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FINANCIAL REPORTING TO FINANCIERS BY AUSTRALIAN MANUFACTURING SMEs

by

Professor Richard G.P. McMahon,

Head, School of Commerce,

The Flinders University of South Australia,

GPO Box 2100,

Adelaide South Australia 5001.

Telephone: 08-82012840

Facsimile: 08-82012644

Email:

School of Commerce

Research Paper Series: 98-11

ISSN 1441-3906

Summary

The purpose of this paper is to present new empirical evidence on financial reporting to financiers by small and medium-sized enterprises (SMEs) engaged in manufacturing in Australia. The primary concern is with preparation and dissemination to external providers of finance of general purpose financial reports that may be historical and/or future-oriented. The nature and frequency of formal financial reporting, undertaking financial audits, the closeness of relationships with financiers outside of formal financial reporting, respondents’ views on how well their financiers appear to understand their businesses, and the propensity for the manufacturing SMEs studied to change their financiers are all considered. The findings suggest that, compared to other Australian SME research, financial reporting to financiers by the collaborating businesses is evidently very comprehensive. This must be seen as encouraging from a financial control viewpoint, and in terms of facilitating access to essential growth funding.

Acknowledgment:

Permission from the Australian Industrial Property Organisation to use data from the Australian Manufacturing Council’s Best Financial Practice study, conducted in 1995, is gratefully acknowledged.

FINANCIAL REPORTING TO FINANCIERS BY AUSTRALIAN MANUFACTURING SMEs

The purpose of this paper is to present new empirical evidence on financial reporting to financiers by small and medium-sized enterprises (SMEs) engaged in manufacturing in Australia. The primary concern is with preparation and dissemination of general purpose financial reports – the balance sheet, the profit and loss statement, and the cash-flow statement. A broad view is taken of what should be included amongst financial reporting practices. Specifically, both historical and future-oriented financial reporting are contemplated. Moreover, related matters such as undertaking financial audits, the closeness of relationships with financiers outside of formal financial reporting (including through financiers’ visits to factory premises, and whether or not financiers are kept informed of significant emerging issues), respondents’ views on how well their financiers appear to understand their businesses, and the propensity for the manufacturing SMEs studied to change their financiers are also considered.

The paper proceeds by first reviewing the very limited empirical evidence presently available in Australia on financial reporting to financiers by growing SMEs. After outlining the research data and method employed in this study, the financial reporting practices of cooperating manufacturing SMEs are described and analysed under the following broad headings: reliance upon external finance, formal financial reporting to financiers, and financier relationships. The paper closes with a summary of findings and conclusions arising from the research.

Previous Australian Research[1]

This section of the paper examines the limited empirical evidence presently available in Australia on financial reporting to financiers by growing SMEs. McCahey (1986) reports on the financial reporting practices of 40 small companies situated mainly in Melbourne, Victoria and surrounding suburbs. Owner-managers are ranked as the most important users of financial reports, closely followed by bank lending officers. Where they exist, non-managing owners are ranked highly as users, but behind owner-managers. The financial reports apparently provided to external users are indicated in Table 1.

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Take in Table 1

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Reflecting the types of financial reports mainly provided, reporting is predominantly on an annual basis. When asked what financial reports they provide in support of loan applications, the respondents to McCahey's (1986) survey indicate as in Table 2.

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Take in Table 2

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The respondents are of the opinion that bank lending officers do not regard the information contained in the financial reports as being as important to the lending decision as the enterprise's credit history.

In 1994, the National Investment Council, an advisory body to the Australian federal government on investment related matters, commissioned a study which sought (inter alia) to assess apparent causes of market failure in relation to financing of SMEs, particularly those with high growth potential. The study resulted in a report entitled Financing Growth: Policy Options to Improve the Flow of Capital to Australia’s Small and Medium Enterprises (Marsden Jacob Associates, 1995, pp. 1-2) which includes amongst its key findings the following:

  • Just 10 per cent or so of SMEs aspire to significant growth, and only about 30 per cent of these are willing to employ external equity financing.
  • Most growth SMEs seeking external equity financing are not ‘investment ready’ in that they fail to meet basic requirements for attractiveness to potential external investors.

