playing very important roles in financial management practices while external accountants are rarely used by SMEs (1.3%). Table 5.23: Responsibility preparing financial budgets No. of firms Percentage Responsibility for preparing budgets Owner % Financial manager 8 5.3% Chief-accountant % Employed accountant % External accountant 2 1.3% Source: Data analysis for the study In addition to preparing financial budgets, up to 83 percent of SMEs in the sample frequently compared between budget and actual results, only 2.7 percent rarely conduct this comparison (Table 5.24). Furthermore, budget periods for comparing budget and actual results tend to be relatively short. Over seventy-eight percent of SMEs carry out comparisons of budget/actual results in monthly periods. This helps SMEs quickly to respond to in achieving budgeted objectives. Table 5.24: Frequency of comparing between budgeted and actual results No. of firms Percentage Frequency of actual/budgeted comparison Rarely 4 2.7% Sometimes % Often % Always % Total % Periods of actual/budgeted comparison Weekly 9 6.0% Monthly % Quarterly % Semiannually 4 2.7% Annually 3 2.0% Total % Source: Data analysis for the study In summary, related to financial planning practices of SMEs in the sample, the following are findings: 205

225 Chapter Five: Data Analysis and Findings A majority of SMEs in the sample (76.6%) always or often prepared financial budgets in the process of business operation. Types of budgets such as sales, selling and administration expenses, labour and cash budgets are prepared by a majority of SMEs whereas fewer SMEs prepare budget balance sheets and income statements. A majority of SMEs has employed accountants and chief-accountants prepare budgets whereas the number of SMEs using external accountants to prepare financial budgets is not significant. Up to 83 percent of SMEs in the sample frequently compare budget and actual results monthly. In addition to financial management practices as reported earlier, this study also aims at describing financial characteristics of SMEs. The next subsection presents descriptive findings of financial characteristics of SMEs in the sample Descriptive findings of financial characteristics Four financial ratios used as variables to measure financial characteristics in this study were current ratio (liquidity measure), debt ratio and debt-to-equity ratio (leverage measure), and total asset turnover (activity measure). In addition, three other ratios used as measures of profitability were return on sales (ROS), return on assets (ROA), and return on equity (ROE). For the purpose of profitability emphasis, profitability ratios will be examined in subsection In this study, data related to financial characteristics were derived from financial statements of firms. The responding SMEs were asked to use the financial statements of the current year including balance sheets and income statements to calculate financial ratios. These ratios were filled into part C of the questionnaire (Appendix 1), which was designed to collect data regarding financial characteristics. Below are the descriptive findings of financial characteristics of SMEs in the sample. 206

226 Chapter Five: Data Analysis and Findings Table 5.25a: Descriptive statistics of financial ratios N Minimum Maximum Mean Std. Deviation Current ratio Debt ratio Debt-to-equity ratio Total asset turnover Return on sales(%) Return on assets(%) Return on equity (%) Valid N 150 Source: Data analysis for the study (N= Number of SMEs in the sample) Table 5.25b: Descriptive statistics of financial ratios of trading SMEs N Minimum Maximum Mean Std. Deviation Current ratio Debt ratio Debt-to-equity ratio Total asset turnover Return on sales (%) Return on assets (%) Return on equity (%) Valid N 99 Source: Data analysis for the study (N= Number of trading SMEs in the sample) Table 5.25c: Descriptive statistics of financial ratios of manufacturing SMEs N Minimum Maximum Mean Std. Deviation Current ratio Debt ratio Debt-to-equity ratio Total asset turnover Return on sales(%) Return on assets (%) Return on equity (%) Valid N 51 Source: Data analysis for the study (N= Number of manufacturing SMEs in the sample) Table 5.25a reports descriptive statistics of financial characteristics of the sample of 150 SMEs without distinction between trading and manufacturing industries while Table 5.25b and 5.25c respectively report descriptive statistics of financial characteristics of the trading and manufacturing SMEs. Table 5.25b and 5.25c also demonstrate differences in means of financial ratios between two groups (trading and manufacturing) of SMEs. However, Table 5.26 reveals that the results of t-tests applied for testing the 207

227 Chapter Five: Data Analysis and Findings differences in the means of financial ratios between two groups report that the differences do not provide enough statistical evidence to conclude that there are differences between two the groups. Table 5.26: Test for difference of means of financial ratios between two groups t df Sig. (2-tailed) Mean Std. Error Difference Difference Current ratio E Debt ratio E E-02 Debt-to-equity ratio Total asset turnover Return on sales (%) Return on assets (%) Return on equity (%) Source: Data analysis for the study Liquidity (Current ratio) Tables 5.25 (a, b, and c, page 207) report that SMEs in the sample maintain relatively high liquidity ratios. On average, current ratios of SMEs are 2.50 for trading and 2.47 for manufacturing. Some SMEs have current ratios up to These ratios are higher than Vuong Quan Hoang (1998) s findings, which reported that the average current ratio of SMEs in Vietnam is 2.10 (chapter 2, Table 2.21, page 54). Table 5.27: Comparison of current ratios Osteryoung, Constand and Nast (1992) s research Current research Industry Cur. Ratio Industry Cur. ratio Trading (Average) 2.67 Trading 2.50 Apparel 2.60 Building materials and supplies 2.40 Drugs 3.20 Food and beverage 2.50 Furniture/appliances 2.40 Jewelry 3.00 Shoes 2.60 Manufacturing (Average) 2.05 Manufacturing 2.47 Furniture 2.40 Electronic components 1.70 Machine tools and equipment 2.10 Apparel 2.00 Source: Osteryoung, Constand and Nast (1992) research and data analysis for this study 208

228 Chapter Five: Data Analysis and Findings However, comparing the current research s findings with Osteryoung, Constand and Nast (1992) s findings (Table 5.27, page 208) reveals that both studies reported current ratios similar for trading but rather different for manufacturing industry. The current research finds that, on average, the current ratio of manufacturing SMEs in Vietnam (2.47) is rather higher that of Osteryoung, Constand and Nast (1992) s research (2.05). Table 5.28 reveals that over 90 percent of SMEs in the sample have a current ratio greater than 1.00, and about 53 percent have a current ratio more than Table 5.28: Descriptive findings of SME current ratios No. of firms Percentage Current ratio Below % From 1 to % Over 1.5 to % More than % Total % Source: Data analysis for the study Maintaining excessively high current ratios has two outcomes. On one hand, it reinforces liquidity, which help SMEs to sustain the uncertainty of business environment. On the other hand, it affects profitability of SMEs because liquid assets have not been used as profitable assets. In this context Van Horne (1986, p145) has stated that: The greater the relative proportion of liquid assets, the less risk of running out of cash profitability unfortunately, also will be less resolution of trade-off between risk and profitability with respect to these decisions depends upon the risk preferences of management. If resolving the trade-off between risk and profitability depends upon risk preferences of management then for SMEs in Vietnam, maintaining excessively high current ratios is acceptable because they operate in a relatively risky environment. However, from a profitability perspective, it seems that maintaining high current ratio causes SMEs to be less profitable than would be expected. This will be analyzed in section 5.4 where bivariate techniques are used to examine the relationship between liquidity and profitability of SMEs and the hypothesis of relation between current ratio and profitability will be tested. 209

229 Financial leverage (Debt and debt-to-equity ratio) Chapter Five: Data Analysis and Findings Table 5.25a (page 207) indicates that, the average debt ratio of SMEs in the sample was 30%, that is, 30 percent of total assets of SMEs are financed from debt and 70 percent from equity. This finding is lower than that reported by Vuong Quan Hoang (1998), who indicated that the average debt-to-total asset ratio of SMEs in Vietnam was 40 percent (chapter 2, Table 2.21, page 54). However, a few SMEs have debt ratios as high as 108 percent while others have low debt ratios of 10 percent. Generally speaking, debt ratios of SMEs in the sample were not high. Table 5.29 reveals that 72 percent of SMEs had debt ratios below 30% while less than 10 percent had debt ratios over 50%. This is not surprising because, in the 1990 s, SMEs in Vietnam have extreme difficulty in finding outside financing sources from commercial banks, credit unions or financial companies. Table 5.29: Descriptive findings of SME debt ratios No. of firms Percentage Debt ratio Below 30% % From 31% to 50% % From 51% to 80% % More than 80% 3 2.0% Total % Source: Data analysis for the study Additionally, Table 5.25a (page 207) indicated that, on average, the debt-to-equity ratio of SMEs in the sample was about 54%. This means that SMEs use about one dollar of debt corresponding to one dollar of equity to finance their total assets. This feature is consistent with the current status of SMEs in that they often use assets funded by equity as collateral to borrow short-term or long-term capital sources. However, this debt-toequity ratio is considered relatively low compared with large companies, which often use about 3 dollars of equity as collateral to borrow up to 7 dollars of debt (Vuong, 1998). In consequence, the possibility of debt financing depends upon the volume of equity source and SMEs with limited equity sources may have extreme difficulty in seeking debtfinancing sources for expansion or growth. 210

230 Business activity (Total asset turnover) Chapter Five: Data Analysis and Findings Table 5.25a (page 207) shows that the average total asset turnover (Sales/Total assets) of SMEs in the sample is 3.84 and a few SMEs had total asset turnovers very high up to This means that, on average, one dollar of total assets of SMEs produces 3.84 dollars of sales, relatively high efficiency in utilizing assets. Concerned with distribution of total asset turnover, Table 5.30 reveals that only 18.7 percent of SMEs had total asset turnovers less than 1 while the remainder had total asset turnovers greater than 1. This suggests that most SMEs (81.3%) produce more than one dollar of sales from a dollar of total assets. In addition, Table 5.30 shows that 18.7 percent of SMEs produce more than 5 dollars of sales from a dollar of total assets. Table 5.30: Descriptive findings of SME activity ratio No. of firms Percentage Total asset turnover Below or equal % More than 1 to % More than 3 to % More than % Total % Source: Data analysis for the study It appears that the efficiency of utilizing total assets of SMEs in the sample is relatively high. However, this is not sufficient evidence to conclude that SMEs are profitable. The next subsection analyzes profitability of SMEs in the sample Descriptive findings of profitability of SMEs One of the main objectives of this research study was to investigate profitability of SMEs. As indicated in chapter 1, this research investigated (1) whether or not SMEs in Vietnam are profitable, and (2) whether financial management practices and financial characteristics affect their profitability. Below are descriptive findings related to the first question while findings to answer the second question will be reported in section

231 Chapter Five: Data Analysis and Findings Overview of profitability As defined in chapter 1, a business is said to be profitable if it produces an annual average profit return that is greater than the free-risk rate of interest, which is estimated as 5.4 percent in the 1990 s in Vietnam. Conversely, if the annual average profit of a business is not greater than the free-risk rate of interest, the business is said to be not profitable or unprofitable. The annual average profits are averaged from three profitability ratios: return on sales, return on assets and return on equity. The free-risk rate of interest is here defined as the deposit rate of interest of state-owned commercial banks, which is of 0.45% per month or 5.4% per year in the year The arguments for the definition of SME profitability as mentioned above are based on the following propositions: Firstly, the deposit rate of interest offered by state-owned commercial banks is considered free-risk because these commercial banks are secured by the Government. Secondly, the free-risk rate of interest is considered the opportunity cost of capital, and SMEs have to produce annual average profits greater than their opportunity cost, otherwise they should cease operating and deposit money into the banks for free-risk rate of interest. Based on the definition of profitability as indicated earlier, Table 5.31 (page 213) reports that 99 of 150 SMEs surveyed (66%) were profitable. While the remainder (34%) was not profitable, that is, they could not produce an annual average profit return that was higher than the free-risk rate of interest. Table 5.31 also shows the size of annual profits of SMEs. Only about 10 percent of SMEs had annual profits of more than VND500 2 million while about 50 percent have annual profit range from VND50 to VND300 million, and 18 percent annually earn less than VND50 million. Levels of annual profit of SMEs in Vietnam are small compared to other countries because firm size is low in terms of total assets and labour. 2 Equivalent of USD35, 714, by the current exchange rate of VND14, 000 for 1USD 212

232 Chapter Five: Data Analysis and Findings Table 5.31: Overview of SME profitability No. of firms Percentage Profitability Not profitable % Profitable % Total % Annual profits Less than 50 million dong % 50 to 300 million dong % 301 to 500 million dong % More 500 million dong % Total % Source: Data analysis for the study What has been discussed above is only an overview of SME profitability, which answered the first research question outlined in chapter 1. A more specific analysis was carried out in subsections and to provide a deeper analysis of profitability of SMEs in the survey Profitability and business structure This subsection analyzes profitability of SMEs in relation to business structure to investigate which types of SMEs are profitable. Table 5.32 reports relationships between profitability and type of industry in which manufacturing SMEs are found to be more profitable than trading. In terms of business structure, manufacturing industry accounted for 34% of SMEs in the sample but 36.4 percent of manufacturing SMEs are profitable while trading industry accounted for 66% but only 63.6 percent are profitable. Conversely, up to 70.6 percent of trading SMEs are not profitable while this percentage is only 29.4 percent for manufacturing. Table 5.32: Relationship between profitability and types of business Not profitable Profitable Total No. % No. % No. % Type of industry Trading % % % Manufacturing % % % Total % % % The form of ownership Private enterprise % % % Limited company % % % Joint stock company 3 5.9% 2 2.0% 5 3.3% Total % % % Source: Data analysis for the study 213

233 Chapter Five: Data Analysis and Findings On the other hand, Table 5.32 (page 213) also provides the findings of relationships between profitability and business structure in which private enterprises are more profitable than limited and joint stock companies. In term of structure, private enterprises, limited companies, and joint stock companies accounted for 26.7%; 70.0%; and 3.3 percent respectively, but the percentage of profitable SMEs are correspondingly 32.3%; 65.7%; and 2.0 percent for private enterprises, limited companies, and joint stock companies. As such, although limited companies occupy 70.0 percent of SMEs in the survey, only 65.7 percent are profitable while private enterprises occupy 26.7 percent but 32.3 percent are profitable and 15.7 percent are not profitable Profitability and business size This subsection analyzes profitability of SMEs in relation to business size to investigate which business size groups (very small, small, or medium) are profitable. Table 5.33 reveals smaller businesses in terms of total assets, annual sales, and labour are more profitable than larger SMEs. For SMEs that have total assets less than VND5 billion, the percentage of profitable SMEs was higher than that of unprofitable SMEs. These findings support the view that small is profitable. Table 5.33: Relationship between profitability and business characteristics Not profitable Profitable Total No. % No. % No. % Total assets Less than 5 billion dong % % % 5 To 10 billion dong 3 5.9% 5 5.1% 8 5.3% More than 10 billion dong 3 5.9% 4 4.0% 7 4.7% Total % % % Annual sales Less than 5 billion dong % % % 5 to 30 billion dong % % % 31 to 50 billion dong 1 2.0% 1 1.0% 2 1.3% More than 50 billion dong 1 2.0% 4 4.0% 5 3.3% Total % % % No. of employees 1 to 10 employees % % % 11 to 30 employees % % % 31 to 50 employees 2 3.9% 6 6.2% 8 5.4% 51 to 100 employees 5 9.8% 5 5.2% % 101 to 250 employees 4 7.8% 6 6.2% % More than 250 employees 2 2.1% 2 1.4% Total % % % Source: Data analysis for the study 214

