Theoretical Literature Review Pecking Order Theory Finance Essay

The purpose of this chapter is to give an introduction to this study and an explanation why the research was being done. First it reviews literature on Small and Medium Sized Enterprises. Thereafter, it also discusses the nature and importance of working capital as well as strategies used in management of working capital. Finally, it analyzes information on the challenges facing SMEs in management of working capital all over the world. The Pecking Order Theory takes into consideration the information asymmetry which indicates that managers know more about the firm's value than potential investors (Myers and Majluf, 1984). The information asymmetry affects the choice between internal and external financing. Based on this concept, the Pecking Order Theory suggests that firms tend to rely on internal source of funds to be financed, and prefer issuing debt to equity if external financing is required (Myers and Majluf, 1984). According to Nakamura et al. (2007 p.76), that order is based on the consideration that "resources generated internally do not have transaction costs and on the fact that issuing new bonds tend to sign a positive information about the company, while issuing new stocks tend, on the contrary, to sign a negative information". The information asymmetry decreases the price of new bonds to be issued and, consequently, increases the transaction costs in the capital markets derived from lack of cash (Myers and Majluf, 1984). From this point of view, companies do not pursue a specific objective for the debt level and they use external funds only when internal funds are not enough (Graham and Harvey, 2001). External source of funds are less desirable because the information asymmetry between managers and investors implies that external source of funds are underpriced in relation to the asymmetry level (Myers and Majluf, 1984). This theory, according to Chen (2004), explain the company's choice to keep an amount of reserve in cash or other forms of financial slacks to avoid the problem of lack of resources and the need of external sources. From this point of view, cash is similar to "negative debt", getting external resources when there is lack of cash and paying debt when there is excess of cash. Thus, the company chooses a more passive cash management policy, waiting to liquidate an existent debt in any time with no cost (Koshio, 2005). Financial slack is a result of large holdings cash or marketable securities, or the ability to issue default-risk free debt, beyond what is needed to meet current operating and debt servicing needs (Myers and Majluf, 1984; Brealey, Myers and Allen, 2008; McMahon, 2006). To have a fast access to debt market, companies chooses a conservative financing, in a way that potential investors see them as a safe investment. According to Smith and Kim (1994) and McMahon (2006), financial slack, in adequate levels, allow the company to pursue positive net present value investment opportunities without issuing risky securities. The conventional rationale for holding financial slack - cash, liquid assets, or unused borrowing power - is that the companies do not want to have to issue stock on short notice in order to pursue a valuable investment opportunity (Myers and Majluf, 1984). Brealey, Myers and Allen (2008) suggested that the Pecking Order Theory explains the reason why more profitable companies usually ask less for borrowing money - not because they don't have lower levels of debt targets but because they don't need external source of funds. On the other hand, less profitable companies issue bonds because they don't have enough internal funds to finance investments decisions. In this matter, those companies also prefer issuing debt before issuing new stocks. Following this theory, not only managers of less profitable companies but also managers of more profitable companies would choose a more aggressive working capital policy, pressuring for lower level of current assets and higher level of financing via suppliers, in a way to source internally the needed funds to finance their companies and to avoid issuing debt and equity. The purpose of the first research hypothesis is to understand if companies with a higher debt level have also lower working capital level, reflected in lower level of inventory, lower credit terms and higher payment terms due to a management decision decide to adopt an aggressive working capital management to avoid issuing new debt and equity.

