A Small Business is not a little Big Business – Part 1

By | August 2, 2016

Back in 1981, John Welsh and Jerry White wrote an article for the Harvard Business Review* using the catchy title above.  For any small business it is worth a read even though it was written so long ago.  The thinking at the time was that small businesses should use the same management principles as big businesses but on a smaller scale.  Welsh and White argued that the very size of small businesses creates special conditions “which can be referred to as resource poverty – that distinguishes them from their larger counterparts and requires some very different management approaches”.  The article then goes on to explain the difference between cash flow and the classic treatment of profit and loss, break even analysis and return on investment.  In a small business the focus must be on liquidity, liquidity, liquidity …. where the business environment tends to be much more volatile, bringing with it a need for agility and an owner-manager who needs to be multi-skilled just to survive.

The article explains quite clearly how growing small businesses need to draw on a bank overdraft for quite some time even though their profit and loss account may be showing steady profitability.  There are a whole lot of reasons for this phenomenon related to the timing of events such as payments to suppliers and receipts from customers plus capital purchases that impact the balance sheet.  These aspects are explained with clear examples in the paper.  What is most interesting is the Debt-Equity impasse.  Lenders use a rule that applies to big stable businesses.  They would like the debt-equity ratio to be no more than 2 after the proceeds of the loan are incorporated into the balance sheet.

However, in a start up or early growth stage business, when the net worth is small the ratio can become incredibly large even though the company may be experiencing strong sales with consistent profitability.  Lenders applying big business norms see these situations as not viable, rejecting the loan application that can threaten the survival of an otherwise sound business operation. Often the solution to this problem is to slow growth and look for ways to increase profitability.  This can be accomplished by containing expenses, improving productivity and even increasing prices or widening the gross margin by decreasing variable costs.  Being careful in the way liabilities are expressed in the balance sheet can also help.  Over time, the debt-equity ratio can be improved opening the door to loan raising.

In current times software such as the Business in Control Model (BIC Model) having been designed for the small to medium sized business has as its main output prediction of cash flow outcomes up to 18 months into the future.  Forecasting the timing of payments and receipts, carefully noting when administration costs (including salaries) are expected to come to account, allowing for seasonal variations in sales and so forth allows the model to forward predict cash flow.  The results can be communicated to lenders and shareholders on a regular basis to keep them informed of the state of play.  The BIC Model uses smart calculation techniques to simplify the process.  It is designed to be run by one or two people in-house, after a training period, at a cost that is much lower than similar models designed for big businesses.  Users of the model learn to become better and better at forecasting outcomes for their business as time progresses.

Times have changed since 1981.  With the ubiquitous availability of smart software, the small business can benefit from financial management principles enjoyed by big businesses without needing large resources that they do not have.

* “A Small Business is Not a Little Big Business”, July-August 1981 issue, article no. 81411


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