AN EXPLORATORY STUDY OF UNDER- AND OVER-INVESTMENT AMONGST
MANUFACTURING SMEs FROM AUSTRALIA’S BUSINESS LONGITUDINAL SURVEY
Professor Richard G.P. McMahon,
Head, School of Commerce,
The Flinders University of South Australia,
GPO Box 2100,
Adelaide South Australia 5001.
Telephone: +61 8 82012840
Facsimile: +61 8 82012644
Email: Richard.McMahon@flinders.edu.au
SCHOOL OF COMMERCE
RESEARCH PAPER SERIES: 01-10
ISSN: 1441-3906
Acknowledgments
The permission of the Australian Statistician to use confidentialised data from the federal government’s Business
Longitudinal Survey, and to publish findings based on analysis of that data, is gratefully acknowledged. Thanks
are also due to Mr David Forsaith, Mr Anthony Stanger, Ms Janice Jones, Mr Matthew Tilling and Mr Michael
Crowley for assistance with qualitative characterisation of under- and over-investing SMEs at the culmination of
this investigation. Responsibility for interpretation of the findings lies solely with the author.
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UNDER- AND OVER-INVESTMENT AMONGST AUSTRALIAN MANUFACTURING SMEs
Abstract
The principal objective in this exploratory paper is to examine the financial problems of under- and overinvesting in a longitudinal panel of 871 small and medium-sized enterprises (SMEs) in the Australian
manufacturing sector. A novel research method for identifying sub-samples of potentially under-investing
and over-investing SMEs is employed. Demographic and financial profiling reveals that under-investment
is most likely to be evident in what are referred to in the SME research literature as life-style businesses.
On the other hand, over-investment is most likely to be evident in what are referred to in the SME
research literature as capped growth businesses. An interesting observation concerning the forms of
manufacturing SME identified is that they constitute two disengagement (or arrested development)
configurations that have emerged in recent empirical development taxonomies for SMEs, and that were
also evident in some earlier SME development typologies. The likely implications of these findings for
SME scholarship and policy-making are discussed.
Introduction
In monetary terms, large enterprises account for most of the capital formation which takes place in an economy,
and they therefore have a vested interest in ensuring that their capital investment decisions are correctly made so
that only value-creating projects are undertaken. This generally leads them to employ the most sophisticated
techniques available for evaluating capital investments – desirably, discounted cash-flow methods. But what of
small and medium-sized enterprises (SMEs) that are normally less capital intensive, and which in aggregate do
not contribute as much to capital formation? In fact, when account is taken of the limited resources that are
usually available to SMEs, the typical lack of expertise in financial management of their owner-managers, and
the likely consequences of making poor decisions, a strong case can be put that making sound capital investment
decisions using appropriate evaluation techniques is as critical in SMEs as it is in their larger counterparts.
And yet, given what is broadly known about SME owner-managers, it would be naive or optimistic not to
be concerned about advocating use of discounted cash-flow methods of capital project evaluation according to
the dictates of modern finance theory. Levin and Travis (1987, p. 31) reinforce this unease with their pragmatic
assertion:
Nor is discounted cash flow analysis the be-all and end-all of capital budgeting decisions in private
companies. Maximizing internal rates of return is less important than dividing the wealth appropriately
between the owners and the organization. Management may well make investments with relatively low
internal rates of return, but its decisions are not reckless. It often does so to move unencumbered wealth
outside the corporation. The danger here is plain, though. When several owners have equal voices and
want to pursue different goals but can't quantify their values, they may relegate capital budgeting
decisions to guesses and miss the rigour of the techniques available for this purpose.
In a more scholarly consideration of this issue, Keasey and Watson (1993, p. 230) conclude:
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. . . the small firm environment is such that any attempts to use the discounted cash flow technique to
evaluate investment projects are so fraught with conceptual and practical difficulties that its benefits (if
any) would be unlikely to prove sufficient to justify its consumption of scarce management time.
These views are lent credence by the international empirical evidence comprehensively reviewed by
McMahon et al. (1993) which suggests that very few SMEs actually use discounted cash-flow techniques or
even other less complicated means of judging the attractiveness of capital investment opportunities. It would
seem that, in the majority of situations in SMEs, no quantitative appraisal of capital projects is undertaken at all.
The degree of necessity of a project is very often the most influential factor in capital budgeting decisions, and
appears to make formal financial evaluation unwarranted from the perspective of owner-managers. Beyond this,
the availability of finance for the purpose is also likely to be a major consideration in whether or not capital
investments are undertaken.
A very real possibility arising from these circumstances is that under- or over-investment in capital
projects could take place in SMEs, seriously undermining the profitability and viability of the businesses
concerned. An SME is considered to have under-invested if, at the margin, a positive net present value
opportunity has been disregarded; while over-investment means that the marginal project accepted has a negative
net present value. Of course, errors of judgement in either direction may also arise due to incorrect
implementation of discounted cash-flow methods. Systematic upward or downward biases in cash-flow estimates
could also be at fault. Whatever the cause, the consequences of under- or over-investment will inevitably be dire
for SMEs with limited capacity to withstand the impact of managerial mistakes.
A thorough search of the SME research literature indicates that there has been only limited consideration
of this important issue by researchers and policy-makers world-wide. Thus, this exploratory paper seeks to
address a prevailing gap in the SME literature and to make particular contributions to knowledge in the
following respects:
 Use of panel data recently made available from the Australian federal government’s Business
Longitudinal Survey (BLS). Much previous work in the SME field has employed cross-sectional data. It
should be noted that there are few, if any, relevant institutional differences between Australia and many
other developed economies that would unduly limit the generalisability of findings from research using
the BLS data set.
 Development of a novel research method for identifying sub-samples of potentially under-investing and
over-investing SMEs.
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 Demographic and financial profiling of potentially under-investing and over-investing SMEs to facilitate
identification of businesses at risk in the broader population.
The paper proceeds as follows. After briefly outlining the findings of some prior research on the issue of
under- and over-investment amongst SMEs, the current research method is outlined. Thereafter, the findings of
the research are presented, followed by conclusions arising from this investigation.