The report goes on to point out that many growth SMEs in Australia simply do not know what is necessary in order to be investment ready, and therefore fail to attract the external financing they require for growth and development.

Consequently, another study was commissioned by the Australian government that culminated in a report entitled Investment Readiness Study (Ernst & Young and Centre for Innovation and Enterprise, 1997, p. viii) which defines investment readiness as ‘ a state of preparedness and/or willingness to take on an equity investor’. Amongst the three major factors identified as being important to an external investor’s assessment of a particular concern’s investment readiness is ‘the capabilities of management and the internal operations and control present in the business to achieve the identified growth potential’ (Ernst & Young and Centre for Innovation and Enterprise, 1997, p. 4). Amongst SME weaknesses associated with a lack of investment readiness are ‘poor internal systems’ and ‘lack of management information systems’. Such failings are claimed to not only limit management’s ability to successfully manage growth; but to also lead to an information asymmetry which makes it difficult for potential financiers to appropriately assess the risk and return parameters for an investment in the business. In a matrix of investment decision criteria for various investor groups, the following financial reporting considerations are listed:

  • Annual budgets and cash-flow forecasts are used.
  • Monthly management information is available.
  • Financial statements are audited.

Clearly then, timely and relevant financial reporting is a key element of investment readiness amongst growth SMEs in Australia.

In connection with the research described later in this paper, in 1995 the Australian Manufacturing Council conducted a mailed questionnaire survey of financial institutions that may provide debt finance to growing SMEs. The survey produced 15 replies from 42 mailings giving a response rate of 35.7 per cent (Australian Manufacturing Council, 1996). It is useful here to give some attention to the results of this survey for light they may shed on expectations of Australian lenders regarding the initial and on-going provision of financial information by SMEs that seek to borrow. Financial institutions surveyed indicate that the main problems they experience with manufacturing SMEs are as follows (Australian Manufacturing Council, 1996):

  • Poor financial reporting and management systems – often high-quality, up-to-date information is not available on a regular and timely basis, but is provided months in arrears.
  • Poor understanding of financial information – especially the significance of debtors, creditors and stock cycles and their impact on cash-flow and ability to service debt.
  • Lack of business plans or financial forecasts – suggesting that no strategies exist to underpin cash-flow projections and that, therefore, the credibility of those projections, and management competence generally, is questionable.

Amongst the reported consequences of these problems related to the limited availability, usefulness and reliability of financial information is ‘uncontrolled growth’ amongst many SMEs approaching financial institutions.

The following information is reported by the financial institutions responding to the survey to be the minimum documentation that must be attached to an application from a potential borrower (Australian Manufacturing Council, 1996):

  • Profit and loss statements and balance sheets for the last three years, possibly audited by an independent professional accountant.
  • Current year cash-flow statement and cash-flow forecasts for the term of the debt.
  • Budget projections for the next 12 months.
  • Aged debtors, creditors and stock schedules.
  • Statement of assets and liabilities of the principals (owners and owner-managers).

Of the types of financial information identified above, cash-flow statements and forecasts are reported to be most critical in determining the outcome of a loan application. Examining the sensitivity of cash-flow projections to changing enterprise, industry and economy-wide circumstances is indicated to be a vital step in evaluating a borrowing proposal. Also most important is information that will allow the lender to ascertain certain financial ratios for an applicant which are then compared to industry and institutional benchmarks to ascertain competitiveness and creditworthiness. Other information that could be sought includes a statement of Directors’ loans and assets, a statement of future capital expenditures, and relevant personal and company taxation returns. As suggested earlier, the ready availability and reliability of all such financial information is apparently taken as a key indicator of managerial competence in the borrowing enterprise.