234 Chapter Five: Data Analysis and Findings In summary, analysis conducted in subsections and provided descriptive findings of relationships between profitability and business structure, and size. These findings are summarized as follows: The percentage of profitable SMEs in manufacturing industry is higher than that of the trading industry. In term of form of ownership, the percentage of profitable SMEs is found higher for private enterprises than that of limited and joint stock companies. In term of business size, the percentage of profitable SMEs is found higher for smaller businesses than that for larger SMEs. However, these are relatively simple descriptive statistical analysis of relationships between profitability and business structure, and business size. More sophisticated statistical analysis related to SME profitability will be examined and reported in section 5.4 in which bivariate analysis and multivariate analysis were applied. 5.4 ASSOCIATIVE ANALYSIS AND FINDINGS OF THE RESEARCH STUDY This section demonstrates and reports to what extent data collected from the survey of 150 SMEs in Ho Chi Minh City, Vietnam supports the model presented in subsection and hypotheses outlined in subsection of chapter 4 (page 165). Firstly, subsection used factor analysis to reduce the large number of variables measuring financial management practices into principal factors or components. Subsection presents results of using bivariate analysis technique to analyze associations between financial management practices, financial characteristics and profitability and subsection reports results using multi-regression analysis to test the model of simultaneous impact of financial characteristics and financial management practices on SME profitability. Finally, subsection reports the result of tests for difference in average profits between efficient and inefficient financial management groups of SMEs. 215

235 Chapter Five: Data Analysis and Findings Factor analysis and principal components of financial management practices As indicated in chapter 4, the efficiency of financial management practices is a complex and multi-dimension construct. In term of context, financial management practices may be summarized into the following areas: (1) accounting information systems, (2) financial reporting and analysis, (3) cash management practices, (4) receivable management practice, (5) inventory management practices, (6) fixed asset management practices, and (7) financial planning practices (McMahon, 1998). Chapter 4 also indicated the efficiency of each area of financial management practices was generally measured by 8 items on nine-point scales. The efficiency of receivable management practices was measured by 9 items on a nine-point scale. In consequence, the efficiency of financial management practices of SMEs in the survey was measured by index or composite measure of 57 items (8 items of each area plus 9 item of receivable management area) on nine-point scales. Using index or composite measurements as mentioned above to measure the efficiency of financial management practices aims at increasing the validity of measurements. However, a large number of variables related to financial management practices made data analysis more difficult and complicated. Factor analysis is often used to overcome this obstacle by grouping together variables that are highly correlated into principal components and, as a result, bring a simplification to analysis (Lehmann, Gupta, and Steckel, 1998). The fifty-seven items (as indicated in section 4.4 of chapter 4) of financial management practices of 150 SMEs in the sample were used as input for the SPSS (Statistical Package for Social Science) computer program to obtain the principal components. Each principal component is a linear combination of items of the financial management practices. Coefficients of the items of financial management practices used to construct principal components are called factor loadings. The proportion of variation explained by each principal component is found by dividing the sum of squared loadings (known as Eigen value) by the number of items of financial management practices. By using Kaiser s (1960) significant rule, which suggested principal components with Eigen values greater than unity should be considered statistical 216

236 Chapter Five: Data Analysis and Findings Table 5.34: Total variance explained and three principal components of financial management practices Initial Eigenvalues Extraction sums of squared loadings Rotation sums of squares loadings Co. Total % of Variance Cumulative % Total % of Variance Cumulative % Total % of Variance Cumulative % E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E Extraction Method: Principal Component Analysis. 217

237 Chapter Five: Data Analysis and Findings significant, three principal components with Eigen values greater than unity were retained (Table 5.34, page 217). These three principal components account for percent of the variation in the original data set consisting of fifty-seven items of financial management practices. Cumulative variance explained by the three principal components and their Eigen values are shown in Table 5.34 (page 217). Table 5.34 identified three principal components of financial management practices. However, since all items of financial management practices make a contribution to each principal component, one of the difficulties in principal component analysis is the interpretation of principal components. To facilitate an easier interpretation of principal components, factor rotation methods were developed. This research study uses varimax orthogonal rotation method developed by Kaiser (1958) because this method is widely used (Chaganti et al., 1989, Weinrauch et al., 1991, Meric and Meric, 1992, Serwinek, 1992, and Busenitz, 1996). This rotation method is based on the criterion of maximizing the factor loadings of dominant variables in each principal component. Kaiser s (1958) varimax rotation facilitates an easier interpretation of principal components. The factor loadings of the three principal components are presented in Table 5.35 (page 219). The three principal components representing various financial attributes of the firms can be named in accordance with the factor loadings of the fifty-seven items of financial management practices as shown in Table Table 5.36: Three principal components of financial management practices Com. Name of the principal component Eigen Cumulative variance value explained (%) 1 Working capital management and short-term planning practices (~29.97) 2 Fixed asset management and long-term planning practices (~58.27) 3 Financial and accounting information practices (~84.14) Source: Data analysis for the study The product of the squared root of the Eigen value of the principal component and the factor loadings of each financial management practice items shows the correlation between the principal component and the financial management practice item. Therefore, the financial management practice item with the highest factor loadings in the three statistically significant principal components are presented in Table 5.35 (page 219). 218

238 Chapter Five: Data Analysis and Findings Table 5.35: Factor analysis results for measuring financial management practices Component Regard accounting information system Prepare accounting information system Update accounting information system Managers/owners involve in preparing accounting information system Managers/owners involve in interpreting accounting information system Acceptability of accounting information system Usefulness of accounting information system Computerization of accounting information system Regard to financial reporting and analysis Frequency of preparing financial statements Owners/managers involve in preparing financial statements Owners/managers involve in interpreting financial statements Usefulness of financial statements Frequency of financial statement analysis Usefulness of financial ratios Computerization of financial reporting & analysis Regard to cash management practices Preparing cash budget Owners/Managers involve in preparing cash budgets Owners/Managers involve in interpreting and using cash budget Usefulness of cash budget Application of cash management theories Acceptability of target cash balance Computerization of cash management Regard to receivables management practices Review debt 's discount period Reasonability of debts' credit period Review debt 's discount policy Discount policy Review percentage of bad debts Reasonability of percentage of bad debts Frequency of implementation of receivable management theories Computerization of receivable management Regard to inventory management practices Review inventory turnover Review inventory level Inventory turnover Acceptability of inventory level Usefulness of inventory budgets Application of inventory management theories Computerization of inventory management Regard to fixed asset management Regard to assessing capital projects Review capital projects Acceptability of capital budgeting Apply techniques of capital budgeting Reasonability of utilizing fixed assets Usefulness of fixed assets acquired Computerization of fixed assets management Regard to financial planning Prepare financial budgets Owner/manager involve in preparing financial budgets Owner/manager involve in interpreting and using financial budgets Usefulness of financial budgets in providing information for making decisions Compare between actual and budgeted results Acceptability of financial planning techniques used Computerization of financial planning Extraction Method: Principal Component Analysis. Rotation Method: Varimax with Kaiser Normalization. 219

239 Chapter Five: Data Analysis and Findings The names given to the three statistically significant principal components are shown in Table 5.36 (page 218). In accordance with the factor loadings of financial management items making the greatest contribution to the first principal component, it was named Working Capital Management and Short-term Planning Practices. This principal component accounts for percent of the total variation in the original data set. Similarly, the factor loadings of financial management items making the greatest contribution to the second principal component, it was named Fixed Asset Management and Long-term Planning Practices. The second principal component accounts for 28.30% (58.27% minus 29.97%) of the total variation in the original data set. Finally, the factor loadings of financial management items making the greatest contribution to the third principal component, it was named Financial and Accounting Information System. The third principal component explains 25.87% (84.14% minus 58.27%) of the total variation in the original data set. Cumulatively, three principal components explained percent of the total variation in the original data set. In summary, factor analysis is a useful statistical tool to reduce a large set of correlated variables to fewer unrelated dimensions and identifies a typology (Laitinen, 1991). In this study, factor analysis was used to group and reduce fifty-seven financial management practice items, which were used to measure the efficiency of financial management practices, in the original data set into three principal components of financial management practices. Three principal components include (1) working capital management and short-term planning practices (WCSP), (2) fixed asset management and long-term planning practices (FALP), and (3) financial and accounting information system (FAIS). These principal components will be used as the independent variables replacing the fifty-seven items related to financial management practices and the variable measuring the efficiency of financial management practices (EFF), which was developed in chapter 4 to measure the efficiency of financial management practices. In subsections and 5.4.3, as examining the relationship between profitability and financial management, the three variables: WCSP, FALP, and FAIS are used as the independent variables together with other independent variables such as current ratio (CUR), debt ratio (DER) and total asset turnover (TAT). 220

240 5.4.2 Bivariate analysis and findings Chapter Five: Data Analysis and Findings Bivariate analysis is used for tests of association to investigate the relationships between variables and reports the results on a correlation matrix before utilizing multiple regression analysis. This is widely used by previous researchers (Murphy III, 1989; Litz and Stewart, 2000). As indicated in chapter 4 and subsection 5.4.1, variables used in this research study include the following: Dependent variables consisting of return on sales (ROS), return on assets (ROA), return on equity (ROE), and profitability (PRO) defined as the average of ROS, ROA and ROE Independent variables consisting of current ratio (CUR), debt ratio (DER), total asset turnover (TAT), working capital management and short-term planning practices (WCSP), fixed asset management and long-term planning practices (FALP), and financial and accounting information system (FAIS). Correlation matrixes are used for association analysis to determine whether correlation and multicollinearity exist between variables Association between profitability and return on sales, return on assets and return on equity As indicated in chapter 4, this research study uses four variables: ROS, ROA, ROE, and PRO as variables to measure profitability of SMEs. The correlation matrix of PRO, ROS, ROA, and ROE are created to analyse correlation between these variables. The objective of this analysis is to determine whether a single measure or many measures of profitability should be used and, as a result, one model or many models should be tested. In measuring correlation between these variables, the Pearson s correlation coefficient is widely used for variables measured by ratio or interval scales (Emory, 1985; Davis, 1996; and Zikmund, 1997, p.627). Table 5.37 (page 222) below presents the correlation matrix of variables measuring profitability of SMEs in the sample. 221

241 Chapter Five: Data Analysis and Findings Table 5. 37: Correlation matrix of PRO, ROS, ROA, and ROE Profitability Return on sales Return on assets Return on equity (%) (%) (%) Profitability (PRO) **.924**.942** Return on sales (ROS).400** Return on assets (ROA).924** ** Return on equity (ROE).942** ** ** Correlation is significant at the 0.01 level (2-tailed). The correlation matrix (Table 5.37) shows that profitability (PRO) and return on sales (ROS), return on asset (ROA), and return on equity (ROE) are positively correlated with the correlation coefficients r = 0.400, and (at 0.01 significant level) respectively. Very high correlation coefficients between profitability and return on asset and between profitability and return on equity are considered sufficient to warrant that only one variable (PRO) needs to be analysed. However, the positive relationship with correlation coefficient r = between profitability and return on sales is not considered sufficiently high to warrant only one measure of profitability and, thus, the measures are analysed independently. As such, after examining the correlation between dependent variables, two variables: ROA and ROE were dropped because they are highly correlated with PRO. Consequently, only ROS and PRO are used as dependent variables to measure profitability of SMEs and two models of SME profitability are tested in this research Association between financial management practices, financial characteristics and profitability This subsection uses correlation matrix to investigate the correlation between financial management practices, financial characteristics and profitability of SMEs. Objectives of this analysis are to discover the relationship between the dependent variable (ROS or PRO) and independent variables and to determine whether the multicollinearity exists. According to Murphy III (1989), multicollinearity indicates a problem in multiple regression analysis. As the independent variables have a high probability of correlation, the regression coefficient (the bs) becomes less reliable, and confidence in the accuracy 222

242 Chapter Five: Data Analysis and Findings of the equation is questioned. A general rule is that if a correlation between any two independent variables is greater than or equal 0.70, then a high degree of interrelationship can be inferred, and the possibility of multicollinearity exists (Murphy III, 1989). Correlation matrix as shown in Table 5.38 is used to determine whether relationships between financial characteristics, financial management practices and profitability and multicollinearity among independent variables exist. Table 5.38: Correlation matrix of PRO and independent variables Profit- Current Debt Total WCSP FALP FAIS ability ratio ratio asset turnover Profitability ** **.399**.498**.343** Current ratio -.553** ** ** -.299** -.310** Debt ratio ** * Total asset turnover.381** **.130 Working capital management and short-term planning practices.399** -.281** (WCSP) Fixed asset management and longterm planning practices (FALP).498** -.299** ** Financial and accounting information system (FAIS).343** -.310**.209* ** Correlation is significant at the 0.01 level (2-tailed). * Correlation is significant at the 0.05 level (2-tailed). The first row of Table 5.38 shows the correlation coefficients between PRO and the independent variables. As expectedly, the relationships between profitability and working capital management and short-term planning practices, fixed asset management and long-term planning practices, and financial and accounting information system are significantly positive with respective correlation coefficients r = 0.399; 0.498; and Table 5.38 also shows the significantly positive correlation between profitability and total asset turnover with r = Conversely, Table 5.38 reveals the relationships between profitability and current ratio is significantly negative with correlation coefficients r = In addition, Table 5.38 shows significant inter-correlation among variables in which current ratio is be found to negatively correlate to debt ratio (r = ), working capital management and short-term planning practices (r = ), fixed asset management and long-term planning practices (r = ), and financial and accounting 223

243 Chapter Five: Data Analysis and Findings information system practices (r = ). Similarly, inter-correlation is also found among other variables. However, correlation coefficients are not strong enough to cause multicollinearity because, as indicated by Murphy III (1989), if a correlation between any two independent variables is greater than or equal 0.70, then the possibility of multicollinearity exists. The first row of Table 5.39 shows the correlation coefficients between ROS and the independent variables as well as among independent variables. Table 5.39: Correlation matrix of ROS and the independent variables Return Current Debt on sales ratio ratio (%) Total asset turnover WCSP FALP FAIS Return on sales (%) ** **.248** * Current ratio -.286** ** ** -.299** -.310** Debt ratio ** * Total asset turnover -.256** **.130 Working capital management and short-term planning practices (WCSP).248** -.281** Fixed asset management and longterm planning practices (FALP) ** ** Financial and accounting information system (FAIS).168* -.310**.209* ** Correlation is significant at the 0.01 level (2-tailed). As expected, the relationship between return on sales and working capital management and short-term planning practices is significantly positive with r = Return on sales and financial and accounting information system practices are also positively but not strongly correlated with r = and a significance level of Conversely, Table 5.39 reveals the relationships between return on sales and current ratio, and between return on sales and total asset turnover are significantly negative with correlation coefficients r = and respectively. However, Tables 5.39 demonstrates there are no significant relationships between return on sales and debt ratio as well as between return on sales and fixed asset management and long-term planning practices. Bivariate analysis with using Pearson s correlation coefficients and presenting the results by correlation matrix only examines association between the dependent variable and each of independent variables. It is not appropriate and, thus, could not used to 224

244 Chapter Five: Data Analysis and Findings examine the simultaneous impact of many independent variables on dependent variable, whereas multivariate analysis is appropriate for examining the simultaneous impact of many independent variables on the dependent variable (Zikmund, 1997) Multiple regression analysis and findings In this subsection, multiple regression analysis was used to determine whether independent variables (CUR, DER, TAT, WCSP, FALP and FAIS) simultaneously impact the dependent variable (ROS or PRO). As a result, the subsection examines whether the multiple regression equation can be used to explain the causal theory of impact of financial characteristics and financial management practices on SME profitability Simultaneous impact of financial characteristics and financial management practices on SME profitability (Model 1) For this model, profitability was used as the dependent variable and independent variables included current ratio, debt ratio, total asset turnover, working capital and shortterm planning practices, fixed asset management and long-term planning practices, and financial and accounting information systems. The relationship between dependent variable and independent variables, and results of testing significance of the model have been respectively interpreted. In interpreting the results of multiple regression analysis, three major elements considered were the coefficient of multiple determination, the standard error of estimate and the regression coefficients (Emory, 1985; Davis, 1996; Lehmann, Gupta, and Steckel, 1998). These elements and the results of multiple regression analysis were presented and interpreted in Table 5.40 below. Firstly, Table 5.40 (page 226) reveals that SME profitability and financial characteristics (measured by current ratio, debt ratio and total asset turnover) and financial management practices (measured by working capital management and shortterm planning practices, fixed asset management and long-term planning practices, and financial and accounting information system) are significantly correlated with the correlation coefficient R = Table 5.40 also reports the model of SME profitability 225

