The study was build on Managerial Efficiency Theory of Profits, which assumes that firms that efficiently manage productive operations successfully meet their customers’ needs. Firms that demonstrate high managerial skills and production efficiency are compensated with above-normal profits (Sanyal, 2019). When management opts to change her operations, such as those that reduce the cost of operating business, product development, pricing structure, market models, they will undoubtedly enhance their profits.
The study builds on the innovation theory, which was propagated by Joseph Schumpeter in 1934. The theory assumes that innovation is the reason behind growth and fluctuations in business investments (Megha, 2016). Schumpeter uses the concept of ‘innovation’ to connote policy measures that reduce costs of production or increase demand for products (Sanyal, 2019). Therefore, economic profits come as a reward to the entrepreneur for his innovations that result in cost falls or increased sales at a better price (Knowledgiate Team, 2017). Cantwell (2001) adds some light on Schumpeter’s view of innovation. Innovation does not mean the temporary profits enjoyed in monopolistic markets by first movers but the ability of a firm to experiment with new technologies to solve problems that may associate to increased costs of production or affect sales volume. The point addressed here is that entrepreneurs should remain innovative since other players in the market are likely to copy the same innovations to their advantages, which affects the profits of the original innovator. Knowledgiate Team (2017) criticizes the theory on two grounds: the theory concentrates on innovations for occuring profits, which ignores several other factors that influence profits, such as financial management practices. The same criticism was raised by (Kaya, 2015) who posits that innovation is a multiplicity of actors, economic and non-economic in a society. Therefore, the entrepreneur ought to be dynamic in all economic development endeavors. The theory views the entrepreneur as merely an innovator yet he is responsible for other functions of the organizations such as financial management. To this, (Sweezy, 1943) adds that the entrepreneur must overcome the pyschological and social resistances that come by when attempting to do new things. In esssence, the author suggests that whether the entrepreneur is the innovator or not, he must exercise leadership potentials towards economic channels. The current study uses the innovation theory to link financial management practices to profitability in small and medium enterprises. Financial management practices are actions of innovation, aimed at reducing the costs of producing goods and services while increasing demand for these good and services.
Financial Management practices
(Kilonzo and Ouma, 2015) defines financial management practices (FMP) as management of funds and how these funds are put to use in achieving organizational objectives and maximization of share holders value. FMP is significant in supporting the diversification of service and product lines and these helps in planning for the growth of the business. Financial management shows the right direction for the future growth of the business by determining how to increase the market value of products and services which results to the economic growth of a country.FMP may include working capital management, capital structure, financial reporting mechanisms, capital budgeting and others.(Lavia-lopez and Hiebl , 2014) states that efficient financial reporting systems are significant in determining the growth and survival of small scale enterprises.(Musah, 2017) establishes that working capital management (WCM) is significant in making rightful decisions related to financial management which has a critical impact on the financial performance of a business enterprise. Capital structure represents the right capital mix of either debt or equity which enables financing business operations (Mazzarol et al… 2015).Companies should adopt optimal financial decisions aimed at increasing the financial performance of their firms and also adopt financial management practices that support the growth of their firms in expanding market share and profits (Muguchia, 2018). Similarly, (Marus Eton et al…, 2020) posits that there is need for business firms to align their business operations to the best financial management practices and train their staff on the internal control activities that ensure adherence to the principles of accounting and financial records. (Yohanes et al.., 2018) argues that an effective financial management practice may lead to expansion of businesses, success and profit making by small scale enterprises’. These financial management practices rotate in the allocation of resources, procurement and cash budgeting by small scale entrepreneurs. It’s significant for small scale enterprises to ensure that they have adequate and constant supply of financial resources to run their activities in order to get good returns. An established financial management practices supports managers to understand the financial position of a firm at a certain point in time and helps in forecasting the future financial need and trends (Muhozi and Mulyungi , 2018).