Prior Research
Scholarly Thought on SME Under- and Over-Investment
The seminal work in the literature of agency theory is that of Jensen and Meckling (1976) who place a great deal
of their emphasis on an agency perspective of owner-managed business enterprises. This work focuses attention
upon the economic issue of separation of ownership and control in business concerns, and it contrasts the agency
relationships and problems that might be encountered in smaller owner-managed businesses, in which ownership
and control are typically merged, with those experienced in larger corporate entities in which the separation of
ownership and control is usually greatest. In this and a long list of subsequent works of similar genre (for
example those of Myers, 1977; Myers and Majluf, 1984; Jensen, 1986; Stulz, 1990; de Miguel and Pindado,
2001), the possibility of under- or over-investment by business organisations emerges as a significant concern
for financial economists. The main thrust of this literature can be summarised as follows:
 Where a business has a positive net present value investment opportunity, but new equity would need to
be issued in order to undertake the project, managers may reject the investment because the expected
positive net present value could be outweighed by underpricing of the new equity. The problem arises
because of considerable information asymmetry between managers and potential subscribers to any new
equity issue. Without a full appreciation of the likely benefits of the investment project, and not
completely understanding the reason for the equity issue, potential subscribers could interpret the issue as
‘bad news’ concerning the business and price the equity accordingly. Thus, under-investment could arise
in this circumstance. To avoid this problem the business would have to purposely build-up sufficient
financial slack and/or retain unused debt capacity, so that a new equity issue could be avoided when an
attractive investment opportunity arises.
 Where a business has substantial free cash-flow, there may be an incentive for managers – founded on
self-interest related to possible rewards from managing a larger, more diverse business – to undertake
negative net present value investment projects in order to avoid distributions of funds to equity holders.
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Thus, over-investment could arise in this circumstance. A remedy for this problem would be to enforce
the distribution of free cash-flows to equity holders, and to require that new investment opportunities be
funded with debt.
Building on these agency-theoretic foundations in a seminal paper on SME finance/financial
management, Ang (1992) reflects on whether, given their characteristics and circumstances, SMEs are inclined
to invest too little or too much in capital projects vis-à-vis recommendations based on modern finance theory.
Ang (1992) identifies the following factors that are likely to encourage under-investment in an SME:
 If there is less than full limited liability, as with an unincorporated legal structure or where an ownermanager with substantial private assets is required by a lender to provide a personal guarantee, fear of
individual bankruptcy may prevent undertaking a low to moderately risky capital investment opportunity
with a positive net present value. On the other hand, if the owner-manager's private net worth is low
relative to potential losses and gains from a high risk investment, a form of limited liability is created
which might cause this project to be undertaken.
 The inevitably high level of agency problems in a partnership may cause partners to limit each others'
ability to undertake capital projects without joint consultation and agreement.
 To the extent that an SME experiences high costs of external financing (including monitoring and
bonding costs), a capital investment which might have a positive net present value if undertaken by a
large enterprise with access to cheaper funds may not be undertaken.
 Where an SME has limited funds because of restricted access to the capital market, or due to internally
imposed financing constraints such as an unwillingness to seek external equity which might bring with it
dilution of control, a positive net present value project requiring a large initial outlay may not be
undertaken.
 An SME with limited technical and managerial resources may not be able to undertake a project with
positive net present value which a large enterprise with the necessary resources would be capable of
implementing.
Ang (1992) then proceeds to recognise influences that might lead to over-investment in SMEs which
include:
 It may be rational for an owner-manager wishing to avoid tax on excessive undistributed profit to create
an offset by accepting a capital project with negative net present value.
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 A dominant owner-manager may choose to minimise profit distributions to non-managing owners by
avidly reinvesting surpluses, especially if enterprise growth might enhance his or her control position.
 The full benefit of a demanding project with positive net present value potential may not be realised
because an untrained or inexperienced owner-manager has overestimated his or her technical and
managerial ability to deal with the difficulties involved.
 An owner-manager may underestimate the true (or implicit) long-run cost of self-provided funds and
reinvested profits, neither of which carry an explicit charge for their use. Finance obtained from family
and friends without a set reward to the provider or at a subsidised rate below that currently payable in the
capital market may be similarly undercosted. As a consequence, the net present value of any capital
project being considered would be overstated.
Ang's (1992) reflections are inconclusive in the sense that it cannot be said whether, on balance, SMEs
are likely to under-invest or over-invest in capital investment opportunities. Nevertheless, it is clear that as far as
the capital investment decision is concerned there is substantial scope in SMEs for departures from some
precepts of modern finance theory. There is no suggestion that the ‘positive net present value’ rule is
inappropriate for SMEs. However, the imperfections anticipated by Ang (1992) might have significant
implications for the manner in which the discount rate is determined and whether or not capital projects can be
evaluated independently.
In a discourse on capital investment and financing decisions in SMEs, Keasey and Watson (1993) identify
the following key considerations extending beyond the practicalities of being able to estimate incremental cashflows, the cost of capital, etc.:
 High exposure to business and financial risks, due to inevitable uncertainties in the SME operating
environment and also owner-managers’ relatively undiversified investment portfolios, will significantly
influence how investment and financing decisions are made in practice. Thus, SMEs may undertake
capital investments with the specific objective of diversifying risk even if this extends them beyond the
competencies and experience of their owner-managers – increasing the possibility that such investments
may prove to have negative net present values and therefore constitute over-investment.
 Given certain characteristics of SME financing, the separation of investment and financing decisions
assumed to be justified for larger concerns is unlikely to be appropriate for SMEs. Most important here is
the alleged ‘finance gap’ faced by SMEs with regards to accessing medium- to long-term development
capital. Thus, SMEs may be predisposed towards capital investments which qualify for asset-specific
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financing such as leasing or hire purchase agreements. Note that, to the extent that assets financed in this
way may not appear on their balance sheets, the SMEs concerned may appear to have under-invested.
