IMPACT OF FINANCIAL MANAGEMENT PRACTICES ON PROFITABILITY OF BUSINESS ENTERPRISES

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CHAPTER ONE

INTRODUCTION

1.1. BACKGROUND TO THE STUDY

Business Enterprises (SMEs) are seen as a driving force for the promotion of an economy (Khan and Jawaid, 2004) and they contribute immensely to the economic development of any country. According to OECD (1997), business enterprises play a major role in economic growth and development, creation of employment and income generation. Business enterprises in Nigeria contribute enormously to National Gross Domestic Product (GDP) and employment in the informal sector. It creates employment and leads to the export of locally manufactured goods and services as well as helping the local government authorities to generate tax revenues for socio-economic development. As in most developing countries, small and medium-scale enterprises form a significant part of the economic growth. Nevertheless, they face a number of problems, including access to finance from formal sources, which is oen considered to be the most important problem (MFPED, 2008). Consequently, the growth of the SME sector directly aects the performance of the nation. In all economies they constitute the vast majority of business establishments and they are usually responsible for the majority of employment opportunities created which account for one third to two thirds of the private sector turnover (Ntsika, 2002). It is estimated that SMEs contribute 56% of private sector employment and 36% of the Gross Domestic Product (GDP) worldwide (Ariano, 2010).

In many countries, SMEs have been a major engine of growth in employment and output over decades. In developing countries they are seen as a major „self-help‟ instrument for poverty eradication due to the ease of entry and exit. The success or failure of small to medium enterprises (SMEs) is contingent on their financial viability and one of the most common problems facing such firms is their ability to secure sufficient cash flow and working capital to remain profitable. Financial management is one of several functional areas of management which is central to the success of any small business (Meredith, 2006). Financial management is the management of finances of a business in order to achieve the financial objectives of the business. McMahon et al. (2008) 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.

Financial management as used in this study is composed of five (5) constructs and these include; working capital management which is also subdivided into cash management, receivables management and inventory management. Other constructs under financial management include; investment, financing, accounting information systems and financial reporting and analysis. Ross et al (2009) indicated three kinds of decisions the financial manager of a firm must make in business; these include the financing decision, and decisions involving short-term finance and concerned with the net working capital, investment and financial reporting. Inefficient financial management may damage business efficiency and this will continuously affect the growth of the Small and Medium enterprises.

However, efficient financial management is likely to help SMEs to strengthen their business efficiency and, as a result, these difficulties can partly be overcome, also regardless of the business enterprise, if the financial decisions are wrong, profitability of the such enterprises will be adversely affected. Consequently, a business organization’s profitability could be damaged because of inefficient financial management. Business Enterprises have often failed due to lack of knowledge of efficient financial management. Similarly, Ang (2002) indicated three main financial decisions including the investment decisions, financing decisions and dividend decisions. Meredith (2006) asserts that 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. However, such areas are not currently well embraced by SMEs in Nigeria and urgent attention needs to be paid to. Lack of effective management during SMEs early stages is also a major cause of business failure for small businesses. Owners tend to manage these businesses themselves as a measure of reducing operational costs.

1.2. STATEMENT OF PROBLEM

Financial management in SMEs is often different to that found in large firms due to the more dynamic nature of their cash flow cycle, general paucity of working capital, and their ability to raise finance through debt or equity (Welsh and White, 1981). SMEs also lack the financial management and accounting systems available to large firms, as well as the professional sta who manage such systems. Typically the owner-manager is required to perform these tasks, oen, but not always, with support from a bookkeeper and an accountant. This is a pattern found throughout the world, both within the advanced economies that comprise the Organisation for Economic Co-operation and Development (OECD) group of nations, and the developing economies (OECD, 2010). Poor business performance has for long remained unexplained most especially in the third-world countries perspective where the Small and Medium Enterprises occupy the large part of the economy. However, some studies from developed nations see (Nguyen, 2001) cite inefficient financial management practices to contribute immensely to SMEs poor business performance. Thirdly, research indicates that most small businesses have inadequate financial structures and activities, this problem causes inconsistent SMEs financial records and large discrepancies arise in the ways the business enterpise report their financial positions. For example, many SME in developing countries may have two or three sets of books for different audiences. Auditing such financial records can be labor and time intensive, which raises the cost of loan processing for SMEs, in addition auditing such financial statement can be unreliable.

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