2.2.2 Agency Theory

According to the Agency Theory (Jensen and Meckling, 1976), a firm can be seen as a nexus of a set of contracting relationships (implicit as well as explicit) among individuals, by means of which shareholders - principals - delegate everyday decisions of business management to managers - agents - who should use their specific knowledge and company's resources to maximize principal agents' return. Through these contracts or internal "rules of the game", shareholders specify "the rights of each agent in the organization, performance criteria on which agents are evaluated, and the payoff functions they face" (Fama and Jensen, 1983, p. 2). Due to a non-rational and opportunistic behavior of agents (Jensen, 1994), the interests and decisions of managers are not always aligned to the shareholders' interests, resulting in agency costs or agency problems. For Shleider and Vishny (1997), the essence of the agency problem is the separation of ownership and control. In large and complex organizations, these problems can be clearly observed, once the valuable and specific knowledge relevant to decision control is diffused among many internal agents across the company (Fama and Jensen, 1983). In this case, owners are not able to participate in the ratification and monitoring of each decision due to the high costs associated. Jensen and Meckling (1976) defined agency cost as the sum of the expenses in monitoring by the principal, the bonding expenditures by the agent and the inevitable residual loss derived from the separation of ownership and control. To minimize divergences of interests, the principal can establish incentives, monitoring mechanisms and instruments to make sure agents don't take actions to jeopardize their interests or to be compensated ("bonding costs") in the case of any agency problem. Fama and Jensen (1983) suggested that the agency problems could be minimized through the separation of the ratification and monitoring of decisions from the initiation and implementation of decisions. Thus, organizations should count on decision control systems as formal decision hierarchy, mutual monitoring systems and active board of directors. Weir and Laing (2003) differentiated three mechanisms designed to protect shareholder interests: incentive, monitoring and disciplinary mechanisms. Incentive mechanisms include executive director shareholdings or board compensation systems (Jensen and Meckling, 1976), while monitoring mechanisms include, for example, the proportion of outside directors on board (Fama, 1980; Fama and Jensen, 1983) and disciplinary mechanisms include the market for corporate control (Jensen, 1986). Monitoring devices were designed by shareholders to aligned agents' actions to their interests (Fama, 1980). According to Tirole (2005), monitoring systems include a variety of instruments such as board composition, auditors, large shareholders, large creditors, investment banks, etc. The decision of how to invest internal funds is central in the shareholders and managers conflicting interests (Jensen, 1986). For Easterbrook (1984), when managers have a substantial part of their human capital or wealth allocated in company's share, they tend to take decisions to enhance the probability of company's survival. These decisions can be reflected in a conservative management of working capital, reducing the risk involved in the business operation, such as to keep high level of inventories beyond the process cycle needs, to offer credit terms above the product turnover, to accept low payment terms not aligned to the market practices, etc. In that case, these investment decisions would be translated in excess of working capital. Therefore, the second research hypothesis is to investigate if companies that present monitoring mechanisms of managers' actions have lower level of working capital requirement. According to Jensen (1986), managers with substantial free cash flow have incentives to engage the company in unnecessary expenses. He defined free cash flow as the excess of cash flow beyond the required to fund all projects that have positive net present values when discounted at the relevant cost of capital. In an organization with low level of monitoring or discipline on management actions, a high level of free cash flow may incentive managers, guided by their own interests, to undertake negative present value capital projects rather than return cash to equity holders (McMahon, 2006). Jensen (1986) suggests that manager tend to invest the free cash flow in new projects because they are motivated to cause their firms to grow beyond the optimal size. Company's growth increases manager's power by increasing the resources under their control, which is also associated with increases in managers' compensation, commonly linked to sales. For McMahon (2006, p. 15), "retaining free cash flow is essentially a negative net present value investment in liquidity". Therefore, companies with high level of free cash flow may have higher agency costs, derived from expenditures with organizational inefficiencies or investments with negative returns. The third research hypothesis aims to explore if companies with higher level of free cash flow also have higher level of working capital, represented by the excess of the difference in current assets and liabilities as a result of investment in inefficient projects with negative or null net present value.

