MATCHING COMMERCIAL WITH FINANCIAL
AND EQUITY MANAGEMENT POLICIES IN SMALL
ENTREPRENEURIAL FIRMS.
THE SMALL BUSINESS GROWTH MANAGEMENT FLIGHT SIMULATOR
CARMINE BIANCHI ENZO BIVONA
Associate Professor of Master Phil. in
Business Management System Dynamics Candidate
University of Bari and Palermo (Italy) University of Bergen (Norway)
C.U.S.A. - System Dynamics Group C.U.S.A. - System Dynamics
Palermo (Italy) Group Palermo (Italy)
http:\www.unipa.it\~bianchi http:\www.unipa.it\~bianchi
bianchi @unipa.it enzob @futuralink.it
Abstract
An Interactive Learning Environment (ILE) has been built in order to reproduce the
budgeting process of a small family-owned entrepreneurial firm, to capture how
current decisions impact on business growth on a longer time horizon. The ILE
matches the accounting-related perspective through which spreadsheet-based budgets
are drawn up, with the system dynamics view. Such a goal has been pursued through
a connection of traditional Excel ® spreadsheets with Powersim™ SD models.
Playing The Small Business Growth MFS allows one to learn how:
= to draw up a budget based on a system dynamics perspective;
= long term goals may be affected by current decisions;
= business/family survival and growth are strongly influenced by current policies;
linking short to medium-long term policies and commercial to financial and equity
management issues is critical to business growth.
1. Introduction
Very often entrepreneurs, either explicitly or implicitly, feel growth as a goal to be
pursued through their own management decisions. Both operational (e.g. sales
revenues) and structural (e.g. net assets) growth are seen as a means to let the business
evolve from an early to a more advanced stage. However, growth may also reveal
itself as a crisis factor; in fact, a too fast, high or unintended growth rate is often a
primary cause of decline in financial and economic company performance. This paper
tries to demonstrate how matching system dynamics (SD) with accounting models
into computer-based, interactive learning environments (ILEs) may support
entrepreneurs and other small business ‘key-actors’ in understanding processes
originated by operational growth strategies, in order to foster analysis, diagnosis and
policy making.
2. Small firms as a field of research
The subject of small business and entrepreneurship has been much discussed in the
management literature. Although an analysis of different concepts of small business
goes beyond the scope of this work, it is possible to distinguish two main different
points of view according to which small firms have been differentiated from larger
ones, i.e. the quantitative and qualitative perspective. For example, Bolton report
(1971) suggests that small firms are those that have: relatively small market shares; a
high degree of personalised owner-management; independence in that they do not
form part of a larger enterprise and that the owner-managers should be free from
outside control in taking their principal decisions. A qualitative approach is adopted
by those who suggest that quantitative parameters (e.g. employees, sales turnover) do
not allow one to define to what extent a firm ought to be considered small or larger
(Curran and Burrows, 1989; Goffee and Scase, 1980). Based on a qualitative
approach, the concept of small business intended in this paper is that of a family-
owned firm, where usually the owner-entrepreneur:
both co-ordinates management operations and is involved in current activities;
is not supported by professional management;
involves other members of the equity-owning family in business operations;
e is seldom supported by formal organisation structures and planning & control
systems;
is not prone to delegate decision power;
e often makes intuitive decisions, particularly concerning on-going operations,
based on experience and a “flair for business”;
e lacks of time available to rationalise strategies, due to his/her emotional
involvement in current business management;
e has to balance both business and family requirements.
In spite of SMEs relevance to economic growth and stability, many entrepreneurs
often seem not to be well supported by the wide range of business actors (e.g., banks,
professional accountants and other external advisors, University researchers, etc.)
with whom they currently interact. This phenomenon could be explained by a number
of factors, such as lack of information, business culture and time available due to
entrepreneurs’ high involvement in current activities. Regardless the causes, a
recurring circumstance is entrepreneurs’ loneliness in facing difficulties hidden by
small business growth (Gumpert and Boyd, 1985), which is very often a primary
cause of failure.
