Financial Literacy Levels of Small Businesses Owners and it Correlation with Firms' Operating Performance

“Financial Literacy Levels of Small Businesses Owners and it Correlation with Firms’ Operating Performance” by Tânia Isabel Mendes Fernandes [email protected] Master in Finance Dissertation Supervisor Professor Cláudia Alexandra Gonçalves Correia Ribeiro 2015 ii Biographical Note Tânia Fernandes was born on April of 1986, in Maia. The master student finished her degree in Business Administration by Faculdade de Economia do Porto in 2008 and three years later initiated the Master in Finance. At professional level, she began her carrier in a summer internship at Banco de Portugal (2008), followed by a professional internship in Beta, a venture capital society (2008/2009) and during the following 4 years worked as a credit risk analyst at Norgarante, S.A. Today, and since May of 2014, she is giving succession to her parents’ company, which is a micro enterprise of electrical equipment. Also, since 2011, she is volunteer in Centro de Apoio ao Sem Abrigo (C.A.S.A), which the main aim is to feed homeless and people in need. iii Abstract In recent years, after the impact of the well-known financial crisis, governments around the world started to express their concern about the levels of financial illiteracy among their citizens, being this problem widely referred as an aggravating factor of this crisis. As a result, research on financial literacy has been developed by, but mainly focused on personal finance issues involving the general public, leaving a gap with respect to the financial literacy levels among small businesses owners. Financial literacy is seen as an important instrument for the success of small businesses, since it helps to understand and evaluate the information needed to make daily decisions that have financial impacts in companies’ day-to-day management. Therefore, the goal of this research is twofold: to assess the financial literacy levels of small business owners (micro enterprises and small enterprises) in the North of Portugal and to analyze the relation between these results and the operating performance of those companies, as a measure of business economic performance. The study tests the hypothesis that, all other factors being constant, a higher financial literacy level of small business owners should motivate a better performance of the company. The relevance around the chosen target is justified by the fact that small businesses, defined by micro enterprises and small enterprises, are an important driver for the Portuguese economy since they represent 35% of the total revenues in 2013, through 98% of an universe of 380.000 companies, and employ a meaningful part of national workforce. The sample in this study is composed by small businesses of the North of Portugal, specifically from the regions of Porto, Braga, Viana do Castelo and Vila Real, and through questionnaires it was obtained the data needed to gauge the levels of financial literacy. The results evidence a rather level of financial literacy among small business owners of the micro and small business in the North of Portugal. And, the data also supports the existence of a significant positive correlation between financial literacy levels and companies’ operating performance. This result highlights the importance of providing to small business owner adequate financial education on the expectation of improving their performance as business leaders. iv Key-words: financial literacy, financial crisis, small business owners, operating performance. v General Index Abstract ............................................................................................................................ iii Index of Tables ................................................................................................................ vi Index of Charts .............................................................................................................. viii 1. Introduction ............................................................................................................... 1 2. Literature Review: Financial Literacy and Small Businesses Performance ............. 4 2.1 Financial Literacy ............................................................................................. 4 2.2 Financial Literacy and Small Business Performance......................................... 8 2.3 Assessment of business owners’ financial literacy levels ........................... 13 3. Study Objectives and Hypothesis ......................................................................... 16 4. Methodology and Data ....................................................................................... 19 4.1 Questionnaire ............................................................................................... 19 4.2 Sample .......................................................................................................... 20 4.2.1 Sample Size Determination ...................................................................... 20 4.2.2 Sample Characterization ........................................................................... 23 4.3 Financial Literacy Index............................................................................... 26 4.4 Operating Performance Model ..................................................................... 27 5. Results analysis ....................................................................................................... 29 5.1 Descriptive analysis of results – Financial Literacy Index .............................. 29 5.2 Statistical analysis of the factors that influence the financial literacy index of small business owners ................................................................................................. 