2.3 Empirical literature review

Cash Conversion Cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable. There are benefits to using the CCC. CCC = Inventory conversion period A  + A  Receivables conversion period A  - A  Payables conversion period Use of the CCC approach provides a framework within which management can analyze the impact of changes in the management of the components of working capital on working capital as a whole, and on the performance of the business (Schilling, 1996, Gallinger and Healey, 1987). Sensitivity analysis of key variables and the impact on performance criteria such as liquidity, efficiency, productivity, and profitability can be undertaken systematically (Gallinger 1997, Gitman, 1997, Schilling, 1996, Brigham and Gapenski, 1994, Maness, 1994, Moss and Stine, 1993, Soenen, 1993, Chang, et al. 1991, Cheatham, 1989, Shulman and Cox, 1985). Measuring working capital in terms of the CCC provides an indication of the volume and speed with which cash is generated in the cycle of buying goods and services, creating inventories, selling for credit, collecting cash from customers (Maness, 1994, Cheatham, 1989), and paying trade creditors. Managing working capital by means of the CCC approach contributes toward maximization of share value (Back, 1988), decreases the need for external financing, preserves proportionate shareholder value, preserves unused debt capacity (Soenen, 1993) and enhances profitability (Chang, et al. 1995, Kamath, 1989, Madura and Veit, 1988 Gallinger and Healey, 1987). Unfortunately the CCC focuses only on the length of time funds are tied up in the cycle. It does not take into consideration the amount of funds committed to a product as it moves through the operating cycle (Maness, 1994, Cooley and Roden, 1991, Gentry, et al. 1990). CCC utilizes days sales outstanding to determine the length of time funds are tied up in accounts receivable. The shortcoming in using day's sales outstanding as a performance measure of receivable management is that it is dependent on sales pattern effect, a collection experience effect and a joint effect that causes accounts receivable to change (Gentry, et al. 1990). The CCC is based on standard accrual accounting information and procedures which is indirectly related to a business's valuation (Gentry, et al. 1990, Cheatham, 1989). This information needs to be transformed into economic information. Richards and Laughlin (1980) do not decompose inventories into its three component parts, raw materials, work in progress, and finished goods (Gentry, et al.1990). The operating cycle as described by Richards and Laughlin (1980) assumes all the costs related to raw materials, production, distribution and collection start on the first day of the cycle and have the same amount as the final value of the product (Gentry, et al.1990). In other words, the dollar costs are not uniform per day of CCC. Given the fact that the length and reliability of the CCC depends on the industry or environment in which the business operates; the concept of float; the number of days a company get credit from suppliers; the length of the production process; and the number of days finished products remain in inventory before they are sold out (Maness 1994, Soenen, 1993, Cooley and Ryan, 1991, Madura and Veit, 1988) the possibility of increasing the CCC as an objective of working capital management rather than only shortening the CCC is ignored. Various researchers (Maness, 1994, Gentry, et al. 1990, Cheatham, 1989) have addressed some of the limitations of the CCC. Cheatham (1989) takes the framework of Richards and Laughlin (1980) one step further by converting the number of days of the CCC to a dollar value to measure the performance of the business's operations (Cheatham, 1989). Maness (1994) takes the basic Richards and Laughlin's approach (1980) and inserts average values into the equation. The weighted cash conversion cycle approach of Gentry, Vaidyanathan and Lee (1990) enables some of the above limitations of the basic CCC approach to be addressed, and is presented and discussed in the next section. Gentry, Vaidyanathan and Lee (1990) take the traditional cash flow line of Richards and Laughlin (1980) and expand on the basic CCC defmition. In short, the weighted CCC measures the weighted number of days funds are tied up in receivables, inventories, and payables, less the weighted number of day's cash payments are deferred to suppliers. The weight used is determined by dividing the amount of cash tied up in each component by the final value of the product so that the performance of management at all levels of working capital can be evaluated, rather than at the aggregate level only. Gentry, Vaidyanathan and Lee (1990) developed the WCCC as a two-stage process. The first phase determines the number of days funds are tied up in raw materials, work in progress, final goods, accounts receivable and gives the weighted operating costs. The weighted operating cost brings costs into the analyses and they are added at each phase of the operating cycle. These costs are adjusted for their respective weights namely their relative dollar contributions. The weighted operating cycle provides an aggregate current asset summary measure for short-run financial management. When managing working capital factors such as fluctuations in the level of economic activity (Brigham and Gapenski, 1994, Madura and Veit, 1988), the term structure of interest rates (Gitman, 1997, Brigham and Gapenski, 1994, Weston and Brigham, 1992, Asch and Kaye, 1989, Back, 1988), the monetary policy of the Reserve Bank (Gitman, 1997, Brigham and Gapenski, 1994, Back, 1988), the business cycle (Nawrocki, 1997, Begg, et al. 1994, Beardshaw and Ross, 1993), monetary and fiscal conditions, and exchange rates need to be included in the analysis upon which their decisions are based.