3. Main factors of failure related to small business growth: the need of a
holistic and learning-oriented approach
The scientific debate on the causes of small business failure has been fruitful,
particularly in the last decade. Financial problems (e.g., undercapitalization, cash
flow management, ability to control costs) have been indicated by some scholars
(Festervand and Forrest, 1991) as the first cause of small business failure. Although
financial analysis and net working capital management is considered as a very
important issue by small business entrepreneurs, a significant percentage of firms do
not use any of these concepts (Nix and McFetridge, 1987). A survey (Hutchinson,
Ray, 1986) also showed that in a 33 firms experiencing a “supergrowth”, 18 suffered
for a long period of time from a negative net working capital (Schulze and Dino,
1998; Merikas et al, 1993; Peel and Wilson, 1996). Management problems have been
indicated as the second leading cause of crisis. Entrepreneurial inexperience and
incompetence have been identified by several authors as a primary cause of small
business crisis (Ault and Miller, 1985; Olivera and Martin, 1993). Another significant
weakness has been indicated in the lack of qualified personnel and ineffective
assignment of rules and tasks to family members and in the ability of entrepreneurs to
adjust to the fast paced environment (Bradley, 1997). Conversely, from a survey
conducted on a sample of unsuccessful small businesses, it has been remarked that it
is not uncommon for entrepreneurs to blame external factors for their failure rather
then themselves. (Lussier and Corman, 1995, p.5). In fact, undercapitalization,
recession and creditor problems have been indicated by the interviewed entrepreneurs
as the major causes for their failure, while poor management, lack of planning,
recordkeeping and financial control are not adequately taken into account (O’Neil and
Duker, 1986). Some other scholars (Moran, 1997; Aitchison, er al, 1994;) have been
focusing their research on small business entrepreneurs personal characteristics in
order to find some relationships with possible constraints to pursuit of the firm’s
growth. However, from the above mentioned literature what does not emerge is
another important factor of small business failure, related to low entrepreneurial
awareness of the relevant business system structure. In fact, quite often the relevant
busine: stem does not coincide with the internal boundaries of the firm. It also
embodies a wider range of variables belonging to other external sub-systems, related
to the competitive, social and equity-owning family environment. Such a
misperception often leads small business entrepreneurs to take their decisions
according to a bounded point of view, both in terms of time horizon and causal
relationships between internal and external relevant variables. Entrepreneurs need not
only to acquire managerial concepts, technical capabilities, or qualified professional
management; they also, and particularly, need to learn (Cressy, 1996). Learning may
allow entrepreneurs to understand and manage business complexity, whose
characteristics are peculiar in the small firms context.
4. Managing small business growth in complex and unpredictable
systems: implications for strategic control
Complexity and unpredictability usually have a specific and different shape in small
firms than in bigger ones. Figure | depicts three main interrelated complexity factors
which often lead to small business failure, i.e.: a) internal; b) external and family-
related factors '. Internal factors are those which are related to variables located
inside the firm. Among them, the most influential may concern: entrepreneurial
managerial attitudes, “debts/equity” ratio, planning & control methodologies and
tools, human resources, innovation management. External factors are mainly related
to competitors, customers, financial institutions and other actors which interact with
the firm from the outside. Perceptions about external factors are a key linking
mechanism between internal and external factors. Lack of understanding industry
“rules of the game” and difficulty to provide financial or human resources to sustain
growth are among main external factors of small business failure. Family-related
factors refer to the overlap (Landsberg, 1983) between the firm and equity-owning
family. Such overlap often leads to two problems: 1) bias in profit and cash flows
expectations leading to uncontrolled liquidity withdrawals from company bank
accounts to satisfy family needs; 2) uncertainty in the definition of roles played by
family members into the firm.
Owing to their particular tendency to be subject to environmental unpredictability,
much more than bigger firms, in small businesses the boundary between ‘short’ and
‘long’ term is usually particularly blurred. Small business entrepreneurs are almost
always completely involved in current activities for three main reasons: 1) usually
they are not prone to delegate; 2) they usually do not dispose of any prompt and
selective information support which allows them to anticipate future events; and, 3)
the weak relative weight of the firm in the relevant environment often forces them to
adopt a reactive and emotional decision making. Managing small firms is often a
matter of a continuous striving aimed at escaping from unexpected external or internal
events. It is a kind of muddling through (Limbloom, 1959) which very often does not
' It is worth remarking that such a schema does not pretend to drastically split three aspects this issue,
as they are inter-related. We only want to depict a systematic picture of the investigated phenomena.