Today’s business firms are faced with the challenges of adopting the best financial management practices which affects financial stability of a firm.(Lakew and Rao, 2014) posits that inefficient FMPs coupled with unpredictable and harsh environment where businesses are operating often leads to huge challenges to the small scale enterprise. (Muneer et al.., 2017) opines that small scale enterprises have inefficient accounting and financial management systems which are completely different from the ones large companies have adopted. Inefficient and poor cash management system puts the business operators in a precarious situation especially when the customers are not satisfied with the services being offered and this may lead to a shift to the next service provider which affects profitability (Festus, 2011).Efficient and effective financial management practice is the base upon which financial manager’s use in tracking the financial success of an organization and the shareholders value (Maduekwe and Kamala, 2016). Firms should maintain an effective and efficient working capital as a policy and they should know how much of the working capital that ought to be maintained for daily operations of the firm (Sarkar and Sarkar, 2013). Managers of business enterprises and finance managers should therefore enforce adherence to cash policies put in place for purposes of guidance and managing cash (Kakeeto et al..,2017)
Cash management is an important practice as it embodies all payments and incomes during a particular period which are highlighted (Bobitan and Mioc , 2011). Optimum cash management is ideal in the sense that having too much cash may turn to be costly especially when one is paying interest on cash.(Mbroh, 2012) argues that efficient cash management system prevents bankruptcy while it increases business sustainability and profitability. Cash flows management is significant especially where accessibility of cash is seen to be exorbitant and difficult. These may be in a period where the economy could have slipped into recession and most businesses would be facing risk as most customers are facing financial difficulties in meeting their obligations. (Eton et al.., 2019) argue that there is need for business owners to consider hiring business experts who could use different statistical models to forecast business performance.
(Tauringana and Afrifa, 2013) defines profitability as an organizations ability to earn financial profit and gain. (Oladipupo and Okfor, 2013) posit that a firm’s net profit is determined by difference between revenue gained during a particular financial period and the enterprise operating expenses during a period of business operations. Profitability is the determinant of the growth, success and sustainability of any business venture (Onwumere et al.., 2012).Profit is a major objective of financial management which is wealth maximization (Malik et al.., 2011). Business enterprises that are not profitable do not survive for long in a highly competitive market. A business enterprise that is not generating revenue or profits does not survive in a hostile market (Eton et al., 2017).Firms should have businesses that are profitable and can sustain themselves in the market even under hostile conditions, (Adebayo and Onyeiwu,2018). In understanding the development and effective growth strategy of a firm and its position in the market is determined through its profitability (Al-Mwalla, 2012). Profit making is fundamental in survival of a business where as growth is seen as a key to long-term success and profitability in a business(Abuzayed, 2012).The growth and success of any business enterprise is determined on the ability of the business enterprise to always be making profit even if it’s facing any financial difficulties the a particular period. (Oladipupo and Okafor, 2013) establishes that it’s imperative for the business enterprise to assess the drivers that may enhance the business profitability if the firm expects to achieve the profitability goal of the business enterprise.(Moore et al.., 2010) argue that small business enterprises assume that higher revenues may result into higher profit margins and fail in realizing that if physical cash isn’t obtained from those revenues, business enterprises would end up with insufficient cash to meet its expenses and thus face challenges in managing its liquidity.
The adoption of various cost control methods such as cash flow management, standard costing and proper budget management system controls higher costs that business enterprises may likely incur at the same level of income where expenses are lower may result in increase of profitability (Kumar and Shafabi, 2011). Cash flow management in a business enterprise is significant in planning for the unforeseen, profitability and business sustainability which all business strives for (Patel, 2010). Most businesses argue that credit sales, increase in cash and inventory may lead to increased business profitability. (Syafri, 2012) urges that the composition of assets and the quality of loans that a business enterprise acquire would definitely affect the business profitability. Profitability of a business enterprise indicates how a business firms is in a position to generate income for a period of time from stock, assets and sales return. (Farah and Nina, 2016) establishes that productivity level and firms size are very strong determinant of profitability. It’s important to note that in conducting any business, finance managers ought to develop an effective profit strategy for their businesses (Gitman and Zutter, 2012).Profitability may be considered an important precursor to enterprise success and that most successful businesses do not suffer from the tradeoffs implied theory (Aron and Andrew, 2015).
Firm’s profitability may be grossly affected by inadequate funds that meet the operating costs and capital expenditure, mismanagement of fund and poor management of funds can greatly affect profitability (Pais and Gama, 2015).Inadequate capital, poor financial planning at your disposal, inadequate ability to match with the expected growth of the business enterprise and poor business forecast are some of the reasons affecting profitability which leads to businesses failure (Salazar, 2012). Profitability of any business enterprise is affected mostly as a result of liquidity and returns on assets invested by a business firm (Mmbaya, 2013).A study to determine the financial factors that affect profitability of SMEs by (Popa & Ciobanu, 2014) found managerial decision on investment to be key, in influencing profitability. The study established that managerial decisions on investment during inflation, unemployment, economic crises and changes in GDP are very important.(Asare & Angmor ,2015) used short-term loan, long-term loan and trade credit to measure the effect of debt finance on profitability. The findings indicate that short-term loan has a significant negative relationship between return on assets and profit margin ratio. Firms would always need thorough training and skills acquisition to better utilize their loans. New loans tend to constrain profitability among start-ups than older Loans (Banarjee, 2014). While this study suggests a link between financial constraints and growth, it lacks quantitative data on firm activity. Small Scale Enterprises that encounter multiple effects against their profitability are expected to have retarded growth levels. However, (Fitzsimmons, Steffens, & Douglas, 2005)found no evidence between growth and profitability. The authors established that growth rates are volatile over time and therefore, exhibiting a non-linear relationship. Examining the factors affecting profitability, (Margaretha & Supartika, 2016) found productivity and industry affiliation to positively influence profitability. Much as the authors recommend firm managers to design business strategies that focus on productivity, they do not show how these two variables affect profitability. In line with industrial affiliation, firms that involve in foreign trading enjoy higher profitability (Prijadi & Desiana, 2017). However, particular drive to profitability is evident among firms with optimal working capital. Small Scale Enterprises with liquidity show higher profitability than large wholesale and retail companies (Mijic, Nuseva, & Jaksic, 2018). (Nyambane and Ouma, 2017) posit that enterprises ought to establish liquidity management policies which would reduce risk for business failure and thus increase profitability. This policy procedure may uphold low cash conversion cycle.