 Given SME owner-managers’ reported preferences regarding the timing and composition of consumption,
it is not obvious their investment and financing decisions should be evaluated using discounted cash-flow
techniques. This partially stems from recognising the complex objective function of SME ownermanagers, in which wealth maximisation may be a relatively minor consideration. External contracting
parties may also dictate objectives. For example, the requirements of lenders may focus attention upon
achieving an adequate cash-flow to service debt commitments rather than necessarily maximising cashflows. Thus, SMEs may undertake capital investments with low risk and poor returns in order to be sure
of meeting borrowing obligations. Depending upon the relationship between risk and return, this could
constitute under- or over-investment.
Finally, in another agency-theoretic paper, Hutchinson (1995) reflects on financing considerations that
might give rise to non-optimal capital budgeting decisions leading to asset substitution or under-investment or
growth limiting behaviour amongst SMEs. Hutchinson (1995, p. 231) draws attention to possible interactions of
SME financing and investment decisions as follows:
. . . where the objective of an owner-manager is to maintain control of the firm, interdependent investment
and financing strategies may be chosen to control the small firm’s cost of capital. This in turn indicates
that the tendency for some small firms to invest sub-optimally and exhibit slower than average growth
may not be primarily determined by limitations on their supplies of finance. On the demand side, it may
well be that in addition to equity aversion, a sub-optimal capital structure decision is made in the form of
a reduced demand for debt. In other words, given the level of equity that an owner-manager chooses, debt
may not be fully expanded to the capacity limit consistent with value maximisation.
The desire to maintain their independence and high risk aversion amongst many SME owner-mangers are at the
core of Hutchinson’s (1995) explanation for these circumstances. Clearly, it is the protection of independence
that could lie behind observed equity aversion and a strong preference for use of debt financing for capital
investments. Owner-managers limit their risk exposure by carefully managing both the operating leverage and
the financial leverage of their businesses. Minimising operating leverage, and therefore business risk exposure,
usually takes the form of reliance upon labour intensive techniques that introduce fewer fixed costs than capital
intensive techniques and can be more easily wound down in a difficult operating environment. Here, then, is a
tendency towards under-investment. Limiting financial leverage, and therefore financial risk exposure, typically
takes the form of not fully utilising debt capacity. Thus, in addition to any supply-side financing constraints that
8
may prevail, voluntary restrictions upon both equity and debt financing further restricts an SME’s ability to
undertake desirable capital investments. Again, under-investment is the likely consequence.
Hutchinson (1995, p. 236) goes on to explain the possible motivation for asset substitution in SMEs using
debt finance in the following terms:
. . . when raising debt finance, [SMEs] have a tendency to shift from what appear to be the intended
projects, to higher risk investments. This creates profit gains to owners if the substituted projects are
successful, but insignificant losses if the projects fail. Debt holders potentially bear the brunt of the
problems if the projects fail but, with fixed interest payments, receive no additional benefits if they are
successful.
Hutchinson (1995, p. 236) explains a possible motivation for under-investment in SMEs using debt finance as
follows:
The . . . problem arises where ‘good’, low risk projects with positive but low net present values, which
would normally be undertaken by all equity financed [SMEs], are rejected. In potentially difficult trading
situations the pay-offs from these projects would go largely to debt holders, at the expense of owners.
The important point is that debt providers are likely to be aware of such motivations for asset substitution and
under-investment amongst SMEs, and would respond by adjusting interest rates and/or collateral requirements
upwards. If SMEs wish to avoid such an effective increase in the cost of debt capital to them, Hutchinson (1995,
p. 236) suggests a possible remedy:
For small firms who are heavily reliant on debt capital, a reduction in the opportunity cost of debt
financing (including collateral requirements) can be achieved by creating conditions which would signal
to debt suppliers, banks, that asset substitution and underinvestment problems would be minimised.
Conditions conducive to this are: the avoidance of major growth opportunities and the maintenance of an
investment strategy which exposes the firm to only moderate levels of business risk.
This could be, of course, a recipe for further non-optimal capital investment decision-making.
The explanation provided by Hutchinson (1995) for avoiding major growth opportunities with significant
risk is that they initially increase the proportion of intangible assets in the total asset base of an SME. It can then
take a substantial period to convert the value of the growth option created into tangible outcomes in terms of
increased returns. During this gestation period any debt provider would be at considerable risk because, if
financial distress is encountered, the collateral value of the growth opportunity becomes seriously compromised.
For this reason, lenders typically formulate their collateral requirements in terms of tangible assets only. This
encourages SMEs to pursue capital investments in relatively safe and non-innovative projects that clearly have
short gestation periods, in order to minimise their cost of debt. It also drives SMEs towards greater use of
cheaper short-term debt, raising the spectre of both financing cost and liquidity problems in adverse capital
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market conditions. Possible amelioration of these circumstances could result from an SME having invested
heavily in developing a strong relationship with its debt provider, so that the value of intangibles such as growth
opportunities and the reputation capital of the owner-manager(s) is more evident to the lender.
Empirical Evidence on SME Under- and Over-Investment
There is now relatively substantial published empirical evidence on the capital budgeting practices of SMEs in
some developed economies. For example, North American evidence on this matter is provided by Soldofsky
(1964), Luoma (1967), Scott et al. (1972), Walker (1975), Grablowsky and Burns (1980), Pattillo (1981),
Runyon (1983) and Pope (1986). United Kingdom evidence is provided by Corner (1967), Murphy (1979),
Pattillo (1981), Hankinson (1984), Arnold-McCulloch and Lewis (1986) and Peel and Wilson (1996). Evidence
for Australia, in which the present study has been undertaken, is provided by Holmes (1986, 1987). Because it is
not the main focus of this paper, this literature will not be reviewed here (for such a review see McMahon et al.
(1993)). However, it is considered important to have identified general scholarly support for the assertion that
very few SMEs use discounted cash-flow techniques for judging the attractiveness of capital investment
opportunities. This, of course, then raises the possibility of under- or over-investment in such concerns.