allow a formal or conscious definition and planning of strategies to be pursued. From
these considerations the conclusion does not emerge, however, that small firms do not
have any strategic information need and do not need to plan for their future. On the
contrary, particularly in small firms, qualitative and quantitative growth depends on
the extent to which the entrepreneur is able to discern relationships between current
decisions (or short-term objectives) and long-term wider goals. Being aware of
dynamic relationships between current and future events is an important outcome of
the learning process (Bianchi et al, 1998). In order to understand the strategic impact
of current decisions on a longer time horizon, a higher selectivity of business control
systems is needed. In fact, current management takes places on an on-going basis, but
not all current decisions have the same level of strategic importance. Detecting weak
signals of strategic change hidden in current activities implies a level of complexity
that is different from longer run decisions related to capital investments. Even though,
in the first case, the structure of the system to be managed (relevant variables,
connections between them, delays, etc.) can be more easily defined than in the second
one, monitoring strategic relevance of current events implies a major difficulty in
detecting in advance weak signals of change as they are usually hidden in a wider
range of daily occurrences in which the entrepreneur is fully involved. Particularly in
the last two decades, literature on strategic control has been proposing several
theories on how to include a ‘strategic’ view into business control systems. However,
poor results have generally been attained in practice. In fact, strategic control has been
applied only with reference to some large companies and very often even the most
careful and straightforward strategic control system design has not been followed by a
real implementation (Goold and Quinn, 1990). This sharp mismatch between theory
and practice seems to be caused by the use of a project approach in business control
systems design (Brunetti, 1985; Bergamin Barbato, 1991; Bianchi, 1996). In fact, a
sharp distinction between strategic and management control system is done, based on
the following implicit hypotheses, i.e.: 1) it is possible to separate short and long term
goals/planning and implementation (Asch, 1992); 2) strategic control mechanisms
have to support strategic planning in setting clear and precise objectives in order to
reduce complexity; 3) responsibility units devoted to strategic planning and control
are different from those oriented to strategy implementation (Lorange and
Chakrawarthy, 1991); 4) tools supporting strategic planning and control are different
from those supporting management control.
Figure 1 - Three categories of the causes of small business failure.
This approach has produced an increasing bureaucratisation and a lack of
communication between the headquarters and planning staff and the operational
divisions, even in many large companies characterised by an articulated organisation
structure using sophisticated control tools. This situation often led divisional
management to depart from policies and goals officially declared in strategic plans
(exposed theory), in order to make other decisions (theory-in-use) (Argyris, 1985)
which were seen as more coherent with the characteristics of the systems to be
managed. In order to include a strategic perspective into business control systems,
particularly when management systems complexity and environmental
unpredictability are significant, it is necessary to use a different approach. Rather than
focusing on systems design, it is much more important to affect people’s mindset. This
shift from a project to a behavioural approach in control systems design is not a trivial
one. The project approach implies that people fit into the structure and its focus is on
information; the behavioural approach is focused on learning. According to this
perspective, the difference between strategic and management control tends to
become more blurred, as the control system (as a whole) is oriented to achieve a
common goal: strategic organisational learning. In other words, such an approach
implies that strategic control may allow people to deal with uncertainty, to better
frame systems in which they are involved, in order to understand management
complexity and unpredictability. Such a goal may be attained only if strategic
management is seen as a continuous (rather than discrete) process, according to which
also current actions may disclose significant strategic outcomes.
Which models and tools can support a small business entrepreneur in managing
growth in a learning-oriented approach? Matching SD and accounting models may
allow one to feed double loop learning (Sterman J. 1994), which supports mental
models’ improvement through an “intelligent” analysis of business phenomena, which
are observed according to the feedback view (Morecroft J. 1994) Such an approach, at
the same time, is likely to exploit, to make explicit and improve what are probably the
most important strategic assets in a small firm: entrepreneurial experience,
perceptions and tacit knowledge.
5. Exploring dynamic interrelationships between commercial, financial
and equity subsystems in a small firm: a case study
An ILE illustrating how one can support policy making in a small firm through the
analysis and diagnosis of feedback loops affecting operational growth, liquidity and
profitability will provided in the second section of the paper. It will be shown how
exploring dynamic interrelationships between different internal and _ external
subsystems may allow decision makers to pursue a sustainable growth, in compliance
with both business and the equity-owning family available resources.
The Small Business Growth Management Flight Simulator has been based on the
Spinnato and Sons case-study, that will be summarised here below.
5.1 Drawing up a budget in a learning-oriented approach
Spinnato & Sons is a family-owned business which distributes to manufacturing firms
a brand of wood-cutting machines. Mr. Spinnato is the owner/entrepreneur. He makes
intuitive decisions, mainly based on his knowledge and “flair for business”. In the
wider business arena, four main forces interact with the firm: competitors, customers,
banks and the Spinnato family. A fragmented offer and strong competition
characterise the industry. Spinnato’s customers are very sensitive to price discounts,
changes in terms of payment and lead (delivery) time policies. Banks grant a
maximum credit on current loans. This allows the firm to finance its current monetary
needs by increasing negative bank accounts. Each month a minimum withdrawal from
company bank accounts is done by the equity-owning family to feed its current
expenses. The family is also used to require an extra level of withdrawals, when it
perceives that the company is growing. Mr. Spinnato (i.e. the player) is now drawing
up an operating budget. How decision making related to the budgeting process can be
supported by accounting and SD models?