Financial Management Practices and Profitability
(Zubair and Muhammad, 2013) argues that working capital management (WCM) is one of the determinants of profitability. It’s therefore significant to note that WCM plays an important role in improving business profitability. WCM practices ensure that firms are in position to continuously operate with adequate cash flows to meet the short term debts and operational expenses that may fall due. WCM especially trade credit management and cash management has a positive relationship with profitability of small scale enterprises (Norah et al.., 2015).The owners of small scale enterprises should pay a lot of attention on the financial management practices due to the positive effects it has on the profitability of their business enterprises (Yensu et al.., 2016). WCM is a significant instrument of profitability and when done through effective control it will measure a firm performance (Chowdhury et al…., 2018).Efficient WCM sets the base to providing enough liquidity for daily operations of the firm as the fall due to leading generation of profits (Wingaroja and O’Neil, 2018). Finance managers ought to have good working capital management techniques in order to create value for their share holders and these would enhance good relationships between profitability and working capital measures in a hostile business environment. (Muhozi and Mulyungi, 2018) notes that having a comprehensive financial plan would improve on the organizations profitability, these would be as a result of proper management of financial transactions by the qualified financial managers in the company. Companies that manage its financial management practices well have constantly reported an improved financial performance. Inefficiency in the financial management practices of the organization may cause damages in business growth and would adversely affect the firm. However, efficient management of finances would steer the business to achieve its growth where as wrong financial decisions are always very costly to a firm and managers should try to avoid such. In order to ensure long term survival of a business enterprise, business managers ought to have efficient and timely financial reporting, up to date accounting information system and adequate working capital so as to gain profits in the sector, (Yohanes et al.., 2018). Financial management practices are very crucial for the well being of business enterprises, survival and profitability (Lakew and Rao, 2014). FMP’s are majorly focused on profitability, liquidity, market values of the business and investment.
The harmonization of cash management practices such as cash payment and cash receipts are key for the enhancement of profitability in an organization (Uwuigbe et al…, 2012).Many business managers do not put much emphasis in cash flow which is a mistake as these managers confuse profits made from the business with the cash flows of the business (All Africa.com, 2013). The adoption of a liberal and a flexible credit policy by business enterprises would most likely increase sales and results into profit increase, but it may also lead to a risk of bad debt (Vijayakumar, 2011), however using a credit policy which is strict may result into increase in liquidity and security that reduces profitability (Akoto et al….., 2013). The ability to manage credit sales effectively may lead to building trust between the business enterprise and suppliers that leads into a long term business relationship and profit increase (Mbawuni et al.., 2014). The significance of effective and efficient credit management is based on a business operations methodology (Enow and Kamala, 2016).Profitability is noted to be positively influenced by credit management, cash management and debtor management (Nzitunga, 2019).Small scale entrepreneurs ought to adopt optimal WCM at which profitability is at its maximum (Afrifa and Padachi , 2016).
(Ali, 2019) urges that FMP had shown a significant improvement in the financial performance in the service companies. The company’s capability keeps on improving in the investment decision and working capital management. (Eton et al…, 2018) posits that business firms ought to devote time and more resources in equipping themselves and their employees with the basic financial management skills and knowledge to embrace business sustainability. Financial management skills should be conducted for small scale entrepreneurs in a bid to sharpen their financial skills with a purpose of improving on their daily operations (Bismark et al…, 2018). The ability of having the right finances injected into business and plan it effectively can support the firm’s growth and profitability. (Nyambane and Ouma , 2017) posits that while the business enterprises strives to meet its current obligations, the usage of cash balances would be ideal while investing the surplus cash in a better way that increases their levels of income.