35 5.3 Operating Performance Results ....................................................................... 43 6. Conclusions ............................................................................................................. 47 Bibliography ................................................................................................................... 49 Appendix A - Questionnaire ........................................................................................... 52 vi Index of Tables Table 1 –Global Planned and Performed Sample ............................................................ 22 Table 2 – Micro Enterprises: Planned and Performed Sample distributed by regions of the North of the country................................................................................................... 22 Table 3 - Small Enterprises: Planned and Performed Sample distributed by regions of the North of the country................................................................................................... 22 Table 4 – Distribution of Business Activity Codes (2 Digit Codes) ............................... 23 Table 5 – Financial Literacy Index (FLI) and corresponding rating level ...................... 28 Table 6 – Industry Dummies Variables ........................................................................... 28 Table 7 – Descriptive Statistics: Firms Revenues and Number of Workers ................... 29 Table 8 – Descriptive Statistics: Original and Global Financial Literacy Index ............. 30 Table 9 – Rating Equivalence of Financial Literacy Index ............................................. 30 Table 10 – Small Business Owners’ Rating: Index Results vs. Self-Evaluation ............ 31 Table 11 – Descriptive Statistics: Partial Financial Literacy Index ................................ 31 Table 12 – Normality Tests ............................................................................................. 35 Table 13 – Hypothesis 1: “Male small business owners present higher financial literacy levels than female gender.” – Kruskal-Wallis test .......................................................... 37 Table 14 – Hypothesis 2: “Small business owners with higher education present higher financial literacy levels.” – Kruskal-Wallis test .............................................................. 38 Table 15 – Hypothesis 3: “Small business owners with education in/or related with economics present higher financial literacy levels.” – Kruskal-Wallis test .................... 39 Table 16 – Hypothesis 4: “Younger small business owners present lower financial literacy levels.” – Kruskal-Wallis test ............................................................................. 40 Table 17 – Hypothesis 5: “The financial literacy levels of small business owners are higher in bigger firms” – Kruskal-Wallis test ................................................................. 41 Table 18 – Hypothesis 6: “The small business owners responsible for companies’ financial area present higher financial literacy levels than those who trust the financial area to external entities.” – Kruskal-Wallis test .............................................................. 42 Table 19 – Hypothesis 7: “There is a positive relation between the financial literacy levels of small business owners and the performance of their firms”. – Kruskal-Wallis test .................................................................................................................................... 42 vii Table 20 – Descriptive Statistics ..................................................................................... 43 Table 21 – Pearson correlation coefficients .................................................................... 44 Table 22 - Results of OLS Regression of Adapted Operating Performance Model........ 45 viii Index of Charts Chart 1 – Age of small business owners’ respondents .................................................... 24 Chart 2 – Education level of small business owners ....................................................... 25 Chart 3 – Financial area responsible................................................................................ 26 Chart 4 – Average Financial Knowledge Index .............................................................. 32 Chart 5 – Realization of the business plan at the beginning of the activity .................... 33 Chart 6 – Frequency of company’s profitability analysis ............................................... 34 Chart 7 – Frequency of cash-flow forecast preparation .................................................. 34 1 1. Introduction Since the mortgage crisis, governments around the world start to express concerns about the levels of financial illiteracy among their citizens, mainly due to the daily confirmation of the increasing of consumer over indebtedness and, also, of household bankruptcy rates. Moreover, the financial illiteracy has been widely referred as an aggravating factor of this financial crisis (Atkinson and Messy, 2011). As a consequence, it is also defended that financial literacy should be seen as a public policy objective in order to improve welfare through better decisions making and mitigate the asymmetry between the final consumer and, mainly, the financial institutions (Huston, 2010). These concerns were rapidly expanded to the scientific community and, nowadays, it is noticed a huge growth of research based on financial literacy matter, mostly in relation with the accurate financial literacy levels, which are seen as indicators to sustain the need for financial education (Huston, 2010). Another reason for this recent growth on research is related with the effects of