Better management practices have been shown to improve firm performance through increased operational efficiency and technology adoption. New research by Isabelle Roland of the University of Oxford uncovers another way in which managerial quality enhances performance.
Her study, to be presented at the Royal Economic Society's annual conference at the University of Warwick in April 2019, shows that better management can improve firms’ ability to ‘save for a rainy day’.
Given that two key obstacles to the growth of small and medium-sized businesses in the UK are access to finance and poor management practices, it is useful to know that firms can become better at saving for a rainy day by improving their managerial skills. Doing that means that they will be better able to overcome financial constraints that prevent them from undertaking capital investment.
Better managed firms save more prudently
When access to external funds is costly, firms need to rely on their cash flow to finance capital investment. But when cash flows are volatile, firms can find themselves short of funds when they need them. This is why firms typically build cash reserves.
These ‘precautionary savings’ enable them to invest even if they experience adverse shocks to their cash flows. In the absence of such buffers, firms might have to pass up good investment opportunities.
Firms with better management practices are better at building these buffers and investing. The constant monitoring of performance and target achievement enables them to better pursue long-term objectives, such as capital investment.
The new study finds evidence of this using data from the World Management Survey (WMS) on UK firms. The WMS is an interview-based survey that defines 18 management practices and scores firms from 1 (worst practice) to 5 (best practice). The measured practices cover four broad dimensions: operations; monitoring; targets; and incentives.
Firms that are a priori financially constrained (those where external finance is costly) are more prudent when they have better management practices. Holding managerial quality constant, an increase in cash flow volatility from the 25th to the 75th percentile of the distribution is associated with an increase in year-on-year savings (as a percentage of total assets) of 0.75 percentage points.
Crucially, this precautionary behaviour is enhanced by better management practices. In other words, a given increase in cash flow volatility is associated with a higher response of the cash-to-asset ratio when a firm has a higher management score.
More specifically, a one standard deviation increase in the management score is associated with an increase in the savings-to-asset ratio by an additional 0.69 percentage points in response to the same increase in cash flow volatility. This corresponds to almost a doubling of the propensity to accumulate precautionary savings.
By contrast, neither cash flow volatility nor management quality have a significant effect on the savings behaviour of firms that are a priori not financially constrained.
Better managed firms invest more efficiently
When firms undertake capital investments, they adjust their capital stocks towards what they deem optimal. This process is not instantaneous because of adjustment costs and/or financial constraints. Investment is more efficient when the speed of convergence towards the optimal capital stock is higher.
The author finds that better managed firms adjust faster towards their optimal capital stock. More specifically, if a firm improves its management quality by one standard deviation, the annual adjustment speed increases from 3% to 5%.
The UK government’s Industrial Strategy
These results are relevant for policy-making in the UK, especially in the light of the government’s Industrial Strategy. The UK is a nation of small and medium-sized enterprises (SMEs). In the light of the UK’s dire productivity performance, the question arises whether SMEs can be an engine of growth.
Two obstacles that hamper SME growth are access to finance and poor management practices. UK firms are poorly managed and the potential productivity gains from improving management practices are large. High-growth firms see managerial skills as a significant obstacle to their success.
In this context, it is useful to know that firms can become better at saving for a rainy day by improving their managerial skills, which means that they are better able to overcome financial constraints that prevent them from undertaking capital investment.
Managing for a Rainy Day? Precautionary Savings and Managerial Quality by Isabelle Roland
Career Development Fellow in Economics at University of Oxford