The ILE based on Spinnato & Sons case-study has been conceived as the core of a
three days course, mainly oriented to small business entrepreneurs and their direct
collaborators. The programme is also oriented to those who wish to start a new firm
and to post-graduate students in business administration.
The first day-course is devoted to deliver participants, through a Powerpoint ® slide
package, basic concepts of financial and small business growth management.
The second day is oriented to introduce the SD methodology as an approach to
understand dynamic interdependencies between variables affected by small business
growth. Participants are also asked to discuss the Spinnato & Sons case-study with the
aim to make explicit their mental models on the issues covered in the ILE.
In the third day the Small Business Growth Flight Simulator is played.
5.2 General briefing
A general briefing is initially done in order to introduce how to run the ILE. Such a
briefing consists of three parts: 1) main sub-systems of the ILE (i.e. the company,
customers, competitors, banks and Spinnato family); 2) the users’ task (i.e. setting
policy levers to improve performance, in terms of profitability, liquidity and family
satisfaction in a four years time horizon); 3) budgeting planning. Decisions on sales
price, terms of payment allowed to customers, lead time, safety inventory coverage,
withdrawals to family assets, investments from family assets, and allowed extra
current family expenses are made quarterly. Users start to draw up the budget for the
first year through an Excel® spreadsheet interface * (figure 2). According to adopted
policies, they have also to assess future sales quantities. After setting policies for the
first year, users may check from Excel® windows the related economic (Profit & Loss
and Break-even analysis) and financial (Financial and Flow of Funds Statements)
budgeted results, that are automatically portrayed in a spreadsheet model, based on
linear relationships and computations, regardless delays between causes and related
effects. On the basis of spreadsheet results, they are able to adjust their policies in
order to achieve desired goals, e.g., in terms of sales revenues, market share, current
income, cash flow, debts-to-equity ratio, etc. Then, they are ready to simulate their
budget decisions through an SD model built in a Powersim™ environment. After a
Powersim™ simulation has been done, results are automatically transferred to the
Excel® file. Although, both the spreadsheet and the SD model share a same database,
the latter follows a different approach. In fact, it takes into account feedback loops,
delays, non-linearities and soft variables that is very hard to include in a spreadsheet
model. Once users have formulated a set of hypotheses explaining the causes of
variances related to the first year, they may modify the original budget and repeat the
simulation, in order to verify their assumptions. Then, they can move to draw up the
budget for the first 6 months of the second year. The above commented iterative
planning-and-simulation process will be extended, with a six months step, over the all
4 years budget period. Then, participants are asked to move to Powersim™, in order to
experience decision making process in a different environment. In fact, the
Powersim™ environment provides a wider range of financial and soft variables (such
as those related to the family “quality of life”) and simulation functions, which allow
users to reinforce the learning process.
? The spreadsheet interface portrayed in figure 2 has been built in order to provide a friendly
environment to which participants are accustomed.
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Policy
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decide]
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player
iM nko creme /rereroet / mira ime cutis Umuee Jaes anion Farias Tu
Figure 2 - Spreadsheet budget input shell
As it is possible to observe from figure 3, a Powersim™ input shell may either accept
budget decisions from the Excel® model or from the slider-bars displayed in the left-
hand side of the window. In a further step, budgeting decisions will be made through
Powersim™ slider-bars (by setting the “Jnput from Powersim” option) in order to
assume, and then verify, competitors’ reactions to commercial policies (Strategic
Mode). Strategic Mode Simulation allows users to test different behaviours related to
market reactions to company commercial policies before decisions are accepted. After
a strategic simulation, users may decide to repeat it by either keeping the past trial
values or setting new decisions. This enables them to evaluate the consequences of
their assumptions, i.e., to explore how the system structure responds to their
hypotheses. During the simulation, learners may also check both business and family
performances through the Powersim™ windows, i.e., business or family graphs and
reports. Figure 4 depicts the above commented budgeting process, based on a
learning-oriented spreadsheet and SD model environment.
a
N
Figure 4 - Budgeting learning-oriented process
Figure 3 - Powersim™ input shell
5.3 Detailed briefing and Base run
In the detailed briefing, the Spinnato case-study is reviewed in order to give users an
insight of the picture in which they will be involved. They take the role of Mr.
Spinnato, they are in charge to manage his family firm, they have the same problems
he faced, they have to pursue company growth taking into account both family and
company requests. Some base runs are then displayed and commented on by learners.
