CHAPTER II
LITERATURE REVIEW
2.0 Introduction
This chapter provides a summary of literature available on the accounting practices and record
keeping of SMEs to improve financial performance. The chapter will discuss on the relationship
between the dependent variable and the study’s independent variables prior to the theoretical
framework that was provided in chapter one. Firstly, the chapter will discuss the dependent variable
“financial performance” and its indicators followed by the independent variables and their indicators.
2.1 Financial Performance and the indicators
Financial performance measures a firm’s ability to manage its finances and firm’s financial health
based on assets, liabilities, revenue, expenses, equity, and profitability. It is a thorough analysis of
company financial statements. Analysts examine a firm’s Income Statement, Cash Flow
Statement, and Balance Sheet. Financial performance indicators are quantifiable metrics used to
measure how well a company is doing (Kotane & Kuzmina-Merlino, 2012). Financial
performance metrics include quick ratio, current ratio, working capital, gross profit margin, net
profit margin, equity multiplier, debt-to-equity ratio, return on equity, return on asset, total asset
turnover, inventory turnover, and operating cash flow (Kotane & Kuzmina-Merlino, 2015).
Financial indicators measure a firm’s financial position, growth potential or well-being using data
provided in financial statements. This can also be used for financial performance analysis by
investors and shareholders to identify potential risks associated with a particular business.
Similarly, lenders and financiers use a firm’s performance data to determine credit worthiness and
repayment capacity. Further, creditors gauge the liquidity position of each borrowing firm before
extending trade credit.
2.1.1 Financial Performance Indicators
These are often expressed as financial ratios, used for making informed decisions using data
provided by financial statements. Critical ratios will be discussed in detail below:
Gross Profit Margin: The ratio determines firms’ profitability before considering the operating
expenses but after deducting the cost of sales. Its formula is as follows: [(Revenue – Cost of Goods
Sold) / Revenue] × 100.
Net Profit Margin: The net profit ratio is another financial performance metric. It measures a
firm’s profitability after deducting all the expenses from gross profits. It is evaluated as follows:
(Net Profit / Revenue) × 100.
Current Ratio: It measures firms’ liquidity. It evaluates a firm’s ability to pay off short-term or
current liabilities (using current assets). It is determined as follows: Current Assets / Current
Liabilities.
Working Capital: It gives an overview of a company’s operational liquidity—whether a firm is
efficient in handling business day to day operations. It is evaluated as follows: Current Assets –
Current Liabilities.
Return On Equity: It is a profitability measure that ascertains a firm’s ability to generate profit
from equity capital that was acquired from the shareholders. It is represented by: Net Profit /
[(Beginning Equity + Ending Equity) / 2].
Return On Asset: This profitability ratio determines a firm’s ability to utilize assets efficiently to
generate profits. Its formula is as follows: Net Profit / [(Beginning Total Assets + Ending Total
Assets) / 2].
Quick Ratio: It is a liquidity metric; it analyzes firms’ ability to clear short-term liabilities using
cash and cash equivalents. Its formula is as follows: (Current Assets – Inventory) / Current
Liabilities.
Operating Cash Flow: Cash flow is a good indication of a firm’s financial performance. This ratio
analyzes a company’s efficiency in maintaining a positive cash flow. This data can be acquired
from companies’ cash flow statements—it can be positive or negative.
Debt Asset Ratio: It is a leverage ratio; it measures a firm’s ability to fulfill its short-term
obligations, long-term obligations, and debts. This ratio considers companies’ overall assets as the
criteria. It is computed as follows: Total Debt / Total Assets.
Leverage: is an equity multiplier that is calculated by a business to illustrate how much debt is
actually being used to buy assets.
Leverage = Total Assets / Total Equity.
Inventory Turnover: This ratio measures companies’ ability to convert stock into sales: Cost of
Inventory Sold / Average Inventory.
Accounts Receivable Turnover: It gauges firms’ efficiency in recovering outstanding credit (sales)
from the debtors. It is evaluated as follows: Net Credit Sales / Average Accounts Receivables.
Accounts Payable Turnover: This indicator evaluates a company’s ability to repay creditors (goods
purchased on credit). It is calculated as follows: Net Credit Purchase / Average Accounts Payable.
2.1 Preparing accounting records and financial performance
Good records provide the financial information that enables an organization to operate more
efficiently, thereby increasing its profitability. The business manager and accountant can identify
all business assets, liabilities, income, and expenses with the aid of accurate and exhaustive
records. This information assists in identifying both the strong and poor business operations
phases. Nelson and Onias (2021) reached the conclusion that maintaining accurate accounting
records results in a profitable business. Madurapperuma et al. (2018) discovered that SMEs
maintain a complete set of accounts to record sales and sales costs, and their findings confirmed
that the preparation of accounting records has a positive effect on the performance of SMEs.
However, only a minority of SMEs maintain informational primary entries. Some small and
medium-sized businesses have kept informational primary entries.
Muchira (2022) investigated the extent to which Micro and Small Enterprise owners and
administrators maintain business records, concentrating on 84 SMEs in Tanzania. Some owners/
managers of medium-sized businesses kept various records, including purchase day or order
records, the receipt book, the expenditure or expenses book, payroll records, and assets register,
according to the findings. Due to a lack of accounting expertise and the expense of employing
professional accountants, further investigation revealed that SMEs do not maintain comprehensive
accounting records. Consequently, SMEs make inefficient use of accounting information to assess
their financial performance. This made it difficult for the business owners to accurately calculate
their profit. The majority of small and medium-sized enterprises do not maintain accurate business
records, preventing them from measuring their financial performance and position.
Small- and medium-sized enterprise operators maintain improper records, including notepads,
walls, and papers. Few small and medium-sized enterprises (SMEs) maintain accurate documents,
including cash book, sales day book, personal cash book, purchase day book, income statement,
and statement of financial position. Dawuda and Azeko (2015). In addition, they corroborated that
SME proprietors are unaware of the importance of maintaining accurate financial records and
believe that establishing a Department of Finance and Accounting with qualified personnel is a
waste of time and resources. In addition, they emphasized that a lack of education and the high
cost of employing qualified staff made it extremely difficult for the owners to maintain accurate
accounting records. Some also failed to maintain accurate accounting records to avoid paying
taxes. Maseko and Manyani (2011) discovered a correlation between the compilation of
accounting records and the financial performance of small and medium-sized enterprises.
Raymond et al. (2014) conducted research on the contributions of accounting records to the
effective operation of SMEs. They discovered that some SMEs may not be able to implement
complex accounting systems, as a number of small businesses kept no records of their financial
operations, finances, etc., while others hired professional accountants to maintain accurate
accounting records. Accounting documents contribute to the performance of small and mediumsized enterprises. Small- and medium-sized enterprises do not, however, maintain accurate
accounting documents. This study also revealed that accounting recordkeeping has a significant
impact on the performance of small and medium-sized enterprises (SMEs), and that if proper
records are maintained, they will facilitate efficient, appropriate, and expeditious financial decision
making and boost the performance of small businesses.
According to Amoako (2013), he investigated the record keeping strategies utilized by SMEs in
Kumasi, Ghana using data derived from 210 SMEs in Kumasi's responses to a structured
questionnaire. The results revealed that small and medium-sized enterprises (SMEs) do not
maintain accurate accounting records because their proprietors do not recognize the importance of
accounting records, lack the necessary accounting knowledge, and cite the expense of employing
an accounting professional. Therefore, the use of accounting information to assess the financial
performance of small and medium-sized enterprises in Ghana was found to be inefficient.
Rahamon and Adejare (2014) investigated the impact of accounting records keeping on the
performance of SMEs using both qualitative and quantitative methods to analyze the collected
data. The study found out that the majority of respondents maintained their business accounting
records. The accounting system was cash-based. As record keeping documents, sales and
purchases, creditors and debtors, receipts, invoices, and payment vouchers served to reduce
operating costs and boost productivity. In addition, they discovered a significant positive
correlation between accounting record keeping and the performance of small-scale businesses.
This suggests that accounting recordkeeping influences the efficacy of small businesses financial
performance.
Based on the preceding literature, the initial hypothesis was formulated as follows:
Ho: Preparing accounting documents has a significant impact on the financial performance of
SMEs.
2.2 Preparing Financial Statements and Financial Performance
Financial statements are formal, original statements prepared to disclose a company's financial
health in terms of profits, position, and future prospects as of a specific date. According to
Rathnasiri (2018), bookkeeping without preparing reports is unlikely to be essential for assisting
with financial decision making unless appropriate reports are prepared and analyzed to affix
meaning so as to aid decision makers.
According to Madurapperuma et al. (2016), the majority of SMEs do not compile a full set of
financial statements. Even with well-maintained account records, an organization may fail to
compile financial statements, as accounting knowledge/skills are required to do so. Financial
statements provide the most fundamental and essential financial decision-making information. The
ability to rely on trustworthy financial information and financial statements is a predictor of
prudent financial decisions. Ineffective decisions can result in ineffective financial management,
which can ultimately result in anguish / failure.
Utilizing financial statements effectively in decision-making can improve financial management
and maintain the company's viability. Even with reliable information, according to Auken and
Carrahe (2013), it is a prerequisite for making financially sensible decisions. Sri Lankan
researchers Madurapperuma et al. (2017) discovered a positive correlation between compiling
Commented [SN1]: Discus the independent variables
one by one and their indicators
financial statements and financial performance based on a sample of 100 registered SMEs in the
Gampaha district. In addition, they stated that as a business matures, the need to produce a
complete set of financial statements increases, particularly for medium-sized businesses. At a
medium size, business financial performance reporting will be accessible to both internal and
external users, such as lenders.
Amoako et al. (2019) reached the conclusion that the income statement is the most frequently
prepared financial report for SMEs. Some SME prepare income statements, cash flow statements,
statements of equity changes, and statements of financial position. However, some businesses do
not maintain accounts of their business transactions and do not prepare financial statements.
Consequently, SMEs make inefficient use of accounting information to assess their financial
performance. This made it difficult for business owners to calculate their profits accurately.
According to Maseko and Manyani (2011), a target population of 100 SMEs was used to
investigate accounting record keeping practices for performance measurement employed by SMEs
in Zimbabwe. The findings demonstrated that most small and medium-sized enterprises (SMEs)
do not compile any financial statements. Only 27% of the 100 SMEs prepared financial statements
to support the reporting of financial performance.
Even with well-maintained books of accounts, an entity may fail to prepare financial statements
because the preparation of financial statements requires accounting skills. According to Karunanda
and Jayamaha (2021), there is a significant positive correlation between financial statement
analysis practices and the financial performance of small and medium-sized enterprises (SMEs).
Therefore, small and medium-sized enterprises that analyze financial statements perform better
than those that do not. Therefore, these studies demonstrate that even though SMEs maintain
accounting records, they do not produce financial statements. Therefore, financial statement
preparation requires accounting knowledge and skills. As a result, these SME proprietors are
unable to conduct financial analysis and make sound decisions in order to determine whether their
businesses are thriving or not. Therefore, it was discovered that preparing financial statements
correlates positively with financial performance.
Based on prior research, the second hypothesis was formulated as follows:
H1: Preparing financial statements has a substantial impact on the financial performance of small
and medium-sized enterprises.
2.3 Computer Utilization and Financial Performance
Despite the rapid development of technology, most SMEs have not adopted the use of ICT for
accounting-related tasks, (Karl, 2019). They use outdated methods such as note journals, wall
writing, and paper to record accounting data. Consequently, they find financial record keeping
unattractive and perceive it to be a costly and time-consuming endeavor. For accounting-related
tasks, various accounting applications and computer software (Excel) are available, such as Quick
book, Sage, MYOB, etc. (Rose, 2017).
According to Madurapperuma et al. (2019), 73% of SMEs in Malawi do not use information
technology (IT) to maintain accounting records. A 44% proportion of the respondents maintained
manual records, while 29% do not maintained any records. In addition, 15% of SMEs used Excel
and 12% used accounting software to maintain accounting records. In addition, they concluded
that the use of ICT in SME record keeping is not for the purpose of capturing accounting data for
performance measurement. However, few SMEs utilize ICT for accounting data security and
control. This is corroborated by the fact that only 27% of SMEs using ICT to report financial
performance prepare financial statements. In addition, they concluded that computer utilization is
positively correlated with financial performance.
Rathnasiri (2019) investigated the use of computers by small and medium-sized enterprises
(SMEs) in financial management practices and found that more than 70 percent of SMEs use
computers to record their daily business transactions, prepare financial statements and
management reports, and manage their cash flow. However, SMEs do not maintain sophisticated
accounting systems and software; instead, they use computers for all accounting-related tasks.
Jennifer and Dennis (2015) conducted research on the impact of financial management practices
on SME growth. A questionnaire was administered to the owners/managers of 41 small and
medium-sized enterprises (SMEs) to capture primary data. They emphasized that the failure of
SMEs to utilize computers and computer-assisted software makes timely financial reporting and
decision-making extremely challenging. In addition, they concluded that innovation is essential to
the development of SME's and that efforts should be made to ensure that SMEs are at the forefront
of innovation in order for them to be competitive through the improvement of financial
management practices through ICT. Once the ever-changing requirements of customers are
satisfied, customer retention and sustainable growth rate will increase.
Based on prior research, a third hypothesis was developed as follows:
H2: Computer use has a significant impact on the financial performance of small and mediumsized enterprises.
2.4 Respondents’ Perception and Financial Performance
While the majority of small and medium-sized enterprises (SMEs) do not maintain accounting
records, there are factors that motivate others to do so. According to Amoako (2013), there are
many which include taxation, income distribution, performance evaluation, monitoring of
receivables and payables, assistance in accessing credit/finance, and business size determination.
According to research conducted by Rathnasiri (2017), the majority of Tanzanian small and
medium-sized enterprises prepare accounting records with the intent of meeting day-to-day
operational requirements. As a result, many SMEs disregard the proper format for preparing
financial statements because they have no intention of complying with legal requirements. But
inadequately prepared accounting information makes it difficult for many small and medium-sized
business owners to evaluate their own financial position, demonstrate the viability of their
business, or facilitate credit financing. This circumstance is likely to lead Tanzanian SMEs to make
poor financial decisions, resulting in poor performance and high rates of failure, the study
concluded. The efficacy of these factors, however, motivates small and medium-sized businesses
to maintain accurate accounting records. Then, they can readily make the correct decisions
regarding their business operations, pay the appropriate taxes, and gain access to credit facilities.
According to Amoako et al. (2014), the reasons why SMEs prepare final accounts, from most
important to least important, are profit determination, control purposes, bank loan requirements,
tax purposes, and other reasons. Rathnasiri (2014) investigated the financial reporting practices of
Zambian SMEs. The researcher selected a cohort of sixty small and medium-sized enterprises
(SMEs) registered with the Ministry of Industry and Commerce. The findings of the study revealed
that almost all SMEs do not prepare financial statements for the purpose of complying with a legal
requirement. The maximum percentage, 88 percent, indicated that SMEs prepare financial
statements as a supplement to their daily operations. Approximately 67 percent of small and
medium-sized enterprises compile their financial statements for financing purposes. As a result,
the majority of SMEs may not adhere to the correct formats for preparing financial statements
because they lack such guidelines.
Karl (2013) investigated the factors that motivate others to keep accounting records. Respondents
concurred that "to keep track of receivables and payables" was the primary reason for keeping
records. A greater proportion of respondents concurred that it is essential to monitor accounts
receivable and accounts payable when operating a business.
According to the findings of Asaduzzaman (2016), there is a positive correlation between the
perception / motivation of respondents and the financial performance of small and medium-sized
businesses that only maintain accounts for limited purposes. The majority of small and mediumsized enterprises maintain accounting records for the purposes of meeting statutory requirements,
financing requirements (bank loan), day-to-day operations, and decision-making. Consequently,
businesses should maintain accounting documents in order to make sound business decisions,
independent of external financing and tax considerations. Then, business proprietors can make the
appropriate decisions to enhance the business's performance. In addition, these incentives enhance
their recordkeeping practices.
Based on prior research the fourth hypothesis was developed as follows:
H3:Respondent’s perception has a significant impact on the organization’s financial performance.
2.5 Chapter Summary
The chapter predominantly focused on the importance of record keeping on SME performance.
The first part of the chapter dwelled much on the relationship between preparing accounting
records and financial performance, followed by relationship between preparation of financial
statements and financial performance, with computer utilization and financial performance coming
third and finally the chapter looked on the relationships between respondents’ perception and
financial performance. The general consensus according to the reviewed studies show that the
independent variables of this study are all significant in explaining financial performance by SMEs
in different settings. However, there were varying magnitudes on the impact of the chosen
variables on financial performance. The next chapter discusses the research methodology of the
study.