2.4 Contextual literature review

2.4.1 Definition of SME

According to the SME Solutions Center (SSC, 2007) in Kenya, there is no specific definition for an SME. Organizations that lend money to the SMEs mostly look at the cash flows from such enterprises so as to test whether they can be able to repay back the money given to them. However, according to the SME solution centre, Micro and Small enterprises can have even one employee and its not easy to examine the cash flows they get, it has not thus been easy to categorize these enterprises according to their cash flows or the number of employees they have. In Kenya, an enterprise that is a formally registered business can qualify to be an SME. The SME definition that is currently in use in the EU is based on the Commission Recommendation 96/280/EC. In accordance with the Article 1, the definition of SMEs adopted by the European Commission is the following: 1. Small and medium-sized enterprises, hereinafter referred to as SMEs, are defined as enterprises which: Have fewer than 250 employees, and have either An annual turnover not exceeding ECU 40 million, or an annual balance-sheet total not exceeding ECU 27 million, and conform to the criterion of independence as defined in 3 below. 2. Where it is necessary to distinguish between small and medium-sized enterprises, the "small enterprise" is defined as an enterprise which: Has fewer than 50 employees and has either an annual turnover not exceeding ECU 7 million, or an annual balance-sheet total not exceeding ECU 5 million, conforms to the criterion of independence as defined in paragraph 3. 3. Independent enterprises are those which are not owned as to 25 % or more of the capital or the voting rights by one enterprise, or jointly by several enterprises, falling outside the definition of an SME or a small enterprise, whichever may apply. This threshold may be exceeded in the following two cases: If the enterprise is held by public investment corporations, venture capital companies or institutional investors, provided no control is exercised either individually or jointly, if the capital is spread in such a way that it is not possible to determine by whom it is held and if the enterprise declares that it can legitimately presume that it is not owned as to 25 % or more by one enterprise, or jointly by several enterprises, falling outside the definitions of an SME or a small enterprise, whichever may apply. In the 2004 SME Finance Conference in Cairo Egypt, Assad presented a paper highlighting the role of SMEs in any economy. SMEs are expected to boost efficiency and growth and lead to economic development because they: constitute the most dynamic segment of many transition and developing economies are an engine of job creation are a seedbed for innovation and entrepreneurship offer new entry, competition and flexibility play an important role in promoting growth and development The importance of Small and Medium Enterprises (SMEs) and Micro Firms in both national and international context is undoubtedly of higher relevance. In a large number of countries the percentage of micro and small firms is extremely high, e.g. 98% in Portugal. These firms are important not only on what concerns to its representation for economic analyses but also for the countries' economies and the implications that it brings to the society. These firms have an important role on many aspects, such as employment, taxes or innovation that, most of times, is regarded as something on the responsibility of large firms or research centers. Through their flexibility and their potential for employment creation, SMEs can play a major role in regional development (Inforegio, 2000).

2.4.2 An Overview of Kenyan Economy

Government of Kenya (2002) said that Kenya, with a gross domestic product (GDP) approaching US$12 billion, is the most developed economy in East Africa. The country possesses an extensive infrastructure, a generally well-educated population, and a strong entrepreneurial tradition. Kenya's pattern of economic output has undergone a structural transformation since independence in 1963. Kenya has a sizeable SME sector that the government is attempting to promote. The sector was estimated to employ about 3.2 million people and contributed about 18 per cent of total GDP in 2003. Earlier government policies aimed at promoting the SMEs were based on welfare considerations: SMEs were regarded as potential generators of employment, vehicles for achieving balanced regional growth and as counterweights to the concentration of economic power by larger firms. This contributed to keeping the SME sector in Kenya weak and uncompetitive. (OECD Development Centre 2004/2005)

2.4.3 Role of SMEs in the Economy

In the mid 1960's, the government of Kenya started to focus on the development of the SMEs in the country. This was due to several factors: First, there was growing concern over low employment elasticity of modern large-scale production. It was claimed that even with more optimal policies, this form of industrial organization was unable to absorb a significant proportion of the rapidly expanding labor force (Cherney et al., 1974; ILO, 1973). Second, there was widespread recognition that the benefits of economic growth were not being fairly distributed, and that the use of large-scale, capital intensive techniques was partly to blame (McCormick, 1988; House, 1981; Cherney et al., 1974).