The base run allows one to became familiar with Powersim™ interface and to be
aware of Spinnato’s business environment. After several simulation runs, users will be
able to manage The Small Business Growth Management Flight Simulator.
5.4 Simulation
Combining Excel® and Powersim™ simulation into the ILE allows participants to
close the learning process loop. In fact, the traditional budgeting process is based on
a single loop approach which implies a comparison of actual with standard values and
ex post variance analysis, that may feed back to modify the initial budget hypotheses
(figure 5). However, according to such an approach decision makers’ mental models
may not be questioned by them when actual and budgeted data are compared. In fact,
quite often people are more used to focusing their attention on the computation of
such variances and their division in sub-variances, rather than on the analysis and
interpretation of their real causes. Variances analysis is related to: sales volumes,
inventories, accounts receivable, current income, bank accounts, cash flows,
investments from personal assets and sales revenues.
Spreadsheet
Spreadsheet Budget
Budget
Ex-post Information
‘Variance Analysis feedback
Ex-post Actual Results peeete SD model
Variance analysis information feedback Variance Analysis information feedback
— Learning
Figure 5 - Traditional single loop budgeting approach Figure 6 - Double loop learning in the budgeting process
Matching the SD with traditional budgeting approach allows decision makers to ex
ante reformulate the budget, according to a more careful analysis of the inter-related
forces which drive business performance. Such an approach is oriented to capture
feedback loops between relevant (internal and external) variables, delays and non-
linear relationships, in order to improve key-actors’ mental models (figure 6). Such an
approach is likely to foster double loop learning.
5.5 De-briefing
The last step in the suggested learning process is de-briefing. It activates double loop
learning as it opens the participants’ mind to shift from a fragmented and static
approach to a holistic and dynamic perspective. Participants are asked to comment on
their decisions and to give an explanation of system behaviour. Some of the issues
which are usually raised in the discussion include: competitors’ reactions, demand
elasticity, limits to market growth, relationships between sales growth and net
working capital, shortages in allowed bank credit, trends in family climate and, more
generally, time delays and non-linear relationships. The outcome of this process is
twofold: a) feedback loops are identified, and b) system boundaries are focused.
These learning targets are also pursued by showing information on market reactions
to decision makers’ policies. These pieces of information were not previously
available in the interface used to draw up the budget. Such a constraint to user’s
information is due to the need to replicate real conditions under which decisions are
usually made, particularly in small firms. The portrayed behaviours support
participants in raising more focused and relevant questions in order to understand the
deep causes underlying their decisions. In order to give the reader a more concrete
insight of possible outcomes emerging from the de-briefing process, two scenarios are
discussed here below.
5.5.1 Fast growth, profitability and liquidity failure caused by emotional
commercial policies in response to liquidity shortages
A first scenario gives an example of irrational and emotional company policies, based
on a mismatch between commercial and financial sub-systems (figure 6).
In order to increase market share and sales revenues, the entrepreneur progressively
rises the terms of payment during the first year and decreases prices in the second
year.
‘Carapany rice “Average current cash flow (1]- Average curent income (2) “Average fanily satisfaction ratio (_o.asa_)
. Average change in Net Working Capital (3)
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Figure 6 — Business and Family graphs
It is possible to identify four main consequences related to this scenario: 1) market
share and sales revenues gradually increase, due to a slow rise in terms of payment; 2)
in spite of higher sales revenues, the current income slightly increases and reaches a
limit to growth earlier than sales revenues 3; 3) net working capital shows a pattern of
behaviour that mirrors current income, leading to a negative cash flow * which fully
absorbs equity-owner’s initial investments; 4) investments from personal assets
progressively decrease average family satisfaction ratio.
Around the 15" month, the entrepreneur realises that the business’ financial structure
does not allow the above strategy to sustain; another limit to the market share increase
is also found into competitors’ reactions to terms of payment increases In order to
overcome the above limits to market share growth, the entrepreneur decides to shift
from a terms of payment to a price based commercial policy. In the entrepreneur’s
mind, resetting terms of payment to their initial value would have allowed the firm to
immediately restore both the net working capital and liquidity. At the same time, such
a strategy was intended to foster an increase in both market share and sales revenues.
However, the expected outcomes are sharply different from the actually achieved
results. In fact, as figure 6 portrays, from around the 15" month, both market share
and sales revenues dramatically fall, leading to a negative current income and still to a
negative cash flow. Such behaviour originates from: 1) a delayed competitors’
This behaviour is due to both a decrease in unit sale price and a rise in interest costs on negative bank
accounts
* Current cash flow = Current internal flow of funds - A Current net working capital.
reaction to the decrease in company’s terms of payment, leading to a lower market
appeal of the firm; 2) a delayed customers’ perception of company price decrease; and
3) a delayed market share increase which does not compensate the decrease in price.