Research Data and Method

A valuable opportunity to obtain new evidence on financial reporting practices of Australian manufacturing SMEs has been provided by the availability, through the federal government’s Australian Industrial Property Organisation, of data from an Australian Manufacturing Council study which led to its publication Practising Balance: Integrating Best Financial Practice Into Your Business (Australian Manufacturing Council, 1996). Cross-sectional research for the Best Financial Practice study involved a postal survey in late 1995 of a random sample, stratified disproportionately over enterprise size and manufacturing industry categories, of approximately 5,500 Australian manufacturing enterprises that are predominantly SMEs in employment terms. The survey used a self-administered, structured questionnaire containing 53 essentially closed questions focused on enterprise characteristics and performance, and financial management characteristics and practices. Responses were received from 1,763 enterprises, representing a response rate of 32 per cent. The Australian Manufacturing Council (1996, p. 78) indicates that ‘Responses were sufficient in each of the 48 cells (industry by size) to be taken as reflecting the full population’. Some marginal differences exist between the nature of respondents and non-respondents to the survey, but no significant non-response bias was discovered in relation to the matters presently of interest.

Over 1,100 responses to Best Financial Practice survey were from SMEs with the equivalent of 300 or fewer full-time employees and legally organised as proprietary companies.[2],[3]Ultimately, 1,050 responses could be used in this research. In terms of enterprise size, manufacturing sub-sector and geographical location in particular, the study sample finally employed is not strictly representative of the population of manufacturing SMEs legally organised as proprietary companies in Australia. However, it cannot be considered poor and/or unusable by contemporary business research standards in this country. In fact, the sample and data obtained appear very suitable given the stated purposes of this research. The sample approximates the larger end of the manufacturing SME spectrum and seems to include business concerns for which the extent and frequency of historical and future-oriented financial reporting could be important prevailing issues, and in which financial reporting practices may impact upon achieved growth and performance outcomes.

The research instrument produced data for 10 or so variables reflecting, in some way, financial reporting to financiers by respondents to the Best Financial Practices survey. Descriptions of the financial reporting variables are provided in the following section of the paper. All variables used in this research are categorical (nominal or ordinal) in nature and/or have irregular distributional properties. Thus, non-parametric/distribution free techniques of statistical analysis are employed exclusively.

Research Findings

Reliance Upon External Finance

This sub-section of the paper documents the reliance apparently placed upon external financing by manufacturing SMEs responding to the Best Financial Practice survey. How recently, if at all, respondents have sought external debt and/or equity finance is revealed in Figure 1.

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Take in Figure 1

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In all, 783 respondents indicate that they have sought external debt and/or equity finance at some stage since their formation. The modal response category is ‘in last year’ and the median response category is ‘1 to 5 years ago’ – together suggesting relatively recent experience of seeking external finance in the study sample.

A Kruskal-Wallis one-way analysis of variance indicates that larger enterprises in employment terms are statistically more likely to have recently sought external financing (n=969, H=15.843, df=4, p=0.003). A Mann-Whitney test reveals a statistically significant difference in incidence of seeking external finance between small enterprises and medium-sized enterprises in the study sample, with the latter tending to have had more recent experience (n=969, U=28,858.500, p=0.050).

The financing practices of businesses over time are ultimately reflected in the structure of their balance sheets – specifically the relative proportions of debt and equity funds cumulatively used. This relativity can be seen as proxying, in some senses, for the amount of influence lenders may have over the affairs of indebted businesses, possibly including their financial reporting practices. The ratio of debt to equity in the balance sheets of respondents to the Best Financial Practice survey is revealed in Figure 2 (the debt to equity ratio is borrowings, including overdrafts, as a percentage of owners’ equity, with loans from owners being regarded as debt).

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Take in Figure 2

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The modal response category is 0 to 25 per cent and the median response category is 26 to 50 per cent – together reflecting relatively moderate or conservative gearing in the study sample. A Kruskal-Wallis one-way analysis of variance suggests that debt to equity ratios tend to be statistically higher for those enterprises that have raised external finance more recently (n=917, H=104.853, df=3, p<0.000).