245 Chapter Five: Data Analysis and Findings with the coefficient of determination R 2 = at a significant level of p = The coefficient of determination indicated that 60.8% of the variation in profitability for the sample of 150 SMEs can be explained by the changes in 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 system while 39.2% remains unexplained. In addition, Table 5.40 reports the summary ANOVA (analysis of variance) table and F statistic, which reveals the value of F (36.994) is significant at the level. The value of F is large enough to conclude that the set of independent variables (CUR, TAT, WCSP, FALP, and FAIS) as a whole was contributing to the variance in SME profitability and therefore the model represents actual performance of SMEs (Keller, Warrack, and Bartel, 1994; Davis, 1996). Table 5.40: SME profitability regression model using profitability as dependent variable Unstandardized Std. Error Standardized t Sig. Coefficients Coefficients Model B Beta 1 (Constant) Current ratio Debt ratio Total asset turnover Working capital management and shortterm planning practices Fixed asset management and long-term planning practices Financial and accounting information system practices Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate ANOVA b Model Sum of Squares df Mean Square F Sig. 1 Regression a Residual Total a Predictors: (Constant), Financial and accounting information system practices, Fixed asset management and long-term planning practices, Working capital management and short-term planning practices, Debt ratio, Total asset turnover, Current ratio b Dependent Variable: Profitability (%) The remaining step in the evaluation of the regression equation is to estimate the contribution of each independent variable in the study. Generally, all independent variables, except debt ratio, significantly contributed in variance of profitability at a 226

246 Chapter Five: Data Analysis and Findings significance level of However, the relative importance of association of each independent variable was different. This was evaluated and interpreted by the standardized coefficients of correlation (beta). Current ratio Profitability was negatively related to current ratio with β = at a significance level of and support was found for hypothesis one, which stated that current ratio is negatively related to profitability. This finding is also consistent with Van Horne (1986) s theory of relationship between profitability and liquidity. The greater the relative proportion of liquid assets, the less risk of running out of cash profitability unfortunately, also will be less resolution of trade-off between risk and profitability with respect to these decisions depends upon the risk preferences of management (Van Horne, 1986). As such the result of testing indicated hypothesis one, which was based on Van Horne s (1986) theory, was strongly supported. This implies that SMEs that have relatively high current ratios will be less profitable and vice versa. Additionally, it provided empirical evidence to support the theory of relationship between profitability and liquidity developed by Van Horne (1986) and explained why the percentage of SMEs that were not profitable is relatively high in this research study. This finding is also consistent with the descriptive finding of relationship between profitability and current ratio as shown in Table 5.41 below. Table 5.41: Descriptive finding of relationship between profitability and current ratio Profitability Total Not profitable Profitable No. % No. % No. % Current ratio Below % % % From 1 to % % % From 1.51 to % % % More than % % % Total % % % Source: Data analysis for the study Table 5.41 shows all SMEs with current ratio below 1 are profitable, and the higher current ratio, the higher percentage of unprofitable SMEs. 227

247 Chapter Five: Data Analysis and Findings Debt ratio Table 5.40 (page 226) shows the relationship between profitability and debt ratio is not significant and, as a result, hypothesis two, which stated that debt ratio is positively related to profitability, was not supported. While unexpected, this could be explained by two reasons. Firstly, profitability was not found to be significantly related to the debt ratio and this might have occurred because the current ratio and the debt ratio are related concepts. The correlation with r = could indicate multicollinearity in the model. However, it is not high enough (r <0.7) to question the validity of the regression model. Secondly, profitability and debt ratio are not always linear related as indicated by Edward and Cooley (1979). In general, whenever the return on assets exceeds the cost of debt, leverage is favourable, and the higher leverage factor, the higher the rate of return on common equity. When the rate of return on assets exceeds the cost of debt, debt ratio is positively related to profitability. However, when the debt ratio is continually increasing, the cost of debt will be increased and profitability will decrease. At this point, the debt ratio is negatively related to the profitability. Figure 5.3 (page 228) shows the relationship between the debt ratio and profitability by which the relationship may be considered in two phases. At the first phase, the debt ratio is below 0.6 and the profitability and debt ratio are positively related. However, at the second phase, as the debt ratio increases over 0.6 the profitability and debt ratio are negatively related. This may be explained as follows. When the debt ratio exceeds 0.6 the debt-to-equity will exceed 1. At that point, one dollar of firm assets is corresponding to more than one dollar of debts. Consequently, firms will increase risk, the cost of debt will be increased and profitability decreases. Therefore, at this phase, profitability is negatively related to debt ratio. As such, debt ratio is not linearrelated to profitability but cubic-related as shown in figure 5.4. However, financial leverage is a complicated issue and the detailed explanation of this issue is beyond this research study. It should be considered and discussed in further research. 228

248 Chapter Five: Data Analysis and Findings Figure 5.4: Relationship between profitability and debt ratio MODEL: MOD_1. Independent: DER Dependent Mth Rsq d.f. F Sigf b0 b1 b2 b3 PRO LIN PRO CUB Profitability Observed Linear Cubic Debt ratio Total asset turnover Table 5.40 (page 226) shows the result of t-test with t- statistic = and β = Profitability was found to be positively related to total asset turnover at a significance level. This finding supports hypothesis three, which stated that profitability is positively related to total asset turnover. It is implied that the higher total asset turnover SMEs, the more profitable they become. However, total asset turnover with β = is not relatively important compared to the current ratio (β = 0.256) in contributing to variance of SME profitability. Efficiency of financial management practices Table 5.40 (page 226) reveals that profitability is positively related to working capital management and short-term planning practices with β = and at significant level. Similarly, profitability was found to be positively related to fixed asset management and long-term planning practices and financial and accounting information system with β = and

249 Chapter Five: Data Analysis and Findings respectively and at a significance level of As such, strong support was found for hypothesis four, which was developed in chapter 4 and stated that profitability is positively related to the efficiency of financial management practices. This finding is also consistent with the descriptive finding of the relationship between profitability and the efficiency of financial management practices of SMEs in the sample as shown in Table 5.42 below. Table 5.42: Relationship between SME profitability and the efficiency of financial management practices Profitability Total Not profitable Profitable No. % No. % No. % Efficiency Inefficient financial % 5 5.1% % management Efficient financial management % % % Total % % % Source: Data analysis for the study Table 5.42 above shows that the proportion of profitable SMEs is much higher for SMEs that are efficient in financial management practices, while the proportion of unprofitable SMEs is much higher for SMEs that are not efficient in financial management practice. Finally, Table 5.40 (page 226) shows that correlation coefficients of variables of financial management practice are higher than that of financial characteristics. This suggests that variables of financial management practices are more important than financial characteristics in contributing to variance of SME profitability. In summary, the results of multiple regression analysis in Table 5.40 revealed that SME profitability was influenced by financial characteristics and financial management practices at the significance level of , and 60.8 percent of variation in SME profitability (R 2 = 0.608) can be accounted for variance in financial characteristics and financial management practices. Specifically, findings of the impact of financial characteristics and financial management practices on SME profitability are summarized as follows: 230

250 Chapter Five: Data Analysis and Findings Current ratio is negatively related to SME profitability at a significance level of and with the standardized correlation coefficient of Debt ratio was not found to be related to SME profitability. Total asset turnover is positively related to SME profitability at a significance level of and with the standardized correlation coefficient of All variables of financial management practices (WCSP, FALP, and FAIS) are positively related to SME profitability at a significance level of and with the standardized correlation coefficients of 0.305, and respectively. In addition, variables of financial management practices are found to be more important than that of financial characteristics in contributing to variation of SME profitability. As indicated earlier (page 228), because debt ratio was not related to SME profitability it should be remove from the multiple regression equation to improve the accuracy of the model (Murphy III, 1989). After removing the debt ratio and rerunning the program, the results of multiple regression analysis are shown in Table Table 5.43: Regression model of SME profitability after removing debt ratio Unstandardized Std. Error Standardized t Sig. Coefficients Coefficients Model B Beta 1 (Constant) Current ratio Total asset turnover Working capital management and short-term planning practices Fixed asset management and long-term planning practices Financial and accounting information system practices Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate ANOVA b Model Sum of Squares df Mean Square F Sig. 1 Regression a Residual Total a Predictors: (Constant), Financial and accounting information system practices, Fixed asset management and long-term planning practices, Working capital management and short-term planning practices, Total asset turnover, Current ratio. b Dependent Variable: Profitability 231

251 Chapter Five: Data Analysis and Findings Table 5.43 reveals that all statistical parameters including F-value, t-test statistics and standard error of estimate have been significantly improved after removing the debt ratio from the multiple regression equation Simultaneous impact of financial characteristics and financial management practices on return on sales (Model 2) In the second model, return on sales (ROS) is used as the dependent variable while independent variables including current ratio, debt ratio, total asset turnover, working capital management and short-term planning practices, fixed asset management and longterm management practices, and financial and accounting information system. Table 5.44 reports the results of testing the model and following are the findings and result interpretation. Table 5.44: SME profitability regression model using return on sales as dependent variable Unstandardized Std. Error Standardized t Sig. Coefficients Coefficients Model B Beta 2 (Constant) Current ratio Debt ratio Total asset turnover Working capital management and shortterm planning practices Fixed asset management and long-term planning practices Financial and accounting information system practices Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate ANOVA b Model Sum of Squares df Mean Square F Sig. 2 Regression a Residual Total a Predictors: (Constant), Financial and accounting information system practices, Fixed asset management and long-term planning practices, Working capital management and short-term planning practices, Debt ratio, Total asset turnover, Current ratio b Dependent Variable: Return on sales(%) Table 5.44 (page 232) reports the model representing the impact of financial characteristics and financial management practice on return on sales with the coefficient 232

252 Chapter Five: Data Analysis and Findings of determination R 2 = at a significant level of p = The coefficient of determination indicated that 25.1% of the variation in return on sales is explained by the five independent variables used to measure financial characteristics and financial management practices, while 74.9% remains unexplained. In addition, Table 5.44 reveals the value of F = is significant at the level. The value of F is not high as that of F in the first model but it is large enough to conclude that the set of independent variables (CUR, TAT, WCSP, FALP, and FAIS) as a whole was contributing to the variance in return on sales and the model is useful (Keller, Warrack, and Bartel, 1994; Davis, 1996). The next step is to evaluate significance of correlation coefficients of independent variables. Current ratio Similar to profitability, return on sales was negatively related to the current ratio at 0.05 but not at a significance level of (Table 5.44, page 232). This finding is also consistent with Van Horne (1986) s theory of relationship between profitability and liquidity. As such, return on sales of SMEs that have relatively higher current ratios will be lower and vice versa. Debt ratio Table 5.44 (page 232) shows the relationship between return on sales and debt ratio is not significant. This is unexpected and could be explained that the return on sales was not found to be significantly related to the debt ratio and this might have occurred because current ratio and debt ratio are related concepts. The correlation between current ratio and debt ratio with r = could indicate multicollinearity in the model. However, it is not high enough (r <0.7) to question the validity of the regression model. Total asset turnover Unlike profitability, return on sales was found negatively and strongly related to total asset turnover with β = and at a significance level of (Table 5.44, page 232). This is reasonable and expected because total asset turnover is defined as sales divided by total assets, while return on sales is defined as net profit divided by sales. If total asset turnover increases as the result of an increase in sales then return on sales will decrease because return on sales is calculated by dividing net profit by sales. Efficiency of financial management practices Three principal components of financial management practices including working capital management and short-term 233

253 Chapter Five: Data Analysis and Findings planning practices, fixed asset management and long-term planning practices, and financial and accounting information system are found to positively relate to return on sales with respective correlation coefficients 2.954; and at a significance level of This finding also supports the hypothesis of a positive relationship between profitability and the efficiency of financial management practices. The results of multiple regression analysis in the case of return on sales used as the dependent variable conducted earlier shows findings as that of multiple regression analysis in the case of using SME profitability as the dependent variable, with the exception of two differences as follows: Total asset turnover was found to be negatively related to return on sales while it was found to be positively related to SME profitability. Variables measured the efficiency of financial management practices were positively related to return on sales at 0.05 significant levels while they were related to SME profitability at a significance level of Test for the difference of average profits between efficient and inefficient financial management groups of SMEs As indicated in chapters 1 and 4, financial management practices included accounting information system, financial reporting and analysis, cash management practices, receivable management practices, inventory management practice, fixed asset management practices, and financial planning. The extent of efficiency of each financial management component is measured by the sum of points of eight items on the ninepoint scale (1 = not efficient at all, 9 = very efficient). If the sum of points of a financial management component of a business is not less than the average point of 40, the business is said to be efficient in applying that aspect of financial management. Conversely, if the sum of a component is less than the average point of 40, the business is said to be not efficient or inefficient in applying that component of financial management. Lastly, a business is said to be efficient in financial management practices, 234

254 Chapter Five: Data Analysis and Findings if all components of financial management practices are efficient. That means all sums of points of components are greater than the average point of 40. Based on the criteria mentioned above, the sample of 150 SMEs were divided into two groups. The first included SMEs that were not efficient in financial management practices is labeled as inefficient group of SMEs, and the second consisting of SMEs that were efficient in financial management practices is labeled as efficient group of SMEs. This subsection presents the result of testing the hypothesis of difference in mean profits of two groups of SMEs. Table 5.45 summarizes descriptive statistics of profitability of the two groups of SMEs. The inefficient group of SMEs (41 SMEs) had mean profit return of 3.19% while the efficient group of SMEs (109 SMEs) had mean profit return of 9.10%. This reveals that the mean profit of the efficient group was nearly three times that of the inefficient group. Table 5.45: Descriptive statistics of profitability of two groups of SMEs N Mean Std. Deviation Std. Error Mean Inefficient financial management Efficient financial management Source: Data analysis for the study Statistical test was conducted to determine whether the mean profit of the efficient group of SMEs was greater than that of the inefficient group. A hypothesis was developed in chapter 4 and following is the result of testing the hypothesis of difference in the mean profits of the two groups of SMEs (Table 5.56). Table 5.46: Independent group test of mean profit difference t-test for equality of means t df Sig. (2- tailed) Mean difference Std. error difference Profitability Equal variances assumed Equal variances not assumed Source: Data analysis for the study The result of testing shown in Table 5.46 reveals that the null hypothesis of equality of mean profits of two groups is rejected at a significance level of Consequently, the hypothesis five indicated in chapter 4, which was stated that the mean 235

255 Chapter Five: Data Analysis and Findings profit of SMEs that are efficient in financial management practices is different from that of SMEs that are not efficient in financial management practices, was strongly supported. It is concluded that the mean profit of SMEs that are efficient in financial management practices was greater than that of SMEs that are not efficient. 5.5 CONCLUSIONS In relation to research objectives and questions, the result of data analysis as presented in chapter 5 provides descriptive findings of financial management practices and financial characteristics of SMEs in Vietnam. SMEs in the sample were found to maintain a relatively high liquidity ratio, low debt ratio and moderate total asset turnover. More sophisticated statistical techniques were applied to analyze the relationships between financial characteristics, financial management practices and SME profitability. The results of multiple regression analysis indicated that SME profitability is simultaneously influenced by financial characteristics (measured by CUR and TAT) and financial management practices (measured by WCSP, FALP, and FAIS). SME profitability was found to be positively related to total asset turnover, working capital management and short-term planning practices, fixed asset management and long-term planning practices, and financial and accounting information system at the significant level of In contrast, SME profitability was found to be negatively related to the current ratio. However, this study could not demonstrate the relationship between SME profitability and the debt ratio. Consequently, support was found for the hypotheses one, three and four but not for the hypothesis two. To emphasize the importance of financial management practices and the impact of the efficiency of financial management practices on SME profitability, the hypothesis of difference in mean profit of two groups of SMEs was also tested. The result of testing indicated that the mean profit of SMEs that are efficient in financial management practices is greater than that of SMEs are not efficient in financial management practices. This result is empirical evidence to demonstrate SMEs that they should pay more attention to financial management practices if they want to improve their profitability and survive in the uncertain business environment in Vietnam. 236

256 Chapter Six: Conclusions And Implications 6.1 INTRODUCTION Chapter 5 presented data analysis and findings of the research study including descriptive and associated findings in relation to the research questions and objectives. The thesis ends with chapter 6 where conclusions drawn from data analysis and implications of the research study will be respectively summarized and presented. The objectives of chapter 6 are (1) to summarize conclusions of financial management practices, financial characteristics, and profitability of SMEs in the sample and the results of testing the model of SME profitability, (2) to indicate how the research study can be implemented by financial practitioners and the Government to improve profitability of the firm, and (3) to suggest further research in the future. This chapter is structured into five sections. Section 6.1 introduces the objectives and structure of the chapter. Section 6.2 summarizes conclusions related to the research questions and testing the model including conclusions on financial management practices, financial characteristics and SME profitability, and conclusions and revision of the model of SME profitability. Section 6.3 indicates how the research study can be applied to financial management practices of SMEs and knowledge of financial management for SMEs in general. Section 6.4 examines the limitations of the research study, and section 6.5 ends the chapter by raising implications and suggestions for further research. Figure 6.1 provides a visual picture of the chapter outline and links among sections as indicated earlier.

257 Chapter Six: Conclusions and Implications Figure 6.1: Structure of chapter Introduction 6.2 Conclusions related to research questions and testing the model Conclusions related to financial management practices Conclusions related to financial characteristics Conclusions of SME profitability Summary of research question answers 6.3 Implications of the research study Implications for financial management practices of SMEs Contributions to knowledge of this research into financial management for SMEs 6.4 Limitations of the research study 6.5 Implications for further research Source: Developed for this thesis 238

258 Chapter Six: Conclusions and Implications 6.2 CONCLUSIONS RELATED TO RESEARCH QUESTIONS AND TESTING THE MODEL This section summarizes conclusions related to the research questions and testing the model analyzed and presented in chapter 5. Conclusions of financial management practices, financial characteristics, and SME profitability are respectively presented in subsections 6.2.1, 6.2.2, and while subsection presents conclusions and the revised model of SME profitability Conclusions related to financial management practices As indicated in chapter 1, one of the objectives of the research was to collect empirical evidence of financial management practices to describe behaviours of SMEs in practising financial management. This subsection summarizes findings of financial management practices of SMEs in the sample Accounting information system practices Descriptive findings of accounting information system practices were investigated and reported in subsection of chapter 5 (Tables 5.4, 5.5, and 5.6, page 190, 191, and 192). From these tables the following conclusions related to accounting information system practices of SMEs are listed. Firstly, 100 percent of SMEs have systems for accounting information organized formally (Table 5.4, page 1990). This finding demonstrates that all SMEs legally organized in the form of private enterprise, limited liability company or joint stock company have organized and maintained formal accounting information systems in which two kinds of financial statements, balance sheets and income statements, are frequently and regularly prepared. This is a prerequisite for examining practices of financial reporting and analysis. Secondly, employed accountants and chief-accountants still play an important role in carrying out most accounting responsibilities whereas external accountants have not been engaged by firms effectively (Table 5.5, page 191). This finding reveals that, to date, the external accountants have not been regularly engaged and 239

259 Chapter Six: Conclusions and Implications most SMEs continue to use employed accountants in their businesses. This proved that the central-planned management mechanism continues to strongly affect management styles of SMEs after a decade of policy reform and transformation to a market economy. Thirdly, chief-accountants are frequently employed for more sophisticated accounting responsibilities such as preparing and interpreting accounting reports while employed accountants are mainly employed for recording business transactions (Table 5.5, page 191). This finding shows that the chief-accountant still plays an important role in controlling financial position of SMEs. Most SMEs appoint a chief-accountant who is responsible for controlling financial matters whereas the financial manager position is rarely found in businesses. These indicate continuity of old management styles, which have not been changed after a decade of reform. Finally, most SMEs have frequently applied computers in their accounting information systems and the most frequent application of computers is to prepare accounting reports (Table 5.6, page 192). Although most respondents answered that they usually use computers in accounting information systems, the ability to apply accounting software is limited. This is an outcome of limitations of financial and human resources within SMEs, which means SMEs have difficulty in developing and carrying out projects providing accounting information system computerization Financial reporting and analysis practices As indicated in subsection of chapter 5 (page 192), findings of financial reporting and analysis practices were analyzed and presented in tables 5.7 to Based on these tables, conclusions and discussions of financial reporting and analysis practices of SMEs are summarized below. Almost 100 percent of SMEs produced financial statements including balance sheets and income or profit and loss statements prepared and analyzed frequently and regularly (Table 5.7, page 193). This shows that SMEs have a strong regard for financial reporting practices and preparing financial statements has become frequent for most 240

260 Chapter Six: Conclusions and Implications SMEs. However, other financial statements such as statements of cash flows and statements of funds are rarely prepared when compared with frequency of preparing balance sheets and income statements. This is consistent with the situations that statements of cash flows have only been mentioned in accounting information system in Vietnam in recent years. SMEs seem to be unfamiliar with preparing statements of cash flows. Most SMEs (about 70 percent) have prepared and analyzed their financial statements based on monthly periods. Nevertheless, about 2 percent of SMEs have never analyzed financial statements (Table 5.8, page 193). Quarterly periods were expected as the most frequently used for reporting. However the findings of financial reporting and analysis practices showed that monthly periods are frequently used by most SMEs. This may be explained in at least two ways. Firstly, SMEs in Vietnam must cope with the uncertainty of the business environment therefore updating and providing updated financial information for making decisions are necessary frequently. Secondly, most SMEs have employed accountants organized into a division of accounting headed by a chief-accountant thus preparing financial statements based on the monthly periods is quite feasible. In terms of kinds of financial analysis used, over half of the SMEs in the sample had frequently applied both trend analysis and ratio analysis (Table 5.10, page 194). Ratio financial analysis was relatively popular as a tool for evaluating and controlling financial position of the firms. Almost all financial ratios were applied. However, ratios of activity such as receivable turnover, inventory turnover, total asset turnover were most frequently used, but ratios of liquidity and ratios of profitability were used infrequently Working capital management practices Following patterns of many previous researchers, investigations and reports of working capital management practices in this research include three areas: cash management, receivable management and inventory management practices. Each were respectively analyzed and reported in subsections , and of chapter 5 (page 195). 241

261 Chapter Six: Conclusions and Implications For cash management, the following conclusions are reported. Firstly, about 80 percent of SMEs always or often prepare cash budgets, and preparing and reviewing cash budgets are frequently based on monthly periods (Table 5.11, page 196). The opinions of many researchers were supported by results of the survey (Appendix 2), which demonstrated that most of the owners or managers of SMEs have rarely been trained in skills of financial management. However, this research showed that SMEs are familiar with using cash budgets as a tool to plan and control cash flows of the firm. On the other hand, about 80 percent of SMEs determined cash balance based on the owner/manager s experience (Table 5.12, page 196). This suggests that experience is viewed as more important than theory in practising cash management. Only 2.7 percent of responding SMEs always or often face cash shortages for expenditure, while about 40 percent always or often have a surplus of cash (Table 5.13, page 197). Nevertheless, only 19 percent of SMEs deposit cash surpluses in bank accounts while up to 75 percent did not know how to use temporary cash surpluses for profits (Table 5.13, page 197). This finding reveals that cash surpluses rather than cash shortages are the major problem for SMEs. Another problem reported was how to invest the temporary cash surplus for profitable purposes. That SMEs have to keep high cash balances is acceptable under conditions of business environment uncertainty. However, this affects SME profitability and a trade-off between liquidity and profitability needs to be considered. As stated above, up to 75 percent of SMEs did not know how to invest cash surpluses for profitable purposes (Table 5.13, page 197). An explanation may be the fact that the money market has not developed in Vietnam, SMEs do not have access to money market instruments such as treasury bills, commercial papers, bank acceptances and similar instruments for short-term investment purposes. SMEs have not had opportunities to invest rather than not knowing how to invest temporary cash surpluses for profits. This conclusion suggests the need to develop money markets, which should be developed simultaneously with capital or stock markets instead of being separately developed as has happened in recent years. In addition to developing money markets, a recommendation for policy makers is that links between components of financial market including money market, capital market and foreign exchange market need to be developed and fostered. 242

262 Chapter Six: Conclusions and Implications Regarding receivable management, results of data analysis and findings were presented in subsection (page 198). Following are conclusions and discussion related to receivable management practices. Eighty percent of SMEs always or often sell their products or services on credit and 63 percent always or often set up their credit polices for the customers, whereas 7 percent of SMEs tend to sell on credit to anyone who wishes to buy (Table 5.14, page 198). This finding suggests that selling products or services on credit is a common trend for SMEs in Vietnam, especially under conditions of a strong competitive market. In consequence, receivable management practices have become extremely important and reviewing levels of receivables and bad debts need to be conducted frequently by SMEs. Therefore it was not surprising that most SMEs reported reviews of their levels of receivables and bad debts monthly. As a result, the percentage of bad debts was still controllable and maintained at an appropriate level (Table 5.16, page 199). The majority of SMEs reported the percentage of bad debt was less than 10 percent of sales. In inventory management practices, results of data analysis and findings were reported in subsection of chapter 5 (Table 5.17 and 5.18 page 200). Based on the results of data analysis, conclusions suggest that inventory management practices of SMEs have not been understood by management. Although they review inventory levels and prepare inventory budgets frequently, the ability to apply theories of inventory management in inventory budgeting is very limited. Over 90 percent of SMEs determine inventory levels based on owner/manager s experience and about 90 percent did not know of the Economic Order Quantity Model (Table 5.18, page 201). Like cash management, the owner s or manager s experience was again found to be more important than application of theories of inventory management. In summary, the survey found that SMEs strongly supported all areas of working capital management practices. Cash and inventory budgets are frequently prepared. Levels of receivables and inventory are reviewed frequently. However, SME owners have a low level of management knowledge, and owner/manager s experience has been seen to be more important than application of theories of financial management. Therefore training skills of financial management for the owners and managers is essential. 243

263 Chapter Six: Conclusions and Implications Fixed asset management practices Results of data analysis and findings of fixed asset management practices were examined and reported in subsection (page 201) of chapter 5. Following are conclusions on fixed asset management practices of the sample of 99 trading and 51 manufacturing SMEs. Firstly, near 80 percent of SMEs always or often evaluate capital projects before making decisions of investment, and review the efficiency of utilizing fixed assets after acquisitions. Some 87 percent of SMEs stated that they use payback period techniques in capital budgeting, only 27.3 percent use the more sophisticated discounted cash flows; that is, the net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR). These findings revealed that SMEs highly regard fixed asset management although their knowledge of management techniques is not outstanding. The majority of SMEs always or often evaluate capital investment projects before making decisions on investment. In addition, efficient utilization of fixed assets after investing is reviewed frequently. However, like the findings of previous researchers, this research indicated that payback-period methods are most popularly used in evaluating capital investment projects while the more sophisticated methods such as NPV, IRR or MIRR are rarely used. The predominance of the payback-period method can be attributed to its simplicity, emphasis on liquidity, and response to external financing pressures. Under the conditions of lack of long-term capital sources, uncertainty of business environment, and financial pressures, the payback capital period seems to be more important than profit return from a project as indicated by Block (1997): The firms (small firms) continue to be dependent on the payback method as the primary method of analysis. This is not necessarily evidence of a lack of sophistication, as much as it is a reflection of the financial pressures put on the small business owner by financial institutions. The question to be answered is not always how profitable the project is, but how quickly a loan can be paid back. 244

264 Chapter Six: Conclusions and Implications Financial planning practices Financial planning practices were analyzed based on tables 5.21, 5.22, 5.23, and 5.24 and findings were reported in subsection of chapter 5 (page 203). The following is summary of conclusions on financial planning practices of SMEs in the sample. Firstly, a majority of SMEs in the sample (76.6%) always or often prepares financial budgets in the process of business operations. This finding suggests that SMEs have relatively high regard for financial planning practices and they are relatively familiar with using financial budgets as tools of planning and controlling financial situation. Secondly, types of budgets such as sales, selling and administration expenses, labor and cash budgets are prepared by a majority of SMEs whereas fewer SMEs prepare the budgeted balance sheets and income statements. This finding suggests that SMEs in Vietnam rarely prepare the budgeted balance sheets and budgeted income statements, although they frequently prepare the actual balance sheets and income statements (Table 5.7, page 192). This is consistent with the current status that concepts of budgeted balance sheet and budgeted income statement are relatively new in Vietnam, they have only been introduced in recent years. Thirdly, the majority of SMEs have employed accountants and chief-accountants to prepare budgets whereas the percentage of SMEs engaging accountants to prepare financial budgets was not significant. That SMEs were found to be dependent upon the organizing and using employed or internal accountants while the external accountant are rarely used suggests that the old management styles, which existed with the centralplanned economy period, and remain have a relatively strong impact on management styles of SMEs in the 1990s. Finally, up to 83 percent of SMEs in the sample frequently compare budgeted and actual results and monthly periods are most popularly used in carrying out the comparisons. Subsections to above presented conclusions and discussion related to financial management practices of SMEs from the survey. These conclusions are summarized and reported in Table 6.1 (page 246). 245

265 Chapter Six: Conclusions and Implications Table 6.1: Summary of conclusions related to financial management practices Items Tables Conclusions Accounting information system 5.4; 5.5 & One hundred percent of SMEs have systems of accounting information organized formally. 2. Employed accountants and chief-accountants play an important role in carrying out most accounting responsibilities whereas external accountants have been extensively engaged. 3. Most SMEs have applied computers in their accounting information systems Financial reporting and analysis Working capital management Fixed asset management Financial planning 5.7; 5.8; 5.9 & ; 5.12 & 5.13; 5.14; 5.15 & 5.16; 5.17; & & ; 5.22; 5.23 & 5.24 and the most frequent application of computers is preparing accounting reports. 1. Nearly 100 percent of SMEs have financial statements including balance sheets and income (profit and loss) statements prepared and analyzed frequently. 2. Most SMEs (about 70 percent) prepare and analyze their financial statements based on the monthly periods. Nevertheless, about 2 percent of SMEs have never analyzed financial statements. 3. In financial analysis, about half of SMEs in the sample have frequently applied both trend and ratio analyses. 4. Ratios of activity such as receivable turnover, inventory turnover, total asset turnover are most frequently used, followed by ratios of liquidity and finally ratios of profitability. 1. In general, about 80 percent of SMEs always or often prepare and review cash budgets based on monthly periods. 2. Only 2.7 percent of responding SMEs always or often face cash shortages for spending while about 40 percent always or often have a surplus of cash. Nevertheless, only 19 percent of SMEs deposit cash surpluses into bank accounts while up to 75 percent did not know how or where to invest the temporary cash surplus for profit. 3. Eighty percent of SMEs always or often sell their products or services on credit and 63 percent always or often set up their credit polices for the customers. In addition, 7 percent of SMEs tend to sell on credit to anyone who wishes to buy, without reviews. 4. Most SMEs review their levels of receivables and bad debts monthly. As a result, the percentage of bad debts is controllable and maintained at a relatively appropriate level. 5. SMEs lack management knowledge. For example, although they often review inventory levels and prepare inventory budgets, the ability to apply theories of inventory management to inventory budgeting is limited. 1. Near 80 percent of SMEs always or often evaluate capital projects before making decisions on investment and review the efficiency of utilizing fixed assets after acquisitions. 2. Eighty-seven percent of SMEs stated that they used payback period techniques in capital budgeting, only 27.3 percent use the more sophisticated discounted cash flows; that is, the net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR). 3. These findings reveal SMEs relatively strongly regard to fixed asset management although their knowledge of sophistication management is not so high. 1. A majority of SMEs in the sample (76.6%) always or often prepares financial budgets in the process of business operation. 2. Budgets such as sales, selling and administration expenses, labor and cash budgets are prepared by a majority of SMEs whereas few SMEs prepare the budgeted balance sheets and income statements. 3. A majority of SMEs let employed accountants and chief-accountants prepare whereas few SMEs engage external accountants to prepare financial budgets. 4. Up to 83 percent of SMEs in the sample frequently compare budgeted and actual results monthly. 246

266 Chapter Six: Conclusions and Implications Conclusions related to financial characteristics This section summarizes conclusions on SME financial characteristics, which were analyzed and presented in section of chapter 5 (page 206). These conclusions relate to descriptive findings of liquidity, financial leverage, and business activity of SMEs in the sample Liquidity In this research, level of liquidity of SMEs was measured by current ratios. As analyzed and presented in subsection , SMEs were found to be in a strong liquidity position. A relatively high proportion of SMEs (90%) was found to have current ratios greater than one (Table 5.28, page 209). In addition, most SMEs were found to maintain relatively high current ratios. On average, the current ratio of trading SMEs was 2.50 while manufacturing SMEs was 2.47 (Table 5.25b and 5.25c, page 207). However, no significant difference in the current ratios between the two sectors was found (Table 5.26, page 208). This finding reveals that, on average, current assets of SMEs are two and half times higher than current liabilities. In other words, each dollar of current liabilities is offset by 2.5 dollars of current assets. In general, this is consistent with Vietnam s uncertain business environment and difficulties of SMEs in obtaining the external financing sources. However, maintaining a relatively high current ratio has adversely impacted on profitability of SMEs since cash surplus were generally not invested for profits Financial leverage Financial leverage was measured by business debt ratios. Analysis and findings of financial leverage were presented in subsection of chapter 5 (page 210). SMEs in the sample were found generally not to use financial leverage. Seventy-two percent of SMEs had debt ratios less than 30% while only about 10 percent had debt ratios more than 50% (Table 5.29, page 210). Debt has not been used to boost profitability. 247

267 Chapter Six: Conclusions and Implications As reported in Table 5.25a (page 207) the average debt ratio of SMEs in the sample was about 30%. In addition, the average debt ratios of trading and manufacturing SMEs were reported to be of 30% and 27% respectively. The t-test did not demonstrate any significant difference in debt ratios between the two groups of SMEs. With the debt ratio of 30%, SMEs presumably do not use significant debt finance. This is not surprising because SMEs in Vietnam have found difficulty in finding external financing sources. This may be explained. Firstly, financial markets, especially capital markets, in Vietnam have not been developed, SMEs are forced to rely on financing sources from commercial banks rather than actively mobilizing sources of funds from capital market. Secondly, commercial banks discriminate between SMEs and large companies in granting loans, especially long-term loans. State-owned commercial banks give priority to state owned companies rather than SMEs. Private and foreign commercial banks assume that SMEs are higher risk than large companies. Loans are difficult for SMEs to obtain Business activity Business activity in this study was measured by total asset turnover and descriptive findings of this ratio were analyzed and presented in subsection of chapter 5 (page 211). SMEs in the sample were found to have moderate total asset turnovers with an average ratio of 3.84 times (Table 5.25a, page 207). Over 80 percent of SMEs were found to have total asset turnovers exceeding one. These findings conclude that the efficiency in utilizing total assets by SMEs was relatively high. On average, SMEs produced 3.84 dollars of sales from each dollar of total assets and about 80 percent of SMEs produced more than one dollar of sales from one dollar of total assets. Table 6.2 (page 249) summarizes the main findings and conclusions of financial characteristics in which current ratio, debt ratio (or debt-to-equity ratio) and total asset turnovers were respectively used as the measures of liquidity, financial leverage and activity. 248

268 Chapter Six: Conclusions and Implications Table 6.2: Summary of conclusions related to financial characteristics of SMES Financial Main findings Characteristics Mean Range % Conclusions Current ratio 2.49 Below SMEs were found to have From 1 to relatively high current ratios More than Debt ratio 29% Below 30% 72.0 SMEs were found to have From 30 to 50% 18.7 Low financial leverage More than 50% 9.3 Total asset turnover 3.84 Below SMEs were found to be From 1 to moderate in total asset More than turnover Return on sales 4.20% Return on assets 7.51% Return on equity 10.75% Source: Summarized from Table 5.25a; 5.28; 5.29 and Conclusions of SME profitability This section summarizes conclusions of SME profitability, which was analyzed and reported in section 5.4 of chapter 5 (page 215). Firstly, the general conclusions of SME profitability are summarized, then, the conclusions related to the relationship between SME profitability and financial management practices, and financial characteristics are respectively summarized and discussed General conclusions of SME profitability Descriptive findings of SME profitability were analyzed and reported in subsection of chapter 5 (page 211). These findings generally revealed that 99 of 150 SMEs surveyed (66%) were profitable and the remainder (34%) were not profitable, that is, they could not produce an annual average profit return that was higher than the free-risk rate of interest (Table 5.31, page 213). The size of annual profits of SMEs was not high. Level of annual profit of SMEs in Vietnam is low compared to SMEs in other countries because of small firm size in terms of total assets and labor. In relation to the types of industry and forms of ownership, the following findings were found: The percentage of profitable SMEs in manufacturing industry was higher than that of the trading industry. 249

269 Chapter Six: Conclusions and Implications In terms of form of ownership, the percentage of profitable SMEs was found higher for private enterprises than for limited and joint stock companies. In terms of business size, the percentage of profitable SMEs was found higher for smaller businesses than for larger SMEs. In addition to descriptive findings and conclusions, this study is concerned with associative findings related to SME profitability. Subsection and respectively present conclusions of the relationships between SME profitability and financial management practices and relationships between SME profitability and financial characteristics Financial management practices and SME profitability By using factor analysis, fifty-seven items used to measure efficiency of financial management practices of SMEs were reduced to three principal components including (1) working capital management and short-term planning practices (WCSP), (2) fixed asset management and long-term planning practices (FALP), and (3) financial and accounting information system (FAIS) as presented in Table 5.36 (page 218). As analyzed and reported in Table 5.38 (page 223), these principal components were found to be significantly related to SME profitability with Pearson s correlation coefficients of 0.399; and respectively at a 0.01 significance level. This finding was expected and leads to the following conclusions: SME profitability is positively related to the efficiency of three principal components of financial management practices The more efficient financial management practices, the higher profitability By raising the efficiency of financial management practices, SMEs can improve their profitability. These conclusions bring about important implications in applying financial management and improving SME profitability, which are summarized in section 6.3 (page 258). 250

270 Chapter Six: Conclusions and Implications Financial characteristics and SME profitability As indicated in chapter 4 and reported in chapter 5, the financial characteristics of SMEs in this research are measured by three ratios: current ratio, debt ratio and total asset turnover. Associative findings of the relationship between SME profitability and these ratios were analyzed and reported in Table 5.36 (page 223). SME profitability was found to be negatively related to current ratio with the correlation coefficient of minus at a 0.01 significance level. This finding leads to the following conclusions: SMEs with higher current ratios are less profitable than SMEs with the lower current ratios Maintaining higher liquidity requires SME trading-off between the two objectives: liquidity or profitability and a wise policy of financial management should be to maintain an appropriate liquidity ratio in order to earn a reasonable profit. Secondly, SME profitability was found to be positively related to total asset turnover with a correlation coefficient of at a significance level of 0.01 (Table 5.38, page 223). This finding concludes that SMEs with high total asset turnover are expected to produce more profit than that with the lower total asset turnover. On the other hand, increasing total asset turnover by raising the efficiency of utilizing the total assets can help SMEs to improve profitability. Finally, SME profitability was not found to be significantly related to debt ratio. Bivariate analysis did not demonstrate any significant correlation between debt ratio and SME profitability. This finding was unexpected because SME profitability was assumed to be positively related to debt ratio. This may be explained since the relationship between debt ratio and SME profitability is not a simple linear relationship, therefore, bivariate analysis could not investigate this relation. A more detail study of financial leverage would be required to investigate this; however, it is beyond the objective of this research. 251

271 Chapter Six: Conclusions and Implications Simultaneous impacts of financial management practices and financial characteristics on SME profitability By using multiple regression analysis, this study investigated simultaneous impacts of financial management practices and financial characteristics on SME profitability. This analysis and its findings were presented in section of chapter 5 (page 225). Financial management practices (measured by the efficiency of three principal components including working capital management and short-term planning practices, fixed asset SME profitability and long-term planning practices, and financial and accounting information system) and financial characteristics (measure by current ratio, debt ratio and total asset turnover) are significantly correlated with a correlation coefficient of R = 0.78 at a significance level (Table 5.40, page 226). With the correlation coefficient of 0.78, financial management practices and financial characteristics were found to be strongly and simultaneously related to SME profitability. In other words, financial management practices and financial characteristics simultaneously impact on SME profitability. Additionally, t-test statistics were used to evaluate the impacts of each variable on SME profitability. Results revealed that, with the exception of debt ratio, all 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 significantly related to SME profitability. Specifically, current ratio was found to be negatively related to SME profitability with the standardized coefficient β = at a significance level. In contrast, total asset turnover was found to be positively related to SME profitability with β = at a significance level. Similarly, 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 positively related to SME profitability with β = 0.305, and respectively. These findings conclude that support was demonstrated for the hypotheses one, three and four but not for the hypothesis two. 252

272 Chapter Six: Conclusions and Implications Since the debt ratio was not related to SME profitability, it was removed from the multiple regression equation to improve the accuracy of the model (Murphy III, 1989). The analysis program was rerun to obtain a revised model of SME profitability, which is presented in section and Figure 6.2 (page 254) Difference in mean profits between efficient and inefficient financial management groups of SMEs This research study was also designed to test the hypothesis of differences in average or mean profitability between efficient and inefficient financial management groups of SMEs. Definitions and measurement of efficient and inefficient financial management were presented in sections 1.6 (page 10) of chapter 1 and (page 234) of chapter 5. A business is said to be efficient in financial management practices if all components of financial management practices are efficient. A component of financial management practices is said to be efficient if its sum of points, which is measured by 8 items on nine-point scales (1 = not efficient at al, 9 = Very efficient), is greater than the average point of 40 (8 x 5 point average). Testing the hypothesis of differences in mean profits of the two groups of SMEs was conducted and presented in section of chapter 5 (page 234). The result of the test rejected the null hypothesis of equality of mean profits of the two groups of SMEs (Table 5.46, page 235). Result of the test supports the hypothesis, which states that the mean profit of SMEs that are efficient in financial management practices is greater than that of SMEs, which are inefficient in financial management practices. This finding leads to the conclusion that the efficiency of financial management practices can bring about a higher profitability for SMEs. Therefore SMEs can improve their profitability by raising the efficiency of financial management practices The revised model of SME profitability This section presents the revised model of SME profitability, which was obtained after removing the debt ratio from the group of independent variables and rerunning the program. After removing the debt ratio and rerunning the program, the model of SME profitability was revised and presented in Figure 6.2 (page 254). This figure is derived 253

273 Chapter Six: Conclusions and Implications from Table 5.43 (page 231) based on the results of rerunning the multiple regression programs. Removing debt ratio improved the accuracy of the model while the coefficient of correlation (R) and the coefficient of determination (R 2 ) remain unchanged. This is shown by the following changes: (1) standard error of the estimate decreased from 3.39 to 3.37, (2) F value increased from to (table 5.40 and 5.43), and (3) all t- test statistics increased significantly. Figure 6.2: The revised model of SEM profitability Current ratio (CUR) Working capital management and shortterm planning practices (WCSP) Fixed asset management and long-term planning practices (FALP) Financial and accounting information system practices (FAIS) SME profitability: (PRO) Return on sales Return on assets Return on equity + Total asset turnover (TAT) Source: Table 5.43, chapter 5 (page 231) Table 5.43 (page 231) provided the coefficient of determination R 2 = at a significance level. This coefficient reveals that 60.8% of the variation in SME profitability can be explained by changes in the following attributes: (1) current ratio with β = , (2) total asset turnover with β = 0.200, (3) working capital management and short-term planning practices with β = 0.300, (4) fixed asset management and long-term planning practices with β = 0.371, and (5) financial and accounting information system with β = while 39.2% remains unexplained. The revised model of SME 254

274 Chapter Six: Conclusions and Implications profitability as presented in Figure 6.2 illustrates findings presented in Table 5.43 (page 231) and provides a visual insight into the impacts of financial management practices and financial characteristics on SME profitability SUMMARY OF RESEARCH QUESTION ANSWERS This subsection summarizes the answers corresponding to each research question as presented in chapter 1. The first research question related to the importance of SMEs in Vietnam and their profitability. This question was answered in chapters 2 and 5. In reviewing the economic structure and SMEs in Vietnam, chapter 2 found that SMEs in Vietnam play an important role in creating employment, and increasing GDP and exporting volume. Chapter 5, based on empirical data, found that sixty-six percent of SMEs are profitable, however, the level of profits was not as large as that of profits of SMEs in the industrialized countries. Research question two was concerned with how researchers in the literature review have identified the context of financial management practices and financial characteristics, and how they proposed to measure SME profitability. This research question was answered in chapter 3 where literature on financial management was reviewed. Answers to this question are summarized below: Financial management practices include accounting information systems, financial reporting and analysis, working capital management practices, fixed asset management practices and financial planning (McMahon, 1998). Financial characteristics include liquidity, financial leverage, activity and profitability (Burns, 1985, Hutchinson, Meric and Meric, 1988, Jaggi and Considine, 1990, Laitine, 1992, and Meric et al., 1997). Profitability is generally measured by the following ratios: return on sales, return on assets, and return on equity (Burns, 1985; Hutchinson, Meric and Meric,1988; Laitinen, 1992, Meric et al., 1997) Research question three related to links between financial management practices and financial characteristics to SME profitability. This question was answered in chapter 3 255

275 Chapter Six: Conclusions and Implications where previous researchers indicated that financial management practices and financial characteristics significantly affect SME profitability (Edwards and Cooley, 1979; Van Horne, 1986; Burns and Walker, 1991). Research question four concerned in this study called for an examination of relationships between financial management practices, financial characteristics and SME profitability in Vietnam. This question was answered in chapters 4 and 5. Chapter 4 designed the measurement scales for efficiency of financial management practices and defined variables to measure financial characteristics and profitability. Chapter 5 analysed data and indicated a positive relationship between financial management practices, financial characteristics and SME profitability, except debt ratios (Table 5.38, page 223). Research question five focussed on the extent to which financial management practices and financial characteristics affect SME profitability. This question was answered in chapter 5 where financial management practices and financial characteristics were found to simultaneously affect SME profitability. Specifically, the current ratio negatively affects SME profitability, while 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 positively affect SME profitability. The final research question related to what action could improve financial management and profitability of SMEs in Vietnam. This question was answered in chapters 5 and 6. After testing the model of SME profitability, chapter 5 indicated SME profitability was influenced by financial management practices and financial characteristics. This was the basis for recommending action that could improve profitability of SMEs. Details of these actions are examined in section 6.3 (page 258) where the implications of the research study are considered. Table 6.3 (page 257) summarizes answers corresponding to each research question defined in chapter 1. These research questions were developed for the research problem; therefore, answering these questions contributes to solve the research problem. Table 6.3 is completed based on reviewing all chapters in linking to each research question, summaries of answers, which were contributed to research problem solution. 256

276 Chapter Six: Conclusions and Implications Table 6.3: Summary of research questions and answers Research questions Research question answers defined Chapter Answer summary 1. How important 2 & 5 SMEs play an important role in creating employment are SMEs in Vietnam and growing GDP. and are they Sixty-six percent of SMEs are profitable, while 34 profitable? 2. How have researchers in the literature review identified the context of financial management practices and financial characteristics, and how have they proposed to measure SME profitability? 3. How important are financial management practices and financial characteristics to SME profitability? 4. What are the relationships between financial management practices, financial characteristics and SME profitability in Vietnam? 5. How do financial management practices and financial characteristics affect SME profitability? 6. What action can improve financial management and profitability of SMEs in Vietnam? percent are not profitable (Table 5.31, page 213). 3 Financial management practices include accounting information system, financial reporting and analysis, working capital management practices, fixed asset management practices and financial planning (McMahon, 1998). Financial characteristics include liquidity, financial leverage, activity and profitability (Meric et al, 1988; Laitinen, 1992). Profitability is generally measured by the following ratios: return on sales, return on assets, and return on equity (Burns, 1985; Meric et al, 1988; Laitinen, 1992) 3 Financial management practices and financial characteristics significantly affect SME profitability (Edwards and Cooley, 1979; Van Horne, 1986; Burns and Walker, 1991) 4 & 5 Variables measuring financial management practices and financial characteristics, except debt ratio, were found to be related to SME profitability (Table 5.38, page 223). 5 Financial management practices and financial characteristics simultaneously affect SME profitability. Current ratio negatively affects SME profitability, while total asset turnover, working capital management and short-term planning practices, fixed asset management and long-term planning practices, and financial and accounting information system positively affect SME profitability (Table 5.40, page 226). 6 Maintain the appropriate current ratio and paying attention to the trade-off between liquidity and profitability. Raising the efficiency of utilizing total assets to increase total asset turnover. Raising the efficiency of financial management practices, particularly the efficiency of working capital management, fixed asset management, and financial and accounting systems. 257

277 Chapter Six: Conclusions and Implications 6.3 IMPLICATIONS OF THE RESEARCH STUDY This section presents implications of the research study outcomes including the implications for financial management practitioners, government, and training organizations and comments on the contribution to knowledge of this research into financial management practices of SMEs Implications for financial management practices of SMEs This research model indicated that variation in SME profitability could be explained by the changes in: 1. current ratio, 2. total asset turnover, 3. efficiency of working capital management and short-term planning practices, 4. efficiency of fixed asset management and long-term planning practices, and 5. efficiency of financial and accounting information system. Furthermore, the hypothesis that differences expected in mean profits between the efficient and inefficient financial management SMEs was supported by empirical data analysis. The model of SME profitability tested by the empirical data in earlier chapters provides important implications for SME financial management practitioners, government, and training organizations. For financial management practitioners, several implications are based on the model of SME profitability and conclusions on differences in average profits between efficient and inefficient financial management SMEs. Implication 1: Viewpoint of financial management role Owners and managers of SMEs in Vietnam believe that marketing plays the most important role in producing profits, while financial management only plays a role in protecting financial position of a business. This research study indicates that efficiency of 258

278 Chapter Six: Conclusions and Implications financial management could lead to high profits and, as such, financial management not only controls the financial position but also significantly contributes to improving and increasing profitability of small business. These conclusions suggest that SMEs should highly regard financial management and view financial management practices as one of the tools to improve and increase profitability. Moreover, based on the findings of this research study, the central role of financial management to the success of any SMEs as indicated by Meredith (1986) has been demonstrated by the empirical data from SMEs in an emerging economy. Implication 2: Actions to improve SME profitability The research model of SME profitability indicates that SME profitability depends upon efficiency of financial management practices and financial characteristics of SMEs. Therefore any action that influences financial management practices and financial characteristics should be carefully considered to determine whether they positively or negatively impact on SME profitability. The current ratio, which is often used as a tool defining and measuring liquidity, is negatively related to SME profitability, the objectives and policies of liquidity should be linked to those of profitability. High current ratios tend to high liquidity and low profitability. However, this does not mean the current ratio should be continuously lowered to raising profitability because such actions will adversely affect liquidity. The trade-off between liquidity and profitability as indicated by Van Horne (1986) and demonstrated in this study should be flexibly applied depending on particular circumstances. Wise policies on financial management achieve both liquidity and profitability objectives. Unless both these objectives are achieved, what financial managers should do is to maintain an appropriate current ratio so that the profitability of SMEs will not be adversely affected. When an enterprise is forced to maintain a relatively high current ratio because of liquidity problems, the adverse effects of this current ratio on profitability should be identified and reduced. Short-time investment of the temporary cash surplus 259

279 Chapter Six: Conclusions and Implications for profitable purpose is often considered actions to reduce the adverse effects of maintaining relatively high liquidity ratios. In contrast to the current ratio, total asset turnover is positively related to SME profitability. High total asset turnover leads to higher profitability for SMEs. In general, actions increasing total asset turnover will positively impact on profitability. Total asset turnover is defined as the ratio between net sales and total assets. Therefore increasing net sales or decreasing total assets will cause total asset turnover to increase. Selling assets that are not necessary for business operations is a typical example of efforts to increase the efficiency of utilizing total assets and increase total asset turnover. In addition, efforts of marketing, sales management, and new product development and the likes will increase net sales and, as a result, increase total asset turnover and profitability. Implication 3: Raising the efficiency of financial management practices to improve SME profitability. The model of SME profitability indicates that SME profitability is positively related to the efficiency of financial management practices. Therefore raising the efficiency of financial management is considered an effective tool for improving and increasing profitability of SMEs. Specifically, the model indicates the efficiency of the following financial management components are positively correlated to SME profitability: working capital management and short-term planning practices including cash management, receivable management, inventory management and short-term financial planning regarding working capital fixed asset management and long-term financial planning practices consisting of managing fixed assets, evaluating capital investment projects, and long-term financial planning regarding capital investments financial and accounting information systems practices including systems for accounting reports and financial reporting and analysis. 260

280 Chapter Six: Conclusions and Implications In financial management practices, the financial manager or owner should have regard to the effects of these components on profitability and decisions should be reviewed to determine whether they affect the efficiency of financial management and thus affect SME profitability. Implication 4: Implications for the government policy-makers The main objective of this study is to identify implications for financial management practices of SMEs. However, in this research study, SMEs were found to have difficulties involving the government policies, which make financial management practices ineffective and ineffective. As reviewed in chapter 2, SMEs continue to play important roles in developing the multi-sector economy and the government has polices to promote and support development of SMEs. Government policies will be more effective if the policy-makers understand current practices of financial management of SMEs. Based on the descriptive findings of financial management practices of SMEs in the survey, this study recommends the following issues to be considered by government policy-makers. Remove discrimination between SMEs and large companies and between state and non-state SMEs in granting loans. Develop the financial market including both capital and money markets. Provide training programs in financial management skills for the owners and managers of SMEs. Implication 5: Implications for training and teaching organizations Findings on financial management practices and financial characteristics of SMEs help teaching and training organization personnel to understand the bahaviour of SMEs in the field of financial management. This will be basis for developing more appropriately training programs for owners and managers of SMEs. 261

281 Chapter Six: Conclusions and Implications Contributions to knowledge of this research into financial management for SMEs This research study has made a number of contributions to knowledge in the fields of SME financial management. The model of SME profitability is considered a most significant and important contribution of this study to knowledge of financial management for SMEs. This model, in one hand, evaluates the financial management theories provided by previous researchers by using empirical evidence from an emerging country. On the other hand, it provides knowledge of simultaneous impacts of financial management practices and financial characteristics on SME profitability, which has not investigated previously. This model also indicates relationships between variables used to measure financial characteristics. Specifically, it indicates the negative relationship between profitability and liquidity and the positive relationship between profitability and activity. A contribution is the use of statistical techniques to identify some relationships not previously emphasized by researchers linkages between current ratios and profitability, linkages between financial leverage and profitability, and linkages between total asset turnover and profitability. This study provides details of the relationships between financial management practices, financial characteristics and profitability of SMEs in developing nations. Previous research provided a large number of descriptive findings of financial management and financial characteristics whereas the associative findings have rarely been investigated. This study supplements the gap by investigating the association between profitability and financial management practices, and financial characteristics of SMEs. Through the study s model, testing of the model and revision of the model, the research demonstrates how field data from an emerging nation (Vietnam) can be applied to modify theoretical model to reflect the business environment of SMEs. 262

282 Chapter Six: Conclusions and Implications This study contributes to the knowledge of financial management practices and financial characteristics of SMEs in Vietnam which can be considered representative of emerging economies. As indicated in chapter 3, the descriptive findings of financial management practices and financial characteristics of SMEs around the world are numerous, however most findings involve SMEs in the developed or market economy countries while findings involving SMEs in the developing or emerging countries are few, and findings involving SMEs in Vietnam are rare. Therefore descriptive findings of financial management practices and financial characteristics of SMEs in this study expand the literature of financial management in general and especially financial management of SMEs in Vietnam. 6.4 LIMITATIONS OF THE RESEARCH STUDY Regardless of its high ambitions, doctoral research is constrained by resource limitations, both financial and non-financial resources. Limitations of time, funding and scope of the study required the research study to focus on a limited number of objectives. Moreover the research problem and questions often directly or indirectly involve multiple areas of financial management while limits of time and funds would not make all areas can be investigated. Because of limited access to scare resources, this study could not research SMEs in all regions of Vietnam but only selected SMEs located in Ho Chi Minh City as the target population and considered the target SMEs representative for all SMEs in Vietnam. Although Ho Chi Minh City is the biggest city with the largest number of SMEs located, differences in knowledge and style of management between SMEs located in Ho Chi Minh City and SMEs located in other regions may lead to differences in financial management practices and financial characteristics. As a result, an overestimation may exist due to the higher level of management knowledge of SMEs in Ho Chi Minh City. Similarly, due to limited resources this study uses the stratified sampling technique with one SME in lieu of 90 for personal interview. Given more time and funds, the fraction would be reduced to 30 and the sample has been broadened. 263

283 Chapter Six: Conclusions and Implications Given difficulties in data collection, data related to financial characteristics in this study were only derived from current financial statements. In consequence, data collection only provided cross-sectional data related to financial characteristics while the longitudinal data was not available for this research study. Also, for the purpose of encouraging and support for the local and private SME development, this study only focuses on the domestic private sector but does not capture the foreign-owned and state sectors. In terms of scope of the study, more specific limitations imposed by the approach adopted in the investigation include: In considering significant aspects of the financial management practices, this study concentrated on internal factors of SMEs but did not capture much external environment factors. The internal business functions of the greatest concern in this study were financial management while other functions such as production management, marketing management, and personnel management were omitted. This study indicates current ratios are negatively related to profitability and positively related to liquidity and maintaining the appropriate current ratio will improve SME profitability while the liquidity was not affected. However, this study could not specify what the appropriate current ratio should be because the appropriate current ratio is dependent on characteristics of each industry. This requires further research with surveys to indicate appropriate current ratios corresponding to each industry. Unfortunately, such extended research was beyond scope of this thesis. 6.5 IMPLICATIONS FOR THE FURTHER RESEARCH This study was designed to examine relationships between financial management practices, financial characteristics and SME profitability. Its limitations were examined in section 6.4. These limitations suggest further research to expand and supplement what could not be captured in this research. Descriptive findings of financial management practices, financial characteristics, and SME profitability and conclusions related to the 264

284 Chapter Six: Conclusions and Implications relationships between financial management practices, financial characteristics and SME profitability could be used as the foundations for the further research. Additional implications of this study for the further research could include the following: Findings on financial characteristics of SMEs could be applied to the further comparative research of differences in financial characteristics between SMEs and large enterprises in Vietnam. Findings on financial management practices could be used as the basis for specific and detailed research into every separate aspect of financial management practices in Vietnam such as financial reporting and analysis, working capital management, fixed asset management, capital budgeting, and for financial planning. This study s findings of relationships between current ratio, total asset turnover and SME profitability could lead to expanded research to the large companies, state and foreign companies in Vietnam. This study could not demonstrate the significant relationships between debt ratios and SME profitability, and this could be explained that debt ratio are not always linear-related to profitability but cubic-related. This finding could be used as the basis for more specific and detailed research on financial leverage and relationships between financial leverage and profitability. This study s research methodological approached and findings on current ratios, debt ratios, debt-to-equity ratios, total asset turnovers, returns on sales, returns on assets, and returns on equity could lead to further research on investigating and building industry averages of financial ratios in Vietnam. Such research is necessary and important for financial management practices in this country. The model of SME profitability developed in this study could be applied as the basis for the further research on building competitive strategies for SMEs. 265

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298 Appendix 1: Survey instrument SURVEY OF FINANCIAL MANAGEMENT PRACTICES OF SMEs IN HO CHI MINH CITY Purpose of the survey: The purpose of this survey is to obtain in-depth information on financial management practices of SMEs located in Ho Chi Minh City. This information is linked to a project of improving financial management practices and profitability of SMEs. Businesses to be surveyed: All small and medium enterprises (SMEs) including stock companies, limited liabilities companies and private enterprises which have less than 500 employees and total capital of less than VND 10 billion will be interviewed in this survey. Large companies, foreign-invested companies, joint-venture companies and stateowned enterprises are not included in this survey. Respondents: We ask that this questionnaire should be answered by the owner or key manager (e.g., financial manager or chief-accountant) who is responsible for financial function in your business. We would like you to answer each question from the perspective of the business unit that you manage rather than from the general ideas or views and please add any additional comments that you believe are appropriate. Non commercialization and confidentiality: Data collected from the survey will be used to test the model relating to a theory developed as a part of a doctoral thesis. It does not involve any commercial activities and all information will be treated in strictest confidence. How to answer the questions: To answer the questions you simply circle the most appropriate numbers, which are listed, excepting of some cases you are requested to fill the appropriate number into the blanks. For example, to answer the following question, if your position is owner you will circle number 1 as follows: 1.1 What is your position in your business (Please circle one that applies)? Owner Manager...2 Chief-accountant...3 Other, please specify...4, please specify. Your cooperation by answering questions raised by the interviewer is viewed as the most important contribution to support for the development of SMEs. Thank you for spending time to answer the questionnaire.

299 A. COMPANY PROFILE (Please circle the appropriate number that best answers to each question) 1. Owner/manager details 1.1 What is your position in your business (Please circle one that applies)? Owner...1 Manager...2 Chief-accountant...3 Other, please specify...4, please specify. 1.2 What is your HIGHEST educational qualification or nearest equivalent (Please circle one that applies)? High school...1 Bachelor degree...2 Master degree...3 Higher degree...4 Others...5, please specify. 1.3 Do you ever attend management training programs related to financial management (Please circle one that applies)? Never...1 Rarely (from 1 to 2 attentions)...2 Sometimes (3 to 4 attentions)...3 Often (more than 4 attentions)...4 Always What best describes your background (Please circles one that applies)? Management general...1 Technical field...2 Business general...3 Financial management...4 Others...5, please specify 2. Business details 2.1 What best describes the type of industry of your business (Please circles one that applies)? Manufacturing...1 Trading...2 Service...3 Others...4, please specify. 2.2 What best describes the form of ownership of your business (Please circles one that applies)? Private enterprise...1 Limited company...2 Joint stock company...3 State company...4 Others...5, please specify. 2.3 How long has your business been established (Please circle one that applies)? Less than 2 years years years...3 More than 10 years...4 2

300 2.4 How many employees does your business currently have (Please fill the number that applies)? Full-time:... employees Part-time:... employees 2.5 Which of the following ranges is the best indication of your business total assets (Please circle one that applies)? Less than 5 billion dong to 10 billion dong...2 More than 10 billion dong Which of the following ranges is the best indication of your business annual sales (Please circle one that applies)? Less than 5 billion dong billion dong billion dong...3 More than 50 billion dong What best describes your business profitability (Please circles one that applies)? Profitable...0 Not profitable Which of the following ranges is the best indication of your business annual net profits? Less than 50 million dong to 300 million dong to 500 million dong...3 More than 500 million dong...4 B. FINANCIAL MANAGEMENT 1. Accounting information system 1.1 Who is responsible for the following duties in your business (Please circle the number that applies for each duty)? Duties Owner Manager Chiefaccountant Employed accountan t External accountant Recording business transactions Preparing accounting reports Interpreting and using accounting information What best describes characteristics of the organization of your business accounting system (Please circle number that applies)? Formal...1 Informal Does your business ever utilize computers in accounting (Please circle number that applies)? Never...1 Rarely...2 Sometimes...3 Often...4 Always...5 3

301 1.4 If yes, which of the following is the most popular application (Please circle number that applies)? Recording business transactions...1 Preparing accounting reports...2 Managing assets...3 Controlling payroll...4 Controlling cash flows...5 Others, please specify...6, please specify Efficiency of accounting information system (Please circle number that applies on each scale) Here are some statements, which describe how owner/manager may feel about the efficiency of accounting information system. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. 1. How does your business regard its accounting information system? 2. How frequent does your business prepare its accounting reports? 3. How does accounting information system in your business update the business transactions? 4. What is owner/manager involvement in preparing accounting information? 5. What is owner/manager involvement in interpreting and using accounting information? 6. How acceptable is your business s accounting information system? 7. How useful is your business s accounting information useful in making decisions? 8. How computerized is your business s accounting information system? Low regard High regard Not frequent at all Very frequent Not updated at all Very updated Low involvement High involvement Low involvement High involvement Very unacceptable Very acceptable Not useful at all Very useful Low High computerization computerization Financial reporting and analysis 2.1 What kinds of financial statements are regularly prepared in your business (May circle more than one number)? Balance sheet...1 Income statement (Profit and loss statement)...2 Statement of cash flows...3 Statement of funds...4 Other...5, please specify 4

302 2.2 Who is responsible for the following duties in your business (Please circle number that applies for each duty)? Owner Manager Chiefaccountant Employed accountant External accountant Never do it Preparing financial statements Analyzing financial statements How often are the financial statements of your business prepared and analyzed (Please circle number that applies for each duties)? Monthly Quarterly Semiannually Annually Never Preparing financial statements Analyzing financial statements What kinds of financial analysis are currently used in your business (May circle more than one number)? Ratio analysis...1 Trend analysis...2 Both...3 Other...4, please specify What kinds of financial ratios are currently used for financial analysis in your business (May circle more than one number)? Current ratio...1 Quick ratio...2 Debt ratio...3 Debt-to-equity ratio...4 Short-term debt ratio...5 Long-term debt ratio...6 Receivable turnover...7 Inventory turnover...8 Fixed asset turnover...9 Total asset turnover...10 Return on sales...11 Return on assets...12 Return on equity...13 Never use any ratio Does your business ever apply computers in financial reporting and analysis (Please circle number that applies)? Never...1 Rarely...2 Sometimes...3 Often...4 Always If yes, what area is your computer applied (Please circle number that applies)? Financial reporting...1 Financial analysis...2 Both...3 Other...4, please specify 5

303 2.8 Efficiency of financial reporting and analysis (Circle one number that applies on each scale) Here are some statements which describe how owner/manager might feel about the efficiency of financial reporting and analysis practices. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. 1. How does your business regard financial reporting and analysis? 2. How frequent does your business prepare financial statements (balance sheet, income statements, statements of cash flows)? 3. How involved is the owner/manager in preparing financial statements? 4. How involved is the owner/manager involve in interpreting and using financial statements? 5. How useful are the financial statements of your business in providing information for making decisions? 6. How frequent does your business analyze financial statements (balance sheet, income statements, statements of cash flows)? 7. How useful are financial ratios applied in financial analysis of your business? 8. How computerized are the financial reporting and analysis practices in your business? Low regard High regard Not frequent at all Very frequent Low involvement High involvement Low involvement High involvement Not useful at all Very useful Not frequent at all Very frequent Not useful at all Very useful Low High computerization computerization Cash management practices 3.1 Does your business ever conduct or occur the following ones (Circle one number that applies for each described below)? Never Rarely Sometimes Often Always Preparing cash budget Determining the target cash balance Occurring cash shortage Occurring cash surplus Utilizing computers in cash management How often is the cash budget prepared and reviewed in your business (Circle one that applies for each)? Never Weekly Monthly Quarterly Semiannually Annually Preparing cash budget Reviewing cash budget

304 3.3 On what basis does your business determine target cash balances (Circle one that applies)? Based on theories of cash management...1 Based on historical data...2 Based on owner/manager s experience...3 Other...4, please specify Where does your business often invest the temporary cash surplus (Circle one that applies)? Bank deposit...1 Treasury bills...2 Both above...3 Other...4, please specify.. No where In cash management, what area is the computer applied (Circle one that applies)? Preparing cash budget...1 Recording cash transactions...2 Both above...3 Other...4, please specify Efficiency of cash management (Circle one number that applies for each scale) Here are some statements which describe how owner/manager might feel about the efficiency of cash management practices. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. Low regard High regard 1. How does your business regard cash management practices? Not regularly at all Very regularly 2. How regularly does your business prepare cash budgets? Low involvement High involvement 3. How involved is the owner/manager in preparing cash budgets? Low involvement High involvement 4. How involved is the owner/manager in interpreting and using cash budgets? Not useful at all Very useful 5. How useful are cash budgets of your business in providing information for making decisions? Very poorly Very well 6. How does your business apply theories of cash management in determining the target cash balance? Very unacceptable Very acceptable 7. How acceptable is the target cash balance determined in your business? Low computerization High computerization 8. How computerized are cash management practices in your business?

305 4. Receivable management practices 4.1 Does your business ever carry out the things listed below (Circle one that applies for each)? Never Rarely Often Sometimes Always Sell products or services in credit Set up its credit policy to the customers Use computers in receivable management How often does your business review its levels of receivables and bad debts (Circle one that applies for each row)? Never Weekly Monthly Quarterly Semiannually Annually Review its levels of receivables Review its bad debts Which of the following ranges is the best indication your business s percentage of bad debts (Circle one that applies)? Less than 5% of sales % of sales % of sales...3 More than 20%...4 Don t know In managing receivables, which areas are computers applied (Circle one that applies)? Managing receivables...1 Managing bad debts...2 Both...3 Others...3, please specify. 4.5 Efficiency of receivable management (Circle one number applies for each scale) Here are some statements which describe how owner/manager might feel about the efficiency of receivable management practices. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. 1. How does your business regard to receivables management practices? 2. How regularly does your business review debtors credit period? Low regard High regard Not regularly at all Very regularly Not reasonable at all Very reasonable 3. How reasonable is debtors credit period in your business? Not regular at all Very regular 4. How regular does your business review debtors discount policy? Not reasonable at all Very reasonable 5. How reasonable is debtors discount policy in your business Not regular at all Very regular 6. How regular does your business review percentage of bad

306 debts? 7. How reasonable is the percentage of bad debts in your business 8. How frequent does your business implement theories of receivables management? 9. How computerized are receivable management practices in your business? Not reasonable at all Very reasonable Not frequent at all Very frequent Low High computerization computerization Inventory management practices 5.1 Does your business ever do the following ones (Circle one that applies for each row)? Never Rarely Sometimes Often Always Review its inventory levels Prepare inventory budget Utilize computer in managing inventory On what basis is the inventory level determined (Circle one that applies)? Based on theories of inventory management...1 Based on historical data...2 Based on owner/manager s experience...3 Other...4, please specify. 5.3 Does your business ever use economic order quantity model in inventory management? Do not know this model...1 Know but never use...2 Sometimes use...3 Often use...4 Always use Efficiency of inventory management (Circle one that applies for each scale) Here are some statements which describe how owner/manager might feel about the efficiency of inventory management practices. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. 1. How does your business regard inventory management practices? Low regard High regard Not regularly at all Very regularly 2. How regularly does your business review inventory turnover? Not regularly at all Very regularly 3. How regularly does your business review inventory level? Very slow Very fast 4. How fast is inventory turnover of your business? Very unacceptable Very acceptable 9

307 5. How acceptable is inventory level of your business? Very useful at all Very useful 6. How are inventory budgets of your business useful in providing information for making decisions? Very poor Very good 7. How does your business apply theories of inventory management in determining the inventory level? Low Computerization High computerization 8. How computerized are inventory management practices in your business? Fixed asset management practices 6.1 Related to fixed asset management, does your business ever do the following ones (Circle one that applies for each row)? Never Rarely Sometimes Often Always Evaluate its projects before making capital investment decisions Review efficiency of using fixed assets after investing Use computer in managing fixed assets Which methods does your business use for assessing capital projects (May circle more than one number)? Payback period...1 Discounted payback period...2 Net present value...3 Internal rate of return...4 Modified internal rate of return...5 Others...6, please specify. 6.3 Which area is computer used in managing fixed assets (Circle one that applies)? Assessing capital investment projects...1 Managing fixed assets...2 Both...3 Others...4, please specify. 6.4 Efficiency of fixed asset management (Circle one that applies for each scale) Here are some statements which describe how owner/manager might feel about the efficiency of fixed asset management practices. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. 1. How does your business regard fixed asset management practices? 2. How does your business regard assessing capital project before making investment decisions? Low regard High regard Low regard High regard Not regularly at all Very regularly 10

308 3. How regularly does your business review capital projects? Very unacceptable Very acceptable 4. How acceptable is capital budgeting utilized in your business? Not advanced at all Very advanced 5. How advanced does your business apply techniques of capital budgeting in determining capital investment projects? Very unreasonable Very reasonable 6. How reasonable are fixed assets of your business utilized? Not useful at all Very useful 7. How useful are fixed assets acquired in your business? Low computerization High computerization 8. How computerized are fixed asset management practices in your business? Financial planning practices 7.1 Related to financial planning, does your business ever conduct the ones listed below (Circle one that applies for each row)? Never Rarely Sometimes Often Always Preparing financial budgets Comparing between budgeted and actual results Using computer in financial planning What are objectives of financial planning? (May circle more than one) Sales maximization...1 Cost minimization...2 Profit maximization...3 Quality product or service...4 Growth...5 Survival...6 No goal or policy What type of budget does your business regularly prepared? (May circle more than one). Sales budget...1 Manufacturing budget...2 Purchase budget...3 Labor budget...4 Overhead cost budget...5 Selling and administration expenses budget...6 Cash budget...7 Budgeted profit and loss account...8 Budgeted balance sheet Who is responsible for preparing budgets (Circle one that applies)? Owner...1 Financial manager...2 Chief-accountant...3 Employed accountant...4 External accountant How often is comparison of between budgeted and actual results conducted (Circle one that applies)? Daily...1 Weekly

309 Monthly...3 Quarterly...4 Semiannually...5 Annually Efficiency of financial planning Here are some statements which describe how owner/manager might feel about the efficiency of financial planning practices. Please indicate the most appropriate number that describes your business position on the scale. 1 Extremely negative 5 Neither negative nor positive 9 Extremely positive There are no right or wrong answers to these questions. Just give your opinion about your business. Low regard High regard 1. How does your business regard financial planning? Not regularly at all Very regularly 2. How regularly does your business prepare its financial budgets? Low involvement High involvement 3. How involved is the owner/manager in preparing financial budgets? Low involvement High involvement 4. How involved is the owner/manager in interpreting and using financial budgets? Not useful at all Very useful 5. How useful are the financial budgets of your business useful in providing information for making decisions? Not regularly at all Very regularly 6. How regularly does your business compare between actual and budgeted results? Very unreasonable Very reasonable 7. How reasonable are financial planning techniques applied in financial analysis of your business? Low computerization High computerization 8. How computerized are the financial reporting and analysis practices in your business? C. FINANCIAL CHARACTERISTICS (Based on the current financial statements of your business, please complete the table as described below?) Financial ratio Description Results Current ratio Current assets divided by current liabilities? Debt-to-equity ratio Total debt/equity? Total asset turnover Sales/Total assets? Return on sales (%) Net income/sales? Return on assets (%) Net income/total assets? Return on equity (%) Net income/equity? Business name: Address: Respondent name: Once again thank you very much for your co-operation. Phone number: Position: 12

310 Appendix 2: Vietnam Background information General Information The Socialist Republic of Vietnam is a one-party communist state, extending km from latitude 23 degrees north to 9 degrees north along the western rim of the South China Sea. Occupying sq. km. and bordering China to the north, Laos to the west and Cambodia to the south-west, Vietnam is marked by two delta regions at either end of the country (the Songkoi - or Red River - in the north, the Mekong in the south), which are separated by the narrow region of the Central Highlands. The extensive Annamite Mountains dominate the north-west. Around 16% of Vietnam's land mass is under cultivation, with the remaining areas either mountainous or forested. Vietnam has substantial territorial claims in the South China Sea and occupies a number of reefs and islands. Its capital, Hanoi, lies on the Red River. Eighty percent of Vietnam's population of 78 million (1998 official estimate) are ethnic Vietnamese. Significant ethnic minorities include the Tai and Hmong in the north and west, the Cham in the centre, and the Chinese and Khmer in the south. Vietnam has a Buddhist majority, its religious minorities including the Cao Dai, the Hoa Hao, and most notably the Roman Catholic, Protestant and Muslim religions. Vietnam is a member of the UN, ASEAN, ARF, ASEM, APEC and the Non- Aligned Movement. It is currently seeking accession to the WTO. Historical Overview After a millennium as a Chinese province, the northern region of Vietnam gained independence in 938, following the dissolution of the Tang empire. Under succeeding local dynasties ruling from Hanoi over the next five centuries, Vietnam fought off several attempts to reintegrate it into China and also expanded its reach southward, gradually annexing the central kingdom of Champa. Dynastic struggles led to civil wars during the sixteenth, seventeenth, eighteenth centuries. During this period, Vietnam gained control over the Mekong delta and the first Christian missions arrived. It was not until 1802 that the present Vietnam was united under a single ruler, Nguyen Anh, whose court was located at the central coastal city of Hue. Despite the continuation of the Nguyen dynasty, Vietnam saw increasing French intervention from the 1850s. Spurred by Hue's persecution of French Christian missionaries and their Vietnamese converts and by a desire not to lose eastern markets to the British, France annexed the southern Cochin-China region, their possession of which 1

311 was recognised by Hue in a 1874 treaty. A treaty of protection over Vietnam followed in By 1901, Vietnam, Cambodia and Laos had fallen collectively under a central French administration, forming the Union Indochinoise. In the decades before the Second World War, a number of groups opposed to colonial rule emerged. Following the suppression in the 1900s of early nationalist movements led by Phan Chau Trinh and Phan Boi Chau and the restriction of constitutionalist movements in the 1910s to the Cochin-China region, Vietnamese nationalism adopted a revolutionary flavour during the 1920s. The Communist Party of Indochina (CPI) was established in Although suppressed by the French military in 1931, the CPI took advantage of an amnesty for political prisoners in 1936 and enjoyed increasing support from Moscow during the late 1930s. The outbreak of war in 1939 led to a ban on left-wing activity and the development of secret CPI networks which were maintained throughout the war. In 1941, the Revolutionary League for the Independence of Vietnam (Viet Minh) was formed under the leadership of Ho Chi Minh. Despite the Japanese advance into Vietnam in 1941, a Vichy French administration maintained authority until early 1945, when it was deposed by the Japanese and a pro-japanese government was appointed by Emperor Bao Dai. Following the Japanese surrender, the Viet Minh took effective control of a number of provinces, mostly in the north. After the abdication of Bao Dai, Ho Chi Minh declared independence and the founding of the Democratic Republic of Vietnam on 2 September But with the division of Vietnam at the 16th parallel between British forces in the south and Chinese forces in the north agreed at the Potsdam Conference, France was able to regain control over the south by the end of 1945 and negotiated the withdrawal of Chinese troops from the north by March Relations between the French and Viet Minh completely broke down by late 1946, leading to a protracted guerrilla war which ended with the French defeat at Dien Bien Phu in May 1954, the Viet Minh being aided to a large extent by Chinese communists. A cease-fire agreement at Geneva in the same month provided for a single Vietnam divided at the 17th parallel. Vietnam was to be administered in the north from Hanoi by the government of the Democratic Republic of Vietnam and in the south from Saigon by the government of the State of Vietnam, which had been founded by the French under Bao Dai in The agreement also provided for the possibility in 1956 of national elections which never eventuated. The following decade saw economic and social restructuring in the north under the Vietnam Workers' Party (formerly the CPI) and the dominance of Ngo Dinh Diem in the south. A Roman Catholic, Diem overthrew Bao Dai to become President in Until his assassination in the 1963 military coup, due in part to increasing Buddhist dissatisfaction with his Catholic-dominated government, Diem took South Vietnam increasingly into the US sphere, his conflict with communists in South Vietnam developing a cold-war dynamic. Accordingly, the Kennedy and Johnson Administrations committed themselves to defending South Vietnam, first with military advisers and then following the Gulf of Tonkin incident in August 1964 with US military force. Australia, New Zealand, Thailand, South Korea and the Philippines also contributed forces. After a series of coups in South Vietnam, the constitutional reforms in 1967 led to the government of General Nguyen Van Thieu, which survived until

312 Although enjoying military superiority and seriously disrupting economic life in North Vietnam through aerial bombardment from 1965 to 1968, the domestically beleaguered United States entered into informal negotiations with North Vietnam in With the advent of the Nixon Administration in 1969, the same year as Ho Chi Minh's death, formal negotiations commenced in Paris. Despite Nixon's intention to reduce US involvement and "Vietnamise" the conflict, a campaign to disrupt communist supply lines led to the expansion of the conflict into Cambodia and Laos. The Paris Agreement was concluded in March 1973, which provided for the withdrawal of US but not North Vietnamese troops. Although the agreement notionally provided for South Vietnam's security, this security was not enforced effectively. Following a final swift campaign in early 1975, North Vietnamese forces entered Saigon on 30 April and renamed it Ho Chi Minh City. Formal reunification took place on 2 July 1976 with the foundation of the Socialist Republic of Vietnam and in December with the foundation of the Communist Party of Vietnam. In the late 1970s, relations with China soured over border disputes, the plight of southern Vietnam's Chinese, China's support for the hostile Pol Pot regime in Cambodia, and Vietnam's orientation towards the USSR. Following the Vietnamese-Cambodia conflict in late 1978 and the imposition of a pro-vietnamese government, tension with China increased leading to full-scale conflict in February and March Sporadic clashes continued throughout the 1980s. Although the USSR-China rapprochement in the late 1980s and the withdrawal of Vietnamese troops from Cambodia in 1989 helped ease conflict, tensions between Vietnam and China over competing claims in the South China Sea continue to the present. Changing global circumstances and desperate economic conditions within the country during the late 1980s forced Vietnam to make its first tentative steps towards political and economic doi moi (renovation). (See political and economic overviews.) In 1994, the United States lifted its economic embargo against Vietnam, imposed after Vietnam and Cambodia war. In 1995, Vietnam became the seventh member of ASEAN. In the same year, the United States and Vietnam established full diplomatic relations, the two countries signing an agreement to normalise trading relations in July Political Overview Vietnam is one of the world's five remaining one-party communist states. Decision making in Vietnam is shared by national and provincial government and agencies, slowing the political process and encouraging a cautious approach to major policy issues. Political power lies with the Communist Party of Vietnam. Its peak organ, the eighteen member Politburo, is elected by the Party's Central Committee, of 170 members, and holds authority over the implementation of social, economic, labour, defence, security and foreign policy. The Party is led by the General Secretary, currently Le Kha Phieu. Party Congresses are held every five years to ratify major policy changes. The ninth Congress will take place in early Between Congresses, Central Committee Plena are convened three or four times per year to decide on important policy issues. Although still conservatively communist, Vietnam has undertaken some reforms in recent years. In 1986, at a time of economic crisis following years of economic stagnation resulting from the effects of the war and unsuccessful collectivisation programs, the Party embarked upon a program of limited market-based economic 3

313 reforms. These reforms were known as doi moi (renovation) and were aimed at a shift towards "market economy with socialist orientation". Under doi moi, the private sector was permitted to exist in a limited capacity. There was also greater decentralised economic planning and a greater acceptance of market forces as the determinant of prices and production. Foreign investment was encouraged, and agriculture was deregulated to allow individual family farms again. Vietnamese living standards rose appreciably, particularly in urban areas. However, the potential benefits of past reforms are now close to being exhausted and further reform is needed to stimulate the Vietnamese economy. While Vietnam's signing in July 2000 of the Bilateral Trade Agreement with the United States indicates a commitment to continued economic reform, the Party remains equally committed to an economy which is led by the public sector, dominated by state owned enterprises (SOEs) and protected by government regulation. The prospect of inequitable development and social disintegration, which some elements of the Party attribute to market forces, has also been a source of considerable debate within the Party. The Party's collective ambivalence towards reform is reflected in Vietnam's current leadership, representing a reformist and conservative mix. The Party is presently faced with a conjunction of difficult issues such as increasing unemployment, growing income disparities between urban and rural areas, social problems (including drug abuse, prostitution and increasing levels of HIV), occasional pockets of provincial unrest, corruption and declining Party membership. Its overriding concern is to maintain political and economic stability, which will ensure its continued existence in the face of a more open economic environment. Since the end of 1997, there have been a number of instances where members of the Party and the general population have been prepared to express dissent. The Party has responded by introducing measures to address the concerns of the general population (such as seeking to channel more of the benefits of economic reform to the rural areas and pursuing administrative reform within the Party) and by projecting itself as the protector of Vietnamese culture. The August 1999 Central Committee Plenum reflected these themes, acknowledging that ineffective organisation and a cumbersome political structure, particularly in state administrative management, had been "responsible for reducing the efficiency of the [Party] leadership and management". The Party also launched a campaign of criticism and self-criticism in May 1999, designed to "purify" itself and to stem internal corruption and mismanagement. The dismissal of former Deputy Prime Minister Ngo Xuan Loc by the National Assembly in December 1999 represents the most prominent outcome of this campaign. Although political reform has never been articulated as an objective, and the paramount position of the Party has never been under challenge, the National Assembly took some cautious steps in 1998 away from complete dominance by the Party, with unexpectedly heated debate over key provisions of legislation relating to land and citizenship. The release of a number of leading dissidents in successive Presidential amnesties, including many prisoners on the Australian Government's list of cases of concern who are believed imprisoned for the peaceful expression of their political or religious beliefs, was taken as an indication of greater political openness. 4

314 Head of State and Government President Vice-President Prime Minister Deputy Prime Minister Deputy Prime Minister Deputy Prime Minister Deputy Prime Minister Minister of Agriculture and Rural Development Minister of Construction Minister of Culture and Information Minister of Defence Minister of Education and Training Minister of Finance Ministry of Fisheries Minister of Foreign Affairs Minister of Health Minister of Industry Minister of Justice Minister of Labour, War Invalids and Social Affairs Minister of Planning and Investment Minister of Public Security Minister of Science, Technology and Environment Minister of Trade Minister of Transport and Communications Governor of the State Bank Minister, Committee for Ethnic Minorities and Mountainous Areas Minister, Government Committee of Organization and Personnel Minister, State Inspectorate Minister, Office of Government Minister, Committee and Physical Culture and Sport Minister, National Committe for Population and Family Planning Minister, National Committee for Protection and Care of Children Tran Duc Luong Nguyen Thi Binh Phan Van Khai Nguyen Tan Dung Nguyen Manh Cam Nguyen Cong Tan Pham Gia Khiem Le Huy Ngo Nguyen Manh Kiem Nguyen Khoa Diem Pham Van Tra Nguyen Minh Hien Nguyen Sinh Hung Ta Quang Ngoc Nguyen Dy Nien Do Nguyen Phuong Dang Vu Chu Nguyen Dinh Loc Nguyen Thi Hang Tran Xuan Gia Le Minh Huong Chu Tuan Nha Vu Khoan Le Ngoc Hoan Le Duc Thuy Hoang Duc Nghi Do Quang Trung Ta Huu Thanh Doan Manh Giao Ha Quang Du Tran Thi Trung Chien Tran Thi Thanh Thanh Politburo of the Communist Party of Vietnam Le Kha Phieu* (General Secretary) Tran Duc Luong* (President) Phan Van Khai* (Prime Minister) Nong Duc Manh* (Chairman of the National Assembly) Pham The Duyet* (Former Chairman of the Hanoi Party Committee, President of the Vietnam National Fatherland Front) Nguyen Phu Trong* (special member assisting Mr Duyet) Nguyen Manh Cam (Deputy Prime Minister) Nguyen Duc Binh Nguyen Van An 5

315 Pham Van Tra (Minister of Defence) Nguyen Thi Xuan My Truong Tan Sang (Head, Economic Commission of the CPV Central Committee) Le Xuan Tung Le Minh Huong (Minister of Public Security) Nguyen Tan Dung (Deputy Prime Minister) Pham Thanh Ngan Nguyen Minh Triet (Party Secretary, Ho Chi Minh City) Phan Dien Economic Overview Key Indicators Population (1998) :78.1 million Exchange rate (15/3/2000) :7636 dong/a$ GDP per capita (1999) :approx. US$360 GDP growth (1999) :4.8% Inflation (1999) :0.1% Total exports (1999) :US$ billion Total imports (1999) :US$ billion Current account deficit (1999) :US$113 million Unemployment (1999 est.) :7.4% (significant variation between urban and rural areas) Macroeconomic Environment and Reform Prospects The Vietnamese economy is currently in transition from a centrally planned to a marketbased economy. However, the economy is still largely centrally planned, with state ownership still the predominant form of ownership. The government is committed to state sector dominance as a key feature of the Vietnamese economy. This is effected through measures such as price controls, production planning and access to credit. However, there has been some development of monetary, fiscal and trade policy as tools of economic management within the context of maintaining a "socialist economy with a market orientation". The financial sector is in poor shape, Moody's ratings agency recently giving Vietnam a B1 rating. Vietnam has a controlled exchange rate which is allowed to fluctuate within a very narrow band. While the dong has been gradually depreciating as permitted by this band, it is still generally regarded to be overvalued. 6

316 The state owned sector is not only protected from international competition, but also from the domestic private sector. However, as part of broader efforts to improve the investment climate for domestic and foreign investors alike, as well as provide employment opportunities for Vietnamese, the government has recognised the legitimacy of the private sector and the inherent disadvantages it faces vis-a-vis the state owned sector. The government is undertaking a privatisation process (equitisation) to improve the overall performance of the state owned sector and allow the private sector to operate in more sectors. The Enterprise Law, passed in 1999, was the first step in providing a legal platform for private sector development. Equitisation has not proceeded as quickly as the government has expected, in part because many state assets are not attractive investment options. Key sectors, such as aviation, power supply, telecommunications and post are among industries which will remain monopolised by large SOEs, and subject to central planning management mechanisms. Vietnam has committed to global economic integration through its participation in AFTA and APEC, its WTO accession negotiations and most recently its signing in July 2000 of the US-Vietnam Bilateral Trade Agreement. However, global integration is a long-term objective and the Government has recently introduced a number of policies which appear to contradict the spirit of trade liberalisation. Although actively encouraging exports, Vietnam is pursuing an import substitution industrialisation policy which affords disproportionate protection to the predominant state owned sector, and restricts imports in an ad hoc manner to protect its currency. Recent Economic Performance The Vietnamese Government's underlying objective is to achieve stable and high economic growth and development. Such growth was achieved in the early to mid 1990s, with real growth averaging 8% annually. However, the combined effects of the stalling reform process, the regional economic crisis, falling demand, including declining foreign and domestic investment, have slowed growth. According to official figures, GDP growth declined from 9.5% and 9.3% in 1995 and 1996 to 4.8% in The IMF estimated growth at 3.5% and the World Bank at around 4% in With an official growth rate of 6.2% for the first half of 2000 (partly the result of the recently improved value of its crude oil exports), Vietnam is expected to meet the government's growth target for 2000 of around 6%. The government has attempted to stimulate growth through a combination of fiscal and monetary policy measures. However, these have yet to prove fruitful. In 1999, unemployment was estimated at 7.4% by the World Bank. This is a major preoccupation for the Vietnamese government in its efforts to maintain economic and political stability. The economy does not generate enough jobs to accommodate the 7

317 annual growth in the labour force. According to the Ministry of Planning and Investment, total investment in Vietnam grew by 9% in But investment, as a proportion of GDP has fallen from 29% in 1997 to 19% in 1999 (World Bank estimate). Half of this decline can be attributed to the decline in foreign direct investment (FDI) flows from around US$2 billion annually between to the IMF's estimate of US$800 million of realised investment in On a sectoral basis, industrial output reached around US$12 billion, an increase of 10.4% over Overall, the industrial sector remained uncompetitive and was frustrated by falling demand, reflected by widespread stockpiling. Sub-sectors most affected were cement, sugar and steel. Of total industrial production, the state sector accounted for 50% (up from 44.5% in 1998), domestic private sector about 20%, achieving a growth rate of 8.8%, and the foreign invested sector about 30%, achieving a growth rate of nearly 20%. The agricultural sector was a bright spot in the economy, with an official growth rate of 5.3%. However, a simultaneous decline in domestic food prices by 7.8% led to the actual lowering of farmers' incomes, driving the decline in domestic demand even further. The consumer price index (CPI) rose by only 0.1% in 1999 and fell consistently from March to October Measures to stimulate demand have not been successful. Statistical data on the services sector is not readily available, but most commentators agree that economic activity in this sector reflects broader economic trends. As in most developing countries, the informal service sector masks underemployment and unemployment to a significant degree. Vietnam's trade deficit fell to US$113 million from US$ billion in 1998, a fall of 95%. Export earnings reached US$ billion, an increase of 23.1%. Notable export performances included crude oil (mainly due to increased world prices), textiles and garments, footwear, seafood, electronic appliances and computers, and handicrafts. The coal, coffee, and tea export sectors contracted. Vietnam's total imports in 1999 were valued at US$ billion, a slight increase of 0.9% or US$200 million from Declining domestic demand and the implementation of import quotas largely limited import growth. Cotton, textile thread, oil and petroleum, steel, plastic and chemicals were among the import sectors experiencing slight increases. 8