The result of this scenario is failure, that is mainly caused by the exploitation of
allowed maximum bank credit. It is worthwhile to observe that maximum bank credit
shows a decreasing pattern over time (in absolute value), because of a family assets
decrease and a “‘debts-to-equity” ratio increase. From the above scenario one can learn
that resetting a policy lever to its initial value does not necessarily imply that the
system is restored to its initial state. In fact, current policies contribute to change the
structure of the environment in which the firm operates. In other words, it is not only
the internal environment that determines business performance: in fact, the way the
firm interacts with a wider range of “actors” (clients, competitors, banks, etc.)
operating from outside must be taken into consideration in order to understand
business dynamics as a condition for policy setting (Forrester J., 1994, 1973; 1975;
1968).
5.5.2 Fast growth and liquidity failure caused by uncontrolled family
withdrawals and lack of invested capital
A second scenario shows how company failure may be caused by a growth policy that
is not sustainable because of excessive bank withdrawals aimed at increasing the
family “quality of life”, both in terms of current expenses and personal assets. Such
phenomenon is mainly caused by bias in profit and cash flows expectations and
related distorted information, combined with entrepreneur’s emotional involvement in
coping with the business/family overlap. As portrayed in figure 7, the firm pursues a
growth policy based on both a decrease in lead time and an increase in terms of
payment. In order to finance such an aggressive policy, the entrepreneur decides to
progressively increase sale price and to reduce safety inventory coverage 5 In the 3“
month, terms of payment are increased to 4 months. As a consequence of such policy,
on the one hand both company market share and sales revenues increase. On the other
hand, net working capital decreases (in spite of higher sales volumes and terms of
payment) because of lower inventories caused by the reduction in safety inventory
coverage. The combined effect of higher income and lower net working capital leads
to an increase in net cash flow. At around the 6" month, the entrepreneur increases
average sale price: in his mind, such an increase is justified by a better product appeal
perceived by clients, because of higher terms of payment and lower lead time. The
initial effect of such a policy is an increase in both the current income and liquidity,
due to higher sales revenues and sales unit contribution margin. However, market
share decreases for two main reasons: 1) customers are more sensitive to lower prices
than higher terms of payment, and 2) the competitive advantage of the firm in “terms
of payment” and “lead time” has been progressively reduced because of competitors’
reactions to company’s aggressive commercial policies. Such an analysis suggests
again that decision makers need to understand market dynamics before setting their
policies. In order to counterbalance such a decreasing pattern in market share, at
around the 9" month, the entrepreneur decides to support the “high price — high terms
of payment” strategy with a lower lead time. At the same time, expectations of further
growth in both profits and cash flows lead him to divest accumulated monetary
Safety inventory coverage is the number of months of sales kept on stock. A reduction in safety
inventory coverage leads to a decrease in inventory financial needs. On the other hand, particularly
when the firm pursues aggressive commercial policies aimed to increase sales volumes, a too high
reduction in such a parameter rises actual lead time (i.e. delivery delay).
resources, in order to increase family assets (e.g., buying property) and “quality of
life”. Also average family current expenses are increased from 7 to about 8.5 millions
£ per month. As a consequence of the above decisions, on the one hand the level of
family satisfaction grows (see “family satisfaction ratio”, portrayed in figure 7).
Nevertheless, on the other hand, both business profitability and liquidity dramatically
worsen. In fact, the lower lead time strategy is only able to generate a delayed and
transient increase in both sales volumes and revenues. Such a behaviour is once again
explained by competitors’ reactions, associated to their high sensitivity to lead time,
which limit business sales revenues and current income growth. In particular, from
around the 15" month, when it is more difficult to further operate on commercial
policy levers, the company liquidity begins to erode for three main reasons: 1) the
higher financial needs associated with increased net working capital resulting from
higher accounts receivable from the rise in terms of payment; 2) the decreasing sales
revenues resulting from price increase and competitors’ reactions to the business’
aggressive commercial policy; and 3) the too high “debts-to-equity” ratio, if compared
to the low available bank credit and the rising financial needs associated with the
pursued growth rate of the firm. At around the 18" month, in order to overcome such
financial stress and the experienced limits to market share growth, the entrepreneur
reduces lead time again. As a consequence of this policy, both market share and sales
revenues grow again. However, they also imply a further increase in net working
capital and, hence, higher financial shortages. The above said financial difficulties
develop into a ci and eventually into a failure (Lyneis J., 1980: p. 359). In this
scenario, profitability is not compatible with liquidity.