A Kruskal-Wallis one-way analysis of variance indicates that debt to equity ratio is higher with statistical significance for larger enterprises in employment terms (n=990, H=23.785, df=4, p<0.000). A Mann-Whitney test reveals a statistically significant difference in debt to equity ratio between small enterprises and medium-sized enterprises in the study sample, with the latter tending to be more highly geared (n=990, U=29,991.500, p=0.024).

Formal Financial Reporting to Financiers

This sub-section of the paper presents new evidence on actual financial reporting to finance providers by manufacturing SMEs responding to the Best Financial Practice survey. Table 3 indicates the types of financial reporting to their financiers apparently undertaken by enterprises in the study sample (to facilitate interpretation of Table 4, names for the relevant nominal study variables are indicated in Table 3).

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Take in Table 3

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Note that business plans normally contain both historical and future-oriented financial statements, often covering several years. Future-oriented financial statements are most likely to be part of annual budgets. Periodic historical financial statements are those prepared at least quarterly. Clearly, there is an high incidence of provision of annual historical financial statements to financiers; and future-oriented financial reporting to financiers also seems relatively commonplace.

Associations between the various forms of financial reporting to financiers identified in the previous paragraph are shown in Table 4.

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Take in Table 4

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These associations range from weak through to moderate, and all are statistically significant. This suggests a tendency for some financiers to be reasonably demanding across the range of financial information that might be requested by them from those SMEs seeking financing support.

A series of Mann-Whitney tests suggests that a statistically significant relationship exists in the study sample between enterprise size in employment terms and provision to financiers of business plans (n=700, U=44,672.000, p=0.001) or future-oriented financial statements (n=682, U=38,965.000, p<0.000) or annual historical financial statements (n=728, U=18,372.500, p<0.000) or periodic historical financial statements (n=668, U=38,208.000, p<0.000). In each case, larger enterprises are more likely to provide the financial information indicated to their financiers. A series of Chi-Square tests indicate that a statistically significant difference exists between small enterprises and medium-sized enterprises in terms of their provision to financiers of business plans (n=700, 2=5.045, df=1, p=0.025) or future-oriented financial statements (n=682, 2=8.577, df=1, p=0.003) or annual historical financial statements (n=728, 2=4.568, df=1, p=0.033) or periodic historical financial statements (n=668, 2=18.692, df=1, p<0.000). In each case, medium-sized enterprises are more likely to provide the financial information indicated to their financiers.

It is interesting to note that, of 312 manufacturing SMEs claiming to have experienced some type of external financing problem, only four report that they have been refused finance because they have submitted insufficient financial information. This could reflect that SMEs are generally forthcoming with financial information when applying for finance and/or, more plausibly, that lenders can ultimately insist that such information is provided. Including the four already referred to in this paragraph, 162 respondents to the Best Financial Practice survey report having been asked to supply more financial information than they initially provided in support of their most recent loan application. This amounts to 23.2 per cent of those who considered the question relevant to their circumstances and answered it. Curiously, a series of Chi-Square tests reveals that no statistically significant difference exists between the likelihood of being asked to provide more financial information by a potential financier and reported provision to financiers of business plans (n=584, 2=0.528, df=1, p=0.468) or future-oriented financial statements (n=574, 2=1.217, df=1, p=0.270) or annual historical financial statements (n=609, 2=1.243, df=1, p=0.265) or periodic historical financial statements (n=563, 2=0.126, df=1, p=0.723).

A Mann-Whitney test suggests that no statistically significant relationship exists in the study sample between enterprise size in employment terms and the likelihood of being asked to provide more financial information by a potential financier (n=697, U=42,258.500, p=0.618). Furthermore, a Chi-Square test indicates no statistically significant difference between small enterprises and medium-sized enterprises in terms of their likelihood of being asked to provide more financial information by a potential financier (n=697, 2=0.003, df=1, p=0.953).