Published empirical evidence on the nature, extent and consequences of under- and over-investment
amongst SMEs has been extremely difficult to find. One source utilised is research studies examining the
financial profiles of SMEs of different size, industries, growth rates, etc. Hutchinson (1989, p. 6) describes a
financial profile as ‘that set of accounting ratios, available from the firm’s profit and loss account and balance
sheet, which usefully and efficiently summarises the financial aspects of the firm such as profitability, liquidity
and gearing’. The pedigree for this line of inquiry over the last three decades or so includes most notably the
works of Gupta (1969), Walker and Petty (1978), Boardman et al. (1981), Hutchinson (1987, 1989), Davidson
and Dutia (1991), Osteryoung et al. (1992) and McMahon (forthcoming). The most recent review found for this
literature is presented in McMahon et al. (1993).
The published empirical evidence available on SME financial profiles of relevance to the present study
generally indicates that:
 Asset turnover ratio is typically significantly lower for larger business concerns (Gupta, 1969; Walker and
Petty, 1978; Davidson and Dutia, 1991; Osteryoung et al., 1992; McMahon, forthcoming). This finding
has been interpreted as indicating that smaller businesses normally make more efficient use of assets than
their larger counterparts. As well, it has been suggested that more prevalent use of non-capitalised leases
and hire purchase agreements amongst smaller businesses would account for this result. However, this
10
finding could also be explained by under-investment by smaller businesses. For example, if smaller
concerns make use of almost wholly written-down, second-hand equipment and typically operate for
longer hours than their larger counterparts, then they would appear to have a higher asset turnover ratio.
Of course, their cost structures may suffer as a result. Looked at from the opposite perspective, the lower
asset turnover ratio of larger businesses could be reflective of over-investment on their part.
 Net profit on sales ratio is typically significantly higher for larger business concerns (Gupta, 1969;
Davidson and Dutia, 1991; McMahon, forthcoming). Interestingly, this finding seems to prevail even if
larger businesses have a significantly lower gross margin on sales (McMahon, forthcoming). The
explanation here is that larger concerns have a significantly lower operating expense to sales ratio because
they enjoy economies of scale. Note that businesses that under-invest are unlikely to benefit substantially
from economies of scale. On the other hand, businesses that over-invest could actually end up
experiencing diseconomies of scale as well as a diminished asset turnover ratio.
Knowledge of these financial relationships is later used in identifying sub-samples of potentially under-investing
and over-investing SMEs.
The only other published empirical evidence found which has relevance to the present study is that
provided by McCarthy et al. (1993). These researchers examine the capital investment decisions of SME ownermanagers during the first three years after establishing their businesses. In particular, consideration is given to
whether decisions to increase or decrease total assets are made solely on the basis of rational economic
evaluations of financial indicators such as feedback on sales turnover. McCarthy et al. (1993, p. 10) hypothesise
that, in fact:
. . . under certain conditions entrepreneurs may be more likely to increase investment, regardless of
feedback. This phenomenon, termed ‘escalation of commitment’ by researchers in decision-making, may
lead to non-rational decisions. They may be non-rational in the sense that psychological processes (which
may not even be recognized by the entrepreneurs) play a role in shaping investment decisions.
McCarthy et al. (1993, p. 12) go on to explain escalation of commitment (or escalation bias) in the following
terms:
Firstly, it is believed that decision-makers who choose an initial course of action and who feel personally
responsible for the decision outcomes become psychologically committed to the chosen course of action.
Secondly, this view holds that receipt of negative performance feedback invokes a self-justification
process whereby decision-makers attempt either to defend themselves psychologically against a perceived
error in judgment or to make the previous choice appear rational through increasing their commitment to
the failing course of action.
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In their research, McCarthy et al. (1993) found evidence of escalation bias in relation to capital
investment decisions in a sample of SMEs in the United States. Apparently, escalation bias is more prevalent
amongst owner-managers who had actually founded their SMEs, and therefore feel personally responsible for
strategic and operational decisions made. It also seems more prevalent amongst owner-managers who had
expressed substantial overconfidence in their investment decisions. Furthermore, escalation bias was found to
exert greater influence when sales feedback from the market is negative. It appears that escalation bias
diminishes with experience over time. Overall then, the McCarthy et al. (1993) study constitutes some limited
evidence of over-investment amongst SMEs.
Research Method
The panel data employed in this research are drawn from the Business Longitudinal Survey (BLS) conducted by
the Australian Bureau of Statistics (ABS) on behalf of the federal government over the four financial years 199495 to 1997-98. Costing in excess of $4 million, the BLS was designed to provide information on the growth and
performance of Australian employing businesses, and to identify selected economic and structural characteristics
of these businesses.
The ABS Business Register was used as the population frame for the survey, with approximately 13,000
business units being selected for inclusion in the 1994-95 mailing of questionnaires. For the 1995-96 survey, a
sub-sample of the original selections for 1994-95 was chosen, and this was supplemented with a sample of new
business units added to the Business Register during 1995-96. The sample for the 1996-97 survey was again in
two parts. The first formed the longitudinal or continuing part of the sample, comprising all those remaining live
businesses from the 1995-96 survey. The second part comprised a sample of new business units added to the
Business Register during 1996-97. A similar procedure was followed for the 1997-98 survey. Approximately
6,400 business units were surveyed in each of 1995-96, 1996-97 and 1997-98. The BLS did not employ
completely random samples. The original population (for 1994-95) was stratified by industry and business size,
with equal probability sampling methods being employed within strata. Further stratification by innovation
status, exporting status and growth status took place for the 1995-96 survey.
Data collection in the BLS was achieved through self-administered, structured questionnaires containing
essentially closed questions. Copies of the questionnaires used in each of the four annual collections can be
obtained from the ABS. The questionnaires were piloted prior to their first use, and were then progressively
refined after each collection in the light of experience. As well as on-going questions, each questionnaire also
included once-off questions dealing with certain matters of policy interest to the federal government at the time
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of the collections. Various imputation techniques, including matching with other data files available to the ABS,
were employed to deal with any missing data. Because information collected in the BLS was sought under the
authority of the Census and Statistics Act 1905, and thus provision of appropriate responses to the mailed
questionnaires could be legally enforced by the Australian Statistician, response rates were very high by
conventional research standards – typically exceeding 90 per cent.