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Figure 7 — Business and Family graphs
5.6 Feedback analysis
The two scenarios commented above depict some of the most common behaviours
that participants are expected to experience in running the Small Business Growth
MFS. As previously remarked, during the budgeting process, participants compare
expected ° with SD model behaviours related to their policies. Such a comparison
leads them: 1) to figure out and sketch causal relationships among relevant variables,
and 2) to fine-tune their policies according to detected variances. Such an analysis is
done by groups (each of them including no more than three participants) during the
6 Expected behaviours are originated by participants’ mental models. They are depicted through the
Excel ® interface and, then, compared with the SD simulation results.
simulation process. After the simulation phase, in a plenary session a facilitator asks
participants to describe their experience and helps them in identifying main relevant
sub-systems and related feedback loops (figure 8). The learning process enhanced by
the use of the Small Business Growth MFS implies that SD model information feeds
back to the previous steps in order to allow users to review under a different
perspective the investigated issues. Double loop learning is reinforced by the
debriefing process, which opens up the learners’ mind in order to better understand
the real causes underlying family business growth dynamics. The most significant
feedback loops originated by decision makers’ behavioural analysis are portrayed here
below. A first positive loop emerges from the effects generated by terms of payment
increase. After a delay, such an increase gives rise — ceteris paribus — to an increase in
customers, which determines higher sales revenues and current income. A higher
current income implies a growth in the cash flows (given an unchanged net working
capital), which increases bank balance and available bank credit. An increase in
perceived available bank credit allows the entrepreneur to rise terms of payment again
(figure 9). However, growth in sales revenues, income and cash flows, based on a
terms of payment policy may be counterbalanced, sooner or later, by liquidity
shortages caused by a net working capital increase. Such an increase is due to the
higher sales revenues and higher average terms of payment allowed to customers.
When the increase in accounts receivable and average inventory is not offset by an
increase in accounts payable (due to terms of payment negotiated with suppliers), the
change in net working capital will decrease cash flows. That will reduce available
bank credit.
er |—[peranie BASE, | a Terms of payment
en BRIEFING RUN “T < fecanenes Customers
\
x \
Avatale
SD MODEL INFORMATION FEEDBACK Revues
\
ee Income
as a
REINFORCING LEARNING PROCESS ea eg
Figure 8 - The learning process overview Figure 9 — Positive terms of payment loop
If the entrepreneur realises that a liquidity shortage might slow down growth, he will
soon either stop increasing terms of payment allowed to customers or will increase
equity, through investments from family assets. The entrepreneur could also restore
the debts-to-equity ratio and reduce terms of payment growth rate. It is a matter of
finding a fine tuning between the average level of terms of payment and the level of
equity invested in order to tackle the dominance of the negative feedback loop
originating from the net working capital (figure 10). Whereas financial shortages are
not promptly perceived and corrective policies are not adopted, further increases in
terms of payment will give rise to a higher net working capital which will worsen
liquidity even more. Eventually, negative bank accounts will produce interest costs
that will progressively increase bank debts (positive loop), on a side, and will reduce
the current income, cash flows and bank accounts (positive loop), on another side.
The effects generated by terms of payment (and, more generally, commercial) policies
are not limited to the internal business system. In fact, such policies will cause
competitors’ reactions, aimed at filling the gap in terms of payment. Adjustments in
competitors’ policies will reduce the increase in the customer base that the firm will
be able to obtain as a consequence of its commercial policies (negative feedback loop
of figure 11). On the other hand, competitors’ aggressive commercial responses will
increase the potential market. This will increase — ceteris paribus — the number of
customers that the firm will be able to get from the market (positive feedback loop of
figure 11). Figure 12 provides a wider insight into the main feedback loops associated
with commercial policy levers operated by the entrepreneur. It shows how a low price
strategy may lead to an increase in the customer base and (if the volume increase
offsets the decrease in contribution margin) sales revenues, that could suggest
decision makers to further decrease prices (positive loop). Likewise, a lower lead time
could lead to a larger customer base and a higher sales revenues that could induce
decision makers to further decrease lead time (positive loop). However, lead time
strategy finds two internal limits two growth, associated with negative feedback loops.
