Benel Lagua l July 29, 2023 l The Manila Times
MICRO, small and medium enterprises (MSMEs) are the backbone of economies worldwide, playing a crucial role in job creation, innovation and growth. The United Nations organizes annually MSME Day on 27th of June to raise awareness of their significance in achieving the Sustainable Development Goals.
In the Philippines, the Magna Carta for MSMEs declares the second week of July as the National MSME Week. The aim is to institute continuing awareness of the primacy of small business in nation-building and in people empowerment, and to celebrate and espouse the firm commitment of the State in the promotion, growth, and development of small business. This year, the Department of Trade and Industry adopted the theme “Upgrade, Upskill, and Upsize MSMEs.”
Among the activities lined up by DTI was the Innovation and Digital Transformation forum focusing on how the SMEs can leverage technological advancements to enhance their operations, empower productivity and tap into new markets. A National Food Fair was also held to provide an avenue for entrepreneurs to showcase the culinary creations, promote local food products and establish business linkages and partnerships.
To be fair, these are all helpful initiatives. As more Filipinos are being encouraged to take on the entrepreneurship route, the more fundamental question for long run sustainability must be focused on value creation. Unfortunately, entrepreneurs too often make their business decisions based on feel and gut instinct. Passion is a necessary but not sufficient ingredient to business survival and continuance.
Having dealt with several small entrepreneurs in my professional life, the vast majority are good production or service people with a dash of marketing skills. The area where gaps often appear is in understanding the numbers that measure enterprise performance.
Financial literacy is an acquired set of skills such as understanding the foundation (reading financial statements), understanding the art of finance (by using limited data to arrive at accurate description of company’s performance), and understanding financial analysis. In business, it is the ability to use financial and business information to understand and make decisions that help an organization become profitable and successful.
A critical issue MSME entrepreneurs must face is understanding how value can be created in the business. To do so, the businesspersons must study finance, which is the language of business. The entrepreneurs need not aim to become financial engineers. Understanding the intuition is enough foundation to address fundamental financial issues. And the most critical question worth answering is value creation and how to measure it.
Value creation ultimately hinges in the capacity of the firm to earn a return that exceeds the cost of capital. The business must fully account for the resources entrusted to the firm, whether by the equity holders or the debt holders. That combined cost must be accounted for, even if not explicit. And the user must consider and measure the risk of the providers which will factor in the return expected.
The business will have two basic types of capital providers, lenders who provide debt capital and owners who provide equity capital. Debt has a fixed return that has priority for repayment, while equity holders will have a residual claim with a variable return. Determining the cost of debt is straightforward, the interest rate charged by the lender. Equity is a little harder as the investor will have to be rewarded for the risks taken. Finance theory helps us here, but it ultimately is a measure of opportunity cost.
Combining the costs and accounting for other factors such as taxes and the proportion of each fund source will lead us to the weighted average cost of capital or WACC. This is an essential benchmark.
Mihir Desai, renowned Harvard Business School Professor, summarizes the three ways to create value. “Companies must do three things. First and foremost, they must beat their cost of capital. If they don’t, nothing else matters. Second, they must beat the cost of capital for many years. And, third, they must reinvest the additional profits at right rates through growth. Beating the cost of capital is all about creating a competitive advantage through innovation. Keeping the gap open between returns and costs of capital for longer periods is what barriers to entry, brands, and intellectual property protection are all about. Finally, reinvesting more profits is all about growing an opportunity through expansions, adjacencies, or integration.”
Our small business entrepreneurs must think smart when looking at financial numbers. The MSME landscape is littered with stories of fleeting successes that never became sustainable. Our MSMEs must aim to build some level of financial intelligence to see their dreams to fruition.
*** Benel Dela Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active Finex member and an advocate of risk-based lending for SMEs.
Today, he is independent director in progressive banks and in some NGOs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as Finex.