The specific BLS data used in this study are included in a Confidentialised Unit Record File (CURF)
released by the ABS on CD-ROM in December, 1999. This CURF contains data on 9,731 business units
employing fewer than 200 persons – broadly representing SMEs in the Australian context. Restricted industrial
classification detail, no geographical indicators, presentation of enterprise age in ranges, and omission of certain
data items obtained in the BLS all help to maintain the confidentiality of unit records. Furthermore, all financial
variables have been subject to perturbation – a process in which values are slightly varied to provide further
confidentiality protection.
This research is concerned only with the manufacturing sector of the BLS CURF. Over 99 per cent of all
businesses in the Australian manufacturing sector are SMEs according to generally accepted definitions
(Australian Bureau of Statistics, 1996). The main reason for considering only the manufacturing sector is that it
is highly probable that cross-industry differences in the nature of business activities, typical employment per
business, capital intensity, etc. could confound the findings of this research. Such influences are, to a reasonable
extent, controlled for by examining a single (albeit broadly defined) industry. There are 3,411 manufacturing
SMEs in the BLS CURF, representing approximately 35 per cent of businesses in the file.
Additional focus is provided to this research by considering only manufacturing SMEs legally organised
as proprietary companies. The main reason for this further narrowing of the unit of analysis is that this research
includes comparisons of groupings of manufacturing SMEs in terms of key financial performance measures.
This becomes problematic if the study sample contains both incorporated and unincorporated businesses because
of the customary procedural difference in accounting for owners’ wages which are not separately reported in the
BLS data. There are 2,413 manufacturing SMEs legally organised as proprietary companies in the BLS CURF,
representing approximately 71 per cent of manufacturing SMEs in the file.
Finally, because a key question requesting information on annual capital expenditures undertaken by
SME’s in the study sample was not asked in the 1994-95 survey, the analysis presented in this paper is confined
to data for the 1995-96, 1996-97 and 1997-98 financial years only.
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Variables used in this research are either categorical in nature or, if metric, have irregular distributional
properties (that is, they are non-normally distributed). Transformation of metric variables to produce normal
distributions is avoided because of difficulties of interpretation often created by such procedures. Thus, nonparametric/distribution free techniques of statistical analysis are employed exclusively.
Research Findings
Identifying Under- and Over-Investing SMEs
The most obvious challenge in conducting research on under- and over-investment amongst SMEs is to be able
to actually identify the businesses in which these financial problems are occurring. Earlier, under-investment was
defined in terms of rejecting positive net present value projects; and over-investment was defined in terms of
accepting negative net present value projects. It should be clear that examining all capital investment projects
under consideration or actually undertaken in a reasonably large sample of businesses, to discover whether their
net present values are positive or negative, would be a non-trivial exercise with very considerable resource
demands. The task would be especially onerous for SMEs as it is unlikely that the incremental cash-flows and
the discount rate required for calculating net present value would have been obtained by owner-managers when
deciding upon capital expenditure opportunities. This is, of course, the most probable explanation for the
paucity of empirical research on under- and over-investment in SMEs noted earlier in the paper.
The approach adopted in this research is to seek an approximate location for under- and over-investing
SMEs in the study sample based on the following reasoning:
 Under-investing SMEs are most likely to be found amongst those businesses in the sample with low
annual capital expenditure compared with their existing non-current assets (that is, with low capital
expenditure intensity), with a high asset turnover ratio (that is, with apparently excellent asset utilisation),
and with a high operating expenses to sales ratio (without benefits from economies of scale).
 Over-investing SMEs are most likely to be found amongst those businesses in the sample with high
annual capital expenditure compared with their existing non-current assets (that is, with high capital
expenditure intensity), with a low asset turnover ratio (that is, with poor asset utilisation), and with a high
operating expenses to sales ratio (due to diseconomies of scale).
Fortunately, data for actioning this line of reasoning are available in the BLS CURF. After thus identifying the
sub-samples in which under- and over-investing SMEs are most likely to exist, the broad strategy of the research
is to compare and contrast characteristics of these with the characteristics of the balance of the study sample.
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While far from exact science, this should provide at least a somewhat blurred picture of what under- and overinvesting SMEs are like from demographic and financial viewpoints – a not unreasonable aspiration in an
exploratory study of a relatively under-researched area of SME finance/financial management.
This research focuses on the on-going longitudinal panel of 871 manufacturing proprietary companies in
the BLS CURF. For each of the 1995-96, 1996-97 and 1997-98 financial years, a sub-sample of potentially
under-investing businesses was obtained by first dividing the study sample into those below the median value for
capital investment intensity and those above it. SMEs below the median value for capital investment intensity
were then divided into those below the median value for asset turnover ratio and those above it. Next, businesses
below the median value for capital investment intensity and above the median for asset turnover ratio were
divided into those below the median value for operating expenses to sales ratio and those above it. Finally, SMEs
below the median value for capital investment intensity, above the median for asset turnover ratio and above the
median value for operating expenses to sales ratio were designated as belonging to the under-investment subsample. Beginning with the whole study sample and following a corresponding procedure, those SMEs above the
median value for capital investment intensity, below the median for asset turnover ratio and above the median
value for operating expenses to sales ratio were designated as belonging to the over-investment sub-sample for
each year of the study. Clearly, it is not possible to absolutely defend the ordering of capital investment intensity,
asset turnover ratio and operating expenses to sales ratio benchmarks in these procedures. Nevertheless,
consultation with colleagues in the field did produce this ordering consensus.
Profiling Under-Investing SMEs
Demographic and financial profiles for the derived sub-sample of potentially under-investing manufacturing
SMEs are presented in Tables 1 and 2 respectively. Statistical comparisons with the demographic and financial
profiles of the balance of the study sample are also made in these tables.
TAKE IN TABLES 1 AND 2 ABOUT HERE
Inspection of the data for capital investment intensity, asset turnover ratio and operating expense to sales ratio
reveals that the desired partitioning of the study sample has been achieved. There are highly significant statistical
differences, in the desired directions, between potential under-investors and the rest of the sample.
Attention is now focused on the shaded data items in the tables revealing statistically significant
differences that are relatively consistent over time, but which are unlikely to be wholly a consequence of the
research method employed in identifying under-investing SMEs. The shaded data suggest that, compared to the
rest of the study sample, under-investors have the following distinctive characteristics:
15
 Somewhat younger, but well beyond infancy.
 Quite a bit smaller in terms of employment and sales.
 Less export oriented.
 Less innovative.
 Fewer managerial employees apart from owner-managers.
 Equity more likely to be 100 per cent held by owner-managers.
 Less likely to have raised new equity capital recently.
 Less likely to have sound financial control.
 Less likely to have a business plan.
 Higher gross margin, but lower net margin.
 Much greater use of debt, especially current debt.
 Somewhat poorer liquidity.
In order to provide some triangulation for the author’s interpretation of the significance of these characteristics,
they were presented independently and without explanation of the nature of the study to two other SME scholars,
and to a further three business scholars unfamiliar with the SME research literature. The various appraisals of the
collective import of the characteristics listed showed substantial agreement.
Noting the characteristics presented above, and observing that the businesses so characterised display no
obvious growth behaviour over time (see Table 1), the under-investors identified in this study appear to be what
are referred to in the SME research literature as life-style concerns (Hanks et al., 1993; McMahon et al., 1993;
Holmes and Zimmer, 1994; McMahon, 2001). These generally have few, if any, growth aspirations. They
principally exist to provide their owner-managers with a source of employment and income. Furthermore, they
are frequently operated in a manner consistent with the life-style aspirations of their owner-managers. Given the
aspirations, capabilities and resources of the owner-managers, such SMEs are likely to be under-investors
because there is little alternative in their circumstances, and because any adverse consequences are, on the
whole, unavoidable.
Profiling Over-Investing SMEs
Demographic and financial profiles for the derived sub-sample of potentially over-investing manufacturing
SMEs are presented in Tables 3 and 4 respectively. Statistical comparisons with the demographic and financial
profiles of the balance of the study sample are also made in these tables.
TAKE IN TABLES 3 AND 4 ABOUT HERE
16
Inspection of the data for capital investment intensity, asset turnover ratio and operating expense to sales ratio
reveals that the desired partitioning of the study sample has been achieved. There are highly significant statistical
differences, in the desired directions, between potential over-investors and the rest of the sample.
Once again, attention is now focused on the shaded data items in the tables revealing statistically
significant differences that are relatively consistent over time, but which are unlikely to be wholly a consequence
of the research method employed in identifying over-investing SMEs. The shaded data suggest that, compared to
the rest of the study sample, over-investors have the following distinctive characteristics:
 Somewhat older, more mature businesses.
 Slightly larger in terms of employment.
 Slightly more managerial employees apart from owner-managers.
 More likely to have raised new equity recently.
 More likely to be family businesses.
 More likely to have sound financial control.
 Lower operating profitability.
 Much lower current debt.
 Much lower use of trade credit.
 Much greater use of bank debt.
Again, in order to provide some triangulation for the author’s interpretation of the significance of these
characteristics, they were presented independently and without explanation of the nature of the study to two
other SME scholars, and to a further three business scholars unfamiliar with the SME research literature. Once
more, the various appraisals of the collective import of the characteristics listed showed substantial agreement.
Noting the characteristics listed above, and observing that, with the possible exception of asset growth,
the businesses so characterised display no consistent or exceptional growth behaviour over time (see Table 3),
the over-investors identified in this study appear to be what are referred to in the SME research literature as
capped growth concerns (Hanks et al., 1993; McMahon et al., 1993; Holmes and Zimmer, 1994; McMahon,
2001). These generally have modest growth aspirations. Bounds to growth could be externally imposed by the
nature of their competitive environment; or may be intrinsic given the nature of their operations. Sometimes,
though, growth is deliberately capped by owner-managers to a rate that moderates dependence upon external
financing – thus limiting surrender of control and accountability obligations this support would normally bring.
Given the aspirations, capabilities and resources of the owner-managers, these SMEs are likely to be over-
17
investors because this possibility is not barred by their circumstances, and because any adverse consequences
may not be immediately evident.
Conclusions
The key findings from this exploratory research into under- and over-investment amongst manufacturing SMEs
in the BLS CURF can be summarised as follows:
 Under-investment is most likely to be evident in what are referred to in the SME research literature as
life-style businesses.
 Over-investment is most likely to be evident in what are referred to in the SME research literature as
capped growth businesses.
An interesting observation concerning the forms of manufacturing SME identified is that they constitute two
disengagement (or arrested development) configurations that have emerged in recent empirical development
taxonomies for SMEs derived by Hanks et al. (1993) and McMahon (2001), and that were also evident in some
earlier SME development typologies (most notably that conjectured by Churchill and Lewis, 1983). It is
acknowledged that the evidence presented here for associating under-investment in capital projects with lifestyle SMEs, and over-investment in capital projects with capped growth SMEs, is essentially ‘circumstantial’.
Nevertheless, it is believed that this exploratory study has established sufficient grounds for these propositions to
be tested in subsequent confirmatory inquiry.
Finally, what are the likely scholarly and policy implications for SME support if the key propositions
coming out of this paper prove to have the backing of later research? Given the inevitability of resource poverty
amongst life-style SMEs (Welsh and White, 1981; Churchill and Lewis, 1983), it would seem that the general
tenor of scholarly and policy support for such businesses should be ‘how to do more with less’. In this respect,
the emerging literature on financial ‘boot-strapping’ amongst SMEs appears instructive. In a milestone empirical
study of the phenomenon amongst smaller businesses in Sweden, Winborg and Landstrom (2001, p. 238) define
financial boot-strapping as ‘the use of methods to meet the need for resources, without relying on long-term
external finance’. In the Winborg and Landstrom (2001) research the most prevalent of 32 financial bootstrapping methods identified is ‘Buy used equipment instead of new’, reported by 78 per cent of respondents.
The sixth most prevalent method is ‘Borrow equipment from other businesses for shorter periods’, reported by
42 per cent of respondents. The eleventh most prevalent method is ‘Lease equipment instead of buying’, reported
by 33 per cent of respondents. Other related boot-strapping methods in the study include ‘Share premises with
others’ (14 per cent), ‘Run the business completely from home’ (11 per cent), and ‘Share equipment with other
18
businesses’ (8 per cent). Clearly then, dealing with circumstances frequently associated with under-investment is
an important element of financial boot-strapping.
Promoting successful financial boot-strapping amongst the life-style SMEs apparently most likely to be
under-investors can, in a sense, be seen as ‘making a virtue of necessity’. If resource poverty is a fact of life for a
smaller concern, how might this situation be best managed to ameliorate the potential financial detriment of
under-investment? Referring to the method employed in the present study to approximately locate underinvestors in the sample, it is not clear where SMEs successfully employing financial boot-strapping would stand
in terms of capital investment intensity. They are still most likely to be above the median for asset turnover ratio;
but they could well be below the median value for operating expenses to sales ratio. In other words, successful
financial boot-strappers are less likely to surface as under-investors as identified in this paper.
As far as capped growth SMEs are concerned, the general tenor of scholarly and policy support could be
‘how not to ruin a stable and successful business’. Simply maintaining the status quo of an SME in the current
global context of competitive and turbulent technical and economic environments is no easy feat. Choosing not
to further grow a well-established, mature SME can, in fact, be a major challenge to its survival (McKenna and
Oritt, 1981; Ulrich and Arlow, 1981; Holmes and Zimmer, 1994). Part of this challenge is the avoidance of overinvestment in capital projects. The remedy would seem to be wider recognition of growth as a key strategic
variable in the longer-term decision-making of SME owner-managers. Rather than growth (or the lack of it)
simply emerging as an ex post consequence of financial decisions made, it needs to be effectively managed in a
strict ex ante sense. Clearly, the promotion of sound financial planning skills, including those of capital
budgeting, could be instrumental to encouraging this perspective amongst capped growth SMEs.
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22
Table 1: DEMOGRAPHIC PROFILES FOR UNDER-INVESTING SMEs
Please Note: Shaded items reveal statistically significant differences that are relatively consistent over
time, but which are unlikely to be wholly a consequence of the research method employed in
identifying under-investing SMEs.
1995-96
Demographic
Characteristics
(median values/proportions)
1996-97
1997-98
UnderInvestors
(n=107)
Rest of
Sample
(n=764)
UnderInvestors
(n=107)
Rest of
Sample
(n=764)
UnderInvestors
(n=107)
Rest of
Sample
(n=764)
10-12**
14-16
10-12**
14-16
12-14
14-16
Total employment (persons)
12**
24
11**
25
11**
25
Sales turnover ($ per annum)
974,000**
3,196,500
976,000**
3,402,500
1,052,000**
3,450,000
Total assets ($)
277,000**
1,706,000
297,000**
1,798,000
305,000**
1,901,000
0.0
0.0
0.0
0.0
0.0*
0.0
Sales growth (% per annum)
-0.6**
3.7
0.0
1.5
0.0
3.6
Asset growth (% per annum)
-3.8**
5.5
-0.2*
2.6
-3.6**
1.2
Capital investment intensity (%)a
0.0**
5.2
0.0**
5.3
0.0**
4.5
Export intensity (%)b
0.0**
0.0
0.0**
0.0
0.0**
0.0
Research & development intensity (%)c
0.0**
0.0
0.0**
0.0
0.0**
0.0
2
2
2
2
2
2
0**
2
0**
2
1**
2
100.0**
100.0
100.0**
92.5
100.0**
100.0
Recently raised new equity (%)
4.7
9.8
0.9*
6.2
0.0*
4.7
Are family business (%)
57.9
51.4
57.9
51.4
56.1
51.7
Have sound financial control (%)d
50.5**
63.5
35.5**
61.6
38.3**
56.8
Have business plan (%)
25.2**
38.2
19.6**
36.0
17.8**
38.5
Enterprise age (years)
Employment growth (% per annum)
Working owners (persons)
Other managerial employees (persons)
Equity held by working owners (%)
a
Annual capital expenditure/closing non-current assets.
b
Annual export sales/annual total sales.
c
Annual research and development expenditure/annual total sales.
d
Use of both budget forecasting and regular income and expenditure reports.
*, ** indicate statistically significant differences from the rest of the sample in an appropriate two-tailed
statistical test at the 5 and 1 per cent levels respectively.
23
Table 2: FINANCIAL PROFILES FOR UNDER-INVESTING SMEs
Please Note: Shaded items reveal statistically significant differences that are relatively consistent over
time, but which are unlikely to be wholly a consequence of the research method employed in
identifying under-investing SMEs.
1995-96
Financial
Characteristics
(median values)
1996-97
1997-98
UnderInvestors
(n=107)
Rest of
Sample
(n=764)
UnderInvestors
(n=107)
Rest of
Sample
(n=764)
UnderInvestors
(n=107)
Rest of
Sample
(n=764)
Return on owners equity (% per annum)
18.9
20.1
22.0
17.6
12.0
17.4
Return on total assets (% per annum)
6.5**
10.3
8.3
9.2
5.4
8.8
Gross margin on sales (%)
66.6**
54.1
68.7**
54.1
66.6**
54.5
Operating expenses to sales (%)
65.3**
47.6
66.1**
48.5
66.2**
48.5
Net margin on sales (%)
1.8**
5.5
2.9**
5.2
1.8**
4.8
Stock turnover ratio (times per annum)
8.2**
5.4
6.9*
5.0
8.6**
4.9
Asset turnover ratio (times per annum)
3.4**
1.8
2.8**
1.8
3.2**
1.8
Asset structure ratio (%)a
40.0
41.1
40.1
39.6
39.0
39.2
Total debt leverage ratio (%)b
85.2**
61.3
85.0**
61.2
79.3**
60.5
Current debt leverage ratio (%)c
60.1**
39.7
50.4**
36.6
47.0**
35.5
38.0
32.0
41.0
31.0
40.0
33.0
Banks & other financial creditors
leverage ratio (%)e
26
19
20.0
20.0
9.0
14.0
Interest expense to sales (%)
0.8
1.0
0.8
0.8
0.4**
0.8
Times interest earned (times)
1.3**
4.3
2.2**
4.7
1.9**
4.7
Working capital ratio (times)
1.0**
1.4
1.2**
1.5
1.3**
1.5
Acid test (times)
0.7*
0.9
0.8
0.9
0.9
1.0
Trade & other creditors leverage ratio
(%)d
a
Closing non-current assets/closing total assets.
b
Total liabilities/total funding.
c
Current liabilities/total funding.
d
Trade and other creditors/total liabilities.
e
Banks and other financial creditors/total liabilities.
*, ** indicate statistically significant differences from the rest of the sample in an appropriate two-tailed
statistical test at the 5 and 1 per cent levels respectively.
24
Table 3: DEMOGRAPHIC PROFILES FOR OVER-INVESTING SMEs
Please Note: Shaded items reveal statistically significant differences that are relatively consistent over
time, but which are unlikely to be wholly a consequence of the research method employed in
identifying over-investing SMEs.
1995-96
Demographic
Characteristics
(median values/proportions)
1996-97
1997-98
OverInvestors
(n=107)
Rest of
Sample
(n=764)
OverInvestors
(n=107)
Rest of
Sample
(n=764)
OverInvestors
(n=107)
Rest of
Sample
(n=764)
14-16*
12-14
16-18*
12-14
16-18
14-16
Total employment (persons)
25*
23
25*
22
32**
22
Sales turnover ($ per annum)
3,006,000
2,673,500
2,840,000
2,718,500
2,983,000
2,800,000
2,263,000**
1,319,500
2,151,000**
1,343,000
2,067,000**
1,360,000
Employment growth (% per annum)
0.0
0.0
0.0
0.0
0.0
0.0
Sales growth (% per annum)
2.3
3.3
0.3
1.1
4.3
2.3
Asset growth (% per annum)
6.2
3.2
4.6
1.9
4.8**
0.1
16.7**
1.3
15.0**
0.8
13.6**
0.0
Export intensity (%)b
0.0
0.0
0.0
0.0
0.0*
0.0
Research & development intensity (%)c
0.0*
0.0
0.0
0.0
0.0
0.0
Working owners (persons)
2
2
2
2
2
2
Other managerial employees (persons)
2
1
2*
2
2*
2
Equity held by working owners (%)
100.0
100.0
52.0
100.0
91.0
100.0
Recently raised new equity (%)
15.0*
8.4
10.3*
4.8
4.7
4.1
Are family businesses (%)
63.6*
50.7
62.6*
50.8
60.7
51.0
Have sound financial control (%)d
70.1
60.7
71.0**
56.7
66.4**
52.9
Have business plan (%)
43.9
35.6
40.2
33.1
47.7**
34.3
Enterprise age (years)
Total assets ($)
Capital investment intensity (%)a
a
Annual capital expenditure/closing non-current assets.
b
Annual export sales/annual total sales.
c
Annual research and development expenditure/annual total sales.
d
Use of both budget forecasting and regular income and expenditure reports.
*, ** indicate statistically significant differences from the rest of the sample in an appropriate two-tailed
statistical test at the 5 and 1 per cent levels respectively.
25
Table 4: FINANCIAL PROFILES FOR OVER-INVESTING SMEs
Please Note: Shaded items reveal statistically significant differences that are relatively consistent over
time, but which are unlikely to be wholly a consequence of the research method employed in
identifying over-investing SMEs.
1995-96
Financial
Characteristics
(median values)
1996-97
1997-98
OverInvestors
(n=107)
Rest of
Sample
(n=764)
OverInvestors
(n=107)
Rest of
Sample
(n=764)
OverInvestors
(n=107)
Rest of
Sample
(n=764)
Return on owners equity (% per annum)
11.2**
21.6
11.3
18.7
12.0
18.0
Return on total assets (% per annum)
7.6**
10.3
7.3**
9.4
6.1**
9.1
Gross margin on sales (%)
65.9**
54.5
67.1**
54.6
66.4**
55.0
Operating expenses to sales (%)
60.9**
47.6
62.5**
48.5
60.9**
48.5
5.6
5.1
5.9
4.7
5.4
4.3
Stock turnover ratio (times per annum)
2.8**
6.1
2.7**
5.6
2.6**
5.8
Asset turnover ratio (times per annum)
1.3**
2.1
1.3**
2.1
1.2**
2.2
Asset structure ratio (%)a
50.1**
39.1
47.7**
39.1
54.3**
37.7
Total debt leverage ratio (%)b
57.7*
65.6
55.3
63.6
59.9
62.8
Current debt leverage ratio (%)c
31.0**
43.2
31.3**
39.1
30.2**
38.8
Trade & other creditors leverage ratio
(%)d
19.0**
35.5
20.0**
35.0
20.0**
38.0
Banks & other financial creditors
leverage ratio (%)e
38.0**
17.0
33.0**
15.0
39.0**
11.0
Interest expense to sales (%)
1.7**
0.9
1.5**
0.7
2.0**
0.6
Times interest earned (times)
2.5
4.0
2.5**
4.8
2.1**
4.9
Working capital ratio (times)
1.4
1.4
1.6
1.4
1.5
1.5
Acid test (times)
0.9
0.8
0.9
0.9
0.9
1.0
Net margin on sales (%)
a
Closing non-current assets/closing total assets.
b
Total liabilities/total funding.
c
Current liabilities/total funding.
d
Trade and other creditors/total liabilities.
e
Banks and other financial creditors/total liabilities.
*, ** indicate statistically significant differences from the rest of the sample in an appropriate two-tailed
statistical test at the 5 and 1 per cent levels respectively.