The first one is related to the increase in net working capital, due to higher inventories
caused by increased sales volumes and safety stocks. The second one is associated
with higher delivery costs that would be sustained to achieve a faster dispatching of
goods. Likewise terms of payment, also growth strategies based on price and lead
time can be counterbalanced by competitors’ reactions that would decrease the gain in
customer base associated with an aggressive use of the above policy levers (negative
feedback). On the other hand, the same reactions could also increase the potential
market, thereby also rising the gain of new customers that the firm would be able to
get from its commercial policies. $ rosa
en & \e we
perern Net Working
Beak Go Sales Capital
Revenues __ ai
Terms of payment
ty neisiomers
~ x
= se Carat”
+ coh ae
Hows “#—___—
Figure 10 - Limits to growth and risks of failure Figure 11 - Competitors and customers’
from net working capital dynamics reactions to company commercial policies
Other relevant feedback loops are related to the business-family overlap (figure 13).
The more the company grows and perceived current income and cash flows increase,
the higher number of family members’ withdrawals requests will result. A positive
loop characterises the relationship between family requests and bank withdrawals
allowed by entrepreneur. In fact, an increase in family current withdrawals is likely to
stiffen family requests on a higher level. However, the spiral “withdrawal requests for
current expenses = withdrawals actually operated on business bank balances =>
withdrawal requests for current expenses” can be counterbalanced — sooner or later —
if the entrepreneur perceives two emerging negative feedback loops associated to
escalating withdrawals. In fact, on the one hand the increasing liquidity withdrawals
give rise to lower bank balances. On the other hand, being such withdrawals an
interim dividend on perceived profits, they would cause a decrease in business equity
(net worth), leading to a higher “debts-to-equity” ratio that would determine a lower
liquidity, because of a weaker business perceived solvency, resulting in a lower
available bank credit. As shown by the second scenario previously commented,
misperception of inter-relationships between commercial, financial and family sub-
systems may lead to company failure. In order to avoid such risks, decision makers
may invest new resources from family assets into the firm (negative feedback loop
“investments = bank balance = available bank credit = investments”).
Nevertheless, the above investments may cause a lower family satisfaction, which
could also lead to a business crisis ’. The entrepreneur may overcome such threat
through withdrawals of liquidity from bank accounts to increase family properties
(negative feedback loop) *.
Balancing withdrawals and investments to achieve an adequate family satisfaction
ratio that is compatible with business liquidity, and matching commercial policies
with financial structure are the key to survival and growth of both the business and the
family. Three main key performance indicators resulting from the above analysis are:
current income, available bank credit and family satisfaction ratio.
<<lnvixtments from Family Avicte> Fall Assets >
Lead Tings —F Potentiat
MKT
a - Feri of payment +
eur eioenenae S
Reactions to company »
4, commercial polices —
a
Chstomers
<< Sales Price >
x \e
sn
op tet vn
= j
€
wundrawats
im
\ [OS ata pon Auf
\V A ‘Panly Assetr
\\e °
\ ea, FT.
Fa) Nig tet oe
[saison nai) Wide Farida Request
¥
Terms of pasment
x
Se &
he
+ Interest
9
Ry Careta
* Tacome
i oa ae
Figure 12 - Main feedback loops related to Figure 13 - Main feedback loops related to
company commercial policies business-family relationships
5.7. What one can learn
To summarise, the Small Business Growth MFS supports participants in
understanding: a) effects of current commercial policies on the financial structure in
the medium-long term; b) limits to sales growth generated by the financial structure;
c) limits to sales growth generated by competitors’ policies and potential market; d)
perils from symptomatic solutions to liquidity shortages; e) perils from escalating
aggressive commercial policies in response to competitors’ reactions; and f) perils
from irrational liquidity withdrawals due to bias in profit and cash flow expectations,
to increase the equity-owning family “quality of life”.
It is possible to refer some of the most significant issues covered by the above
analysis to three main archetypes (figure 14): 1) limits to growth; 2) shifting the
burden; and 3) escalation. The inner section of figure 14 portrays limits to business
growth, caused by the net working capital dynamics. The upper section shows how
the shifting the burden archetype may describe the unintended effects of
undercapitalization on both liquidity and profitability. The bottom section illustrates
the risks of escalation related to a war on price (or other commercial levers) between
the firm and its competitors. Another important message which emerges from the
above remarks is that decision makers ought to set their policies not only on the basis
of their internal environment, but also based on the dynamic relationships between the
firm and external actors (competitors, customers, suppliers, banks, etc.) with whom it
interacts. Exploring relevant system boundaries is not a matter of building huge
"Tn fact, a lower family satisfaction ratio may give rise to contrasts among family members, that would
reduce the confidence towards the entrepreneur and involve him in making emotional and reactive
business decisions.
* Tt is worth remarking that both withdrawals and investments also produce their effects on business
equity.
models, but instead of selectively understanding how external sub-systems interact
with the firm.
aie he.
-
Figure 14 - Systems archetypes underlying small business growth dynamics
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