financial literacy on individual retirement planning success. The increasing concern of governments around the world with the straining employersponsored for the Social Security System, mainly caused by rise of life expectancies and falling of birth rates, is opening a door for financial literacy as one of the solutions for this matter. Through financial education governments would be able to encourage their citizens to take more self-responsibility for their retirement incomes. (Lusardi and Mitchell, 2011b).. Despite the importance of small businesses in many economies, the major research done so far is mainly focused on personal finance issues of general public, leaving a gap for the analysis of the levels of financial literacy among small businesses (Brown et al., 2006). Portuguese economy is greatly dependent on the small businesses’ activity, including small enterprises 1 and micro enterprises 2 . In the fact, in 2013 these small businesses accounted for 35% the total revenue of our country and for 53% of the total employment (Banco de Portugal, 2014). 8 2.2 Financial Literacy and Small Business Performance The rare literature about small business owner’s financial literacy provides a slightly different definition of financial literacy, being the main distinction related with the understanding of information provided by financial statements. Instead of financial knowledge being only focus on the comprehension of borrowing and saving matters, interest compounding, concept of inflation and risk diversification. A small business owner must be able to evaluate the information needed to make decisions that have financial ramifications or consequences on the business. According to Brown et al. (2006), financial literacy for small business owners must contemplate the ability to read and understand fundamental financial statements, as well as, the ability with numbers, in order to make informed judgments and to make effective decisions regarding the use and management of money. A recent work from two authors describes financial literacy as “the ability to understand and use business financial statements to generate key financial ratios to evaluate and manage a business.” – (Pearl and Eileen, 2014) Despite the definition of financial literacy regarding personal finance issue be more developed and widely accepted, the definition of financial literacy regarding small business is much more demanding, not only, for financial knowledge, which must contemplate the capability of read and understand financial statements information, but also in financial behavior, with the habits concerned with the analysis of financial information, and financial preferences or attitudes, which must be positively correlated with financial knowledge and behavior, in the moment of taking the daily management decisions. However, as it has not been given much attention to financial literacy of small businesses owners, the literature does not provide an embracing definition of financial literacy in business context. Differing to what happens with financial literacy for personal finance issues. Since many economies around the world are dependent of the success of small businesses, which is also the case of Portugal, it is important not only provide the levels of financial literacy of general public, but also gauge the levels of financial literacy of small businesses owners. 9 In most of small businesses is common to find its owner as an employee, which is mainly focus on the operational area of the business, forgetting the strategy and planning of the business activity, and where financial education could make the difference, by improving business owners’ financial skills. In fact, Brown et al. (2006), with an educational program, evidence the rise of financial literacy among entrepreneurs, and Pearl and Eileen (2014) could evidence the relation between financial literacy and the success of small businesses, by clearing the connection between the inadequate financial literacy and financial difficulties experienced by entrepreneurs. According to Banco de Portugal, between 2010 and 2013, on average, the number of small business, micro enterprises and small enterprises (according to the division set by Portuguese law, under the 2 nd article of the decree-law nr. 372/2007), increased 1% per year, despite the number of Portuguese employed by those companies decreased 2% per year. Mainly due to small enterprises since micro enterprises registered a different path by growing 1.7% per year. The total revenue of small business at that timeline has an unfavorable performance by falling around 4% per year, but still representing 35% of total revenue, in 2013. Despite this evolution, and according to the same source, in 2013, the micro and small enterprises together employed 53% of Portuguese workers, against 27% of big enterprises and 20% of medium enterprises. The studies at literature about small business owner’s financial literacy are very scarce and it was not found anyone similar to the present research in order to establish a benchmark. Sage (2012) carried out a survey about Canadian Small Business Financial Literacy, with a sample of 300 small businesses, where it gauges the perceptions, knowledge and habits of small business owners related with financial and resources management. The main results of this survey provide the perception of the respondents about the areas they need to learn more about (financial planning, tax payment and cash-flow), the areas they feel more comfortable with (dealing with clients, dealing with suppliers and managing the finances of their businesses) and the areas where they fail most of the 10 time (dealing with taxes, managing sales and marketing and managing the finances of their businesses). Despite the interesting