Across the world, micro, small and medium sized enterprises have been known to be the backbone of the economy and have played a key role in developing countries for decades. According to the data provided by the International Council for Small Business (ICSB), formal and informal micro-, small and medium-sized enterprises (MSMEs) make up over 90% of all firms and account, on average, for 70% of total employment and 50% of GDP.
As declared by the General Assembly of the United Nations, 27 June has been set aside to raise public awareness for these enterprises and their contribution to a sustainable development and the global economy.
In my over two-decade years as a banker and consultant, my dealings with clients have been mostly centred around SMEs and the difficulty they face in accessing funds and managing their finances. I have been able to conclude that in addition to the financial challenges SMEs face, another pressing issue is their coping mechanisms and strategies.
The economy is highly volatile, with constantly changing trends, and many SMEs lack the necessary knowledge to stay afloat. A volatile environment simply refers to a situation where the competition level is very high and leaves less room for an equal share of the market due to external forces. This is evident in the present economy following the impact of the Covid-19 pandemic.
For SMEs, coping in a volatile environment requires adopting a capital management strategy that ensures the business operates efficiently while fulfilling its short-term and long-term financing.
Today, I will be focusing on the concept of capital management and how SMEs can efficiently ensure the continuity of business operations while fulfilling its short-term and long-term financing.
What is capital management?
Advisory HQ, a top news and ranking organisation focused on the business world, defines capital management as “a financial strategy aimed at ensuring maximum efficiency in a company’s cash flow.” Thus, the answer to “what is capital management?” is simply “managing a company’s money.”
In reality, however, capital management is much more complex as it involves a balance between a number of competing factors, ie knowing what measures to implement and at what times. It also means a focus on the assets and liabilities of the company – a company must be able to balance its current assets against its current liabilities in order to meet its financial obligations as and when due.
The capital management strategy to be adopted in choosing the mix of short- and long-term funds is usually a trade-off between risk/security and profitability and it is dependent on the maturity of the funds being used.
Short-term funds have lower interest rates which results in higher profitability while long-term funds have higher interest cost, resulting in lower profitability. So, if the goal of the company is profitability, short-term financing will be used. In addition to interest rate fluctuations, there is the uncertainty of refinancing short-term funds. These will increase the cost of the funds thereby reducing the profitability. Whereas, with long-term funds, those risks do not apply. So, if the goal of the company is security, long-term financing will be used.
What are the capital management strategies available to SMEs?
There are mainly three capital management strategies that can used to choose the mix of long- and short-term funds for financing in SMEs.
A conservative strategy - a strategy focusing on lower profitability and lower risk. Here, long term funds are used to finance the company’s fixed assets, permanent current assets and a part of temporary working capital. It suggests not to take any risk in working capital management and to carry high levels of current assets in relation to sales. Surplus current assets enable the firm to absorb sudden variations in sales, production plans, and procurement time without disrupting production plans. Businesses financed with equity can adopt this strategy by getting long-term finance generated from the sale of company shares without having to fear insolvency.
An aggressive strategy - a strategy focusing on higher profitability and higher risk. Here, short-term funds are used to fund the costs of the current cycle, ie the complete temporary working capital and a part of permanent working capital while long-term funds are used to fund the company’s fixed assets and a part of the permanent working capital. SMEs funded by purely debt capital can adopt the aggressive strategy which generates a high risk and high profitability.
A hedging or maturity matching strategy - a strategy that can be said to fall somewhere between conservative and aggressive strategies. It favours moderate risk and profitability. A number of approaches can be used to manage risk and return of both long- and short-term funds, ie each of a company’s assets would be financed by a debt instrument of almost the same maturity, for example an asset that is maturing after 30 days will have its payment matched with a debt whose due date of payment is after almost 30 days. This strategy works on the cardinal principle of financing, ie utilising long-term funds for financing long-term assets, such as fixed assets, and a part of permanent working capital and short-term funds for financing short-term asset, ie temporary working capital. SMEs funded by both equity and debt can adopt the matching/hedging strategy which states that current and fixed asset will be met with long- and short-term funds.
What is the way forward for SMEs?
From our point of view, the pandemic brought about some pros and cons that affected the process of doing business. For example, during the pandemic lockdown, many businesses were shut down while some changed their operating models to stay afloat. It was not business as usual.
Some of the adopted strategies included:
Diversification into other service areas or products to attract customers. Our article on exploring new markets explains how to go about this.
Price change - With regards to price level changes, it is important to review existing pricing strategies and align them with current market dynamics. For example, SMEs can negotiate flexible payment structure with suppliers
Taking advantage of government support and policies to support small and medium-scale businesses. This depends on the industry or sector your business operates under. The covid-19 protocol on monetary policies made it possible for businesses to have access to lower interest rates and credit facilities.
Optimisation of the use of virtual communication and digital offerings to customers.
I believe that the key to managing the effect of the pandemic and improving a company's working capital is by devising new ways of solving the challenges posed to business. For example, a company can:
Balance current assets against current liabilities.
Leverage on proper invoicing methods.
Find ways of increasing sales income and collecting on accounts receivable.
Track expenses against revenue to discover which of the strategies to adopt.
Ensure that all necessary raw materials are present to avoid any production stoppages.
Ensure finished goods go to market on time to be able to collect accounts receivable. This will be used to settle all accounts payable. Any extra revenue or profit will create a cushion for the next cash cycle.
For more support on how to choose a capital management strategy, please reach out to us at enquiries@ovacgroup.com
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