2.4.4 Nature and Importance of working capital

Pandey (2006) defines working capital as the difference between current assets and Liabilities. Current assets mainly refer to inventory, receivables and cash while current liabilities considered here are creditors (payables). A statement reporting the changes in working capital is useful in addition to the financial statements. He further adds that there are two concepts of working capital: Gross working Capital: This refers to the firm's investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short term securities, debtors (account receivables), bills receivable and stock (inventory) Net working capital: It refers to the difference between current assets and current liabilities. Current Liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets. These two concepts of working capital are not exclusive and have equal significance from the management viewpoint. The working capital meets the short-term financial requirements of a business enterprise. It is a trading capital, not retained in the business in a particular form for longer than a year. The money invested in it changes form and substance during the normal course of business operations. The need for maintaining an adequate working capital can hardly be questioned. Just as circulation of blood is very necessary in the human body to maintain life, the flow of funds is very necessary to maintain business. If it becomes weak, the business can hardly prosper and survive. Working capital starvation is generally credited as a major cause if not the major cause of small business failure in many developed and developing countries (Rafuse 1996). The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. Poor financial management exacerbates the cash flow problems of many small businesses and in particular the lack of planning cash requirements (Jarvis et al, 1996). Van Horne (2001) classifies working capital types into two categories. The first category is called permanent working capital, which specifies the amount of current assets required to meet a firm's long-term minimum needs for a company. The other type of working capital is called temporary working capital. This is the amount of current assets that varies with the company's seasonal requirements (Van Horne, 2001).

2.4.5 The Management of Working Capital

According to Horne and Warchowicz 2001, working capital management is the administration of the firms' current assets (inventory, cash and marketable securities and receivables) and the financing (current liabilities) needed to support current assets. For small companies, current liabilities are the principal source of external financing. These firms do not have access to the longer-term capital markets, other than to acquire a mortgage on a building. While the performance levels of small businesses have traditionally been attributed to general managerial factors such as manufacturing, marketing and operations, working capital management may have a consequent impact on small business survival and growth (Kargar and Blumenthal, 1994). The management of working capital is important to the financial health of businesses of all sizes. The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way. However, there is evidence that small businesses are not very good at managing their working capital. Given that many small businesses suffer from under capitalisation, the importance of exerting tight control over working capital investment is difficult to overstate. Padachi (2006), states that a firm can be very profitable, but if this is not translated into cash from operations within the same operating cycle, the firm would need to borrow to support its continued working capital needs. Investments in current assets are inevitable to ensure delivery of goods or services to the ultimate customers and a proper management of the same should give the desired impact on either profitability or liquidity. If resources are blocked at the different stage of the supply chain, this will prolong the cash operating cycle. Although this might increase profitability (due to increase sales), it may also adversely affect the profitability if the costs tied up in working capital exceed the benefits of holding more inventories and/or granting more trade credit to customers. Another component of working capital is accounts payable, but it is different in the sense that it does not consume resources; instead it is often used as a short-term source of finance. Thus it helps firms to reduce its cash operating cycle, but it has an implicit cost where discount is offered for early settlement of invoices. (Padachi 2006) Although working capital is the concern of all firms, it is the small firms that should address this issue more seriously. Given their vulnerability to a fluctuation in the level of working capital, they cannot afford to starve of cash. The study undertaken by (Peel et al., 2000) revealed that small firms tend to have a relatively high proportion of current assets, less liquidity, exhibit volatile cash flows, and a high reliance on short-term debt. The recent work of Howorth and Westhead (2003), suggest that small companies tend to focus on some areas of working capital management where they can expect to improve marginal returns. For small and growing businesses, an efficient working capital management is a vital component of success and survival; i.e. both profitability and liquidity (Peel and Wilson, 1996). They further assert that smaller firms should adopt formal working capital management routines in order to reduce the probability of business closure, as well as to enhance business performance. The study of Grablowsky (1976) and others have showed a significant relationship between various success measures and the employment of formal working capital policies and procedures. Managing cash flow and cash conversion cycle is a critical component of overall financial management for all firms, especially those who are capital constrained and more reliant on short-term sources of finance (Walker and Petty, 1978; Deakins et al, 2001).

2.4.6 Working Capital Management Strategies

According to Dunn (2001), working capital management involves focusing on the key elements of working capital cash flows in a cycle into, around and out of a business. It is the business lifeblood and every manager has to keep it flowing and to use the cash flows to generate profits. Two elements of the working capital cycle absorb cash (i.e. inventory and receivables.) The main sources of cash are payables, equity and loans. According to Dunn (2001), the commonly used working capital management strategies are: The conservative working capital management strategy: This is whereby the current assets to fixed asset ratio are high. The company invests relatively high in current assets in relation to its sales. In this approach, cash levels will be generally higher to avoid liquidity problems. In this case, there is a notable high investment in short-term bank deposits and other short-term liquid investments. The moderate working capital management strategy: This is whereby the ratio of current assets to fixed assets is one. Companies with this working capital management policy have moderate earnings. The aggressive working capital management strategy: This is whereby the current asset to fixed asset ratio is lower. Companies using such a policy exhibit poor liquidity and have volatile earnings.

2.5 Working Capital Challenges facing SME's

Although the problems faced by SMEs in Kenya vary by sector, limited access to financing is a problem that is experienced across the board. In spite of Kenya's relatively large financial services sector, only about 10 per cent of the population is estimated to have access to banking services. The bulk of the poor, who mostly live in the rural areas, have no access to formal financial services. Consequently, small entrepreneurs start their business by investing their own savings and/or using funds obtained from relatives or friends. This might be supplemented by loans from informal lenders or by credit from suppliers. It is only after the business has been operating for some time, usually as a micro-enterprise or on a small scale that any attempt is made to seek financing from a bank for further development and expansion. The main reason why commercial banks are reluctant to lend to the SMEs is that this type of business seldom has any credit history or marketable assets to use as collateral. SMEs are weak in Africa because of small local markets, undeveloped regional integration and very difficult business conditions, which include cumbersome official procedures, poor infrastructure, dubious legal systems, inadequate financial systems and unattractive tax regimes (Kauffman 2004). According to Marwanga, Okomo, & Epstein (2002), the most worrying challenge faced by SMEs is funding. Most new small business enterprises are not very attractive prospects for mainstream banks, with their rigid lending regulations. In Kenya, several lending schemes have been developed to address this key sector of the economy, but the solutions offered so far have been inadequate. Moreover, the schemes do not address the SMEs that operate in the rural areas where the majority of Kenyans live. Perret (2003) identifies that the financial services demanded by SME are varied, and normally are categorized as loan products, savings products, and miscellaneous services. The potential demand for each of these products not only varies between the products themselves, but also is country specific. The demand for these products in Romania is discussed below:

2.5.1 Loan Products

The World Bank Technical Paper on financial markets in Rural Romania [i] estimated that only 50% of all private sector rural enterprises had a demand for loans. Estimates made by micro finance practitioners of the number of micro-clients who would want to borrow ranged from 10% of all potential micro enterprises to 90% of the total. If it is assumed that the demand for credit by urban and peri-urban micro enterprises would be somewhat higher than in the rural areas at, say, 67%, a national weighted average of active micro enterprises wanting to access credit would approximate 54% of the total number of micro enterprises, or about 272,000 entities.

2.5.2 Savings Products

By North American and Western European standards, Romanians are prolific savers, with an average savings rate for the period 1998-2002 of 13% of GDP. This high level of savings is serviced by a network of 3,156 bank branches and 840 credit co-operatives [ii] , which suggests that for most Romanians who wish to serve in monetary assets, they would have the opportunity to do so. Additionally, the World Bank (WB) notes that most rural enterprises have some type of bank account. This suggests that there is only a limited unfulfilled demand for this service. With this factor in mind, and given the regulatory hurdles to obtaining the required banking license in order to mobilize savings, there is not a pressing need for micro finance providers to extend this service. The exception being that they may wish to mobilize savings services by the micro finance sector.

2.5.3 Other Financial Services

While many of the other financial services normally required by micro businesses are available in Romania (e.g. funds transfers by Western Union), it is likely that the outlets for them are limited, as well as being expensive. As such, there is probably a considerable amount of pent-up demand for these financial products. While this need is recognized, a detailed market survey of these products in terms of demand, and the products' potential profitability, is considered beyond the scope of this literature and, therefore, is not covered in any depth. It is suggested, however, that as the micro finance market grows, serious consideration be given to the provision of these services.

2.5.4 Access to financial services

Most studies of private sector development in countries in transition identify access to financial services as a critical element to the development of small and medium size enterprise. The financial system serves several important functions. It provides an accepted and sound medium of exchange and a payment mechanism within a country; encourages mobilization of resources through savings mobilization; helps to allocate resources to activities with highest returns, if market prices prevail; spreads risks by offering a diversity of financial instruments; and it leads to wider ownership of society's assets. SMEs and other business firms require access to long and short term financing, on reasonable terms (market), to function properly. Credit, unless provided from abroad, depends on the financial institutions' ability and capacity to mobilize local/national savings, directly or through access to capital markets, on the part of financial institutions. Without adequate savings mobilization there cannot be a significant lending or investment program. Price stability, market interest rates, and cost efficiency in the operation of financial institutions, not only determine the viability of the latter, but the ability both to mobilize savings and provide the different length maturities businesses seek to meet their credit needs. Fontes (2005) notes that the main problems related to SME access to finance in China are the following:

2.5.5 Structure of the financial system

China lacks an adequate credit system for SMEs, composed of the appropriate financial-service institutions. Large state-owned commercial banks have a very high market share of deposits and loans. The rating requirements for loans are quite high and are not met by SMEs, or the minimum amount that banks will lend vastly exceeds the demands for SMEs. City and rural credit cooperatives cannot fill this gap due to their own structural limitations. A related issue is the insufficient development of the capital market in China. The capital markets started being developed by the sale of state-owned enterprises shares, but with a very cautious gradualist approach. This affected the initial development of stock markets.

2.5.6 Existence of collateral to banks

The most common mechanism to reduce informational problems in financing SMEs is the use of appropriate collateral. In general, it is easier to assess the value of assets instead of the value of expected future cash flows. In the United States, for instance, 92 percent of SME debt is secured by appropriate collateral and 52 percent of debt is guaranteed by the owners of the firms (Berger and Udell 1998). The most common form of collateral is accounts receivable or inventory.

2.5.7 Credit rating

There is a lack of credit rating assessments for SMEs in China, together with low incentive of SMEs to build a credit reputation since it does not have a direct effect on future borrowing. This affects negatively the quality of loans and decreases further the credit rating of SMEs. A nationwide credit assessment system for SMEs was proposed in 2001. This credit assessment system was intended to improve the information processing and transmission of the credit situation of SMEs.

2.5.8 Accounting and auditing

Financial structure of private firms is often opaque. There is a lack of transparent, audited financial records. There are restrictions in the registration under different forms of incorporation that gives incentives to firms to misrepresent financial flows, total employees, stocks of assets, and other aspects of the accounting and financial structure of firms. The tax system also can be circumvented partially by misreporting, usually under recording. As in other countries where incentives for true reporting are weak, firms are said to keep different accounting books: one for the government, one for banks and the last one for themselves (International Financial Corporation 2003).

2.5.8 Economies of Scale

There are important economies of scale in the activity related to borrowing by banks. These economies of scale cannot be exploited at the typical borrowing scale of SMEs, and consequently banks will prefer large loans which can only be demanded by larger enterprises.

2.5.9 Tax and investment policy treatment

Private SMEs have disadvantages in accessing credit and receiving approval due to their weaker connection to local authorities as compared to state owned enterprises or privatized former state-owned enterprises (Kanamori and Zhao, 2004). This is also true for incentives in investment policy with respect to state-owned and foreign enterprises (Kanamori, 2004). Foreign firms, for instance, can enjoy special tax exemption programs, where they get exemptions for two years after the first year that they register profits. SMEs face barriers to growth from poor or inadequate information regarding the wider market environment (pricing, demand, trends) and with poor communications between suppliers and markets (Grimard 1998). According to Tambunan (2006) in less developed countries (LDCs), SMEs are facing obstacles that are sometimes similar to those experienced by Large Enterprises. However, SMEs, especially the smaller ones are much more vulnerable in relation to these problems. The nature or complexity of many of these problems is also related to the size of enterprises or activities. The smaller the size of enterprises the more complex the problems they face. The problems may differ from region to region and between one industry-group to another. Although the problems vary even between individual enterprises in the same size category and within a branch of activity, there are certain problems which are common to all SMEs which are linked to three groups of issues: infrastructure, institution, and economic issues. Other issues include no access to formal training and, as a result, lack of skills in particular as regards basic economic skills and managerial expertise, lack of formal schooling sometimes even resulting in illiteracy, limited access to property rights, limited access to formal finance and banking institutions, excessive government regulations in areas such as business start up, in particular as regards cumbersome, time demanding and costly procedures for business registration and lack of information on prices.

2.5.10 Control of debtors and creditors

Chittenden et al (1998) reported that granting of credit has existed as long as trade itself. They also state that trade credit is an important source of short-term finance because it represents a substantial component of the business assets and liabilities for the small business. In their findings they found that more than 96 per cent of small businesses provide credit to their customers. McMahon and Holmes (1991) found that owner-managers tend to neglect accounts receivable management and that it is exogenously determined and beyond their active control. On the other hand, Chittenden et al, (1998) reported that management of accounts receivable is paramount to the survival and success of every business. A UK study found that trade debtors represent 28 per cent of total assets, whilst trade creditors are equivalent to 11 per cent of total assets (Chittenden et al, 1998). In contrast, trade debtors levels in a business can absorb cash and therefore result in low or negative levels of cash flow, the effect of which can result in the bills being paid late or impossible to pay at all (Scott, 1991). So the collection of past-due receivables can make a significant contribution to a company's cash flow (Perry, 1995). Chittenden et al (1998) found that late payment in all sectors in the United Kingdom related to trade debt and the same problem continues in Australia where the small business experience that paying on time has become an issue.

2.5.11 Cash flow and cash allocation

The UK study found that even if a company does not have the necessary internal cash flow to take advantage of trade discounts, substantial cost saving would result in borrowing the money to settle accounts (Chittenden et al, 1998). In addition the survey found that businesses face a significant opportunity cost by building up cash reserves to buffer any downturn (Chittenden et al, 1998). In fact 54 per cent from the UK study have had surplus cash in the business on a regular basis, especially in the service businesses (Chittenden et al, 1998).

2.5.12 Record keeping

Review of previous literature suggests that there is clearly significant progress in encouraging small businesses owner managers to install and use accounting information systems (McMahon and Holmes, 1991). Holmes (1991) raised the issue financial management practices for the small owner-managers' is limited and they require education and training to the point where operating a small business utilises cash-based accounting systems to provide an acceptable level of financial control.

2.6 Conclusion

Some research studies have been undertaken on the working capital management practices of both large and small firms in Romania, India, UK, US and Belgium (Burns and Walker, 1991; Peel and Wilson, 1996) to identify the push factors for firms to adopt good working capital practices or econometric analysis to investigate the association between WCM and profitability (Shin and Soenen, 1998;Anand, 2001;Deloof, 2003). There are no studies that address the working capital challenges facing SMEs in a developing country like Kenya. This is what this study sought to address.

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