finding of Sage Canadian Survey, their results are based on respondents’ perceptions and not so much on specific understanding of financial statements, correspondent to the financial knowledge, which is a fundamental pillar to provide accurate levels of financial literacy. Additionally, some of the question of this survey where asked in order to understand the frequency of usage of technology and accounting software, which is reasonable considering the institution which carry out the study. Brown et al. (2006) carried out a study based on financial literacy of small businesses owner-entrepreneurs in their first year of activity. The basis of this study is settled on a program called “Training in Business Basics”, specially created for this population target of new small businesses with less than ten employees. The authors, in order to carry out their study, provide 147 small businesses of United Kingdom in their first three years of life with educational modules based on basic finance. The argument behind this study is on the belief that small business owners with the adequate financial education will be less needed of accountants and financial advisors on trust, in order to understand the financial position of their companies and make informed financial decisions by their own. Although, and similarly to Sage (2012), the major findings of these authors are mainly related to perceptions of financial awareness and literacy, they concluded that, even though the participants appeared to be aware of their own lack of financial literacy, still they did not perceive the importance of this matter in relation to other aspects of running a small business. Pearl and Eileen (2014) surveyed 14 small businesses owners in Florida in order to determine their level of financial understanding and their usage habits of financial statements in making management decisions, which is almost the same to say, that they were gauging the levels of financial literacy. Since, according to their study SmallBusiness Financial Literacy is defined “as the ability to understand and use business financial statements to generate key financial ratios to evaluate and manage a business”. 11 The questions used in their survey focused mainly in two of the three pillars that sustain the definition of financial literacy widely accepted according to the literature: Financial Knowledge and Financial Behaviors, excluding, Financial Attitudes. The authors mainly conclude with this case study that was a clear connection between lack of financial literacy and financial difficulties experienced by entrepreneurs, and adequate financial education can partially decrease the financial difficulties. Couto (2013) studied the Portuguese entrepreneurs financial literacy levels of incubators’ companies for North and Center of Portugal, although the questionnaire used in order to carry out her work was essentially based in questions about entrepreneurs confidence levels and financial behavior, without include any question about financial knowledge, which is a pillar, not only, for financial literacy in personal finance issues, but also a main matter in gauging the financial literacy levels of small business owners according to the literature. Despite this gap, the major findings of her work shown that 66% of studied sample present a good levels of financial literacy. Considering the studies found so far at literature about the financial literacy levels of small business owners, it is possible to notice that there is no one that could possible serve as a benchmark for the present research. This gap at literature sustain the need for this investigation, which has two main goals: assess the levels of financial literacy of small business owners and correlate this literacy level with their firms’ performance. To the best of our knowledge, there are no studies in the literature analyzing the relation between the companies’ operating performance and the financial literacy levels of small business owners. This is quite normal due the scare literature about financial literacy among small business owners. Since it is especially the owner or the structure and functioning of the board that can directly affect the operating efficiency and operating performance of the company, the argument behind the study of the relation between these two variables, operating performance and business owners’ financial literacy levels, is on the belief that a high level of financial literacy of a business owner should positively influence firm’s operating performance, through their financial knowledge, attitudes and behaviors. 12 The expected results of this relation or, in other words, facing an expected positive correlation between the mentioned variables, will not only strengthen the results obtained through the built questionnaire, but also, it will works as a evidence for the need for education towards financial matters. The search for the operating performance model at literature was mainly concerned with the characteristics of those variables, the operating performance as dependent variable and the financial literacy levels as an independent variable and also measured as a rating on a scale of 5 to 1, where, in our study, 5 represents a very high financial literacy level and 1 a very low financial literacy level. For this study an adaptation of Bauwhede (2009) model is used. Bauwhede analyses the relation between corporate governance compliance and operating performance for a set of large listed European companies. The model explains firm’s operating performance, measured by Return on Assets (as a proxy), through the following variables: CG Comp, which is a rating proxying for the extend of compliance with international best practices regarding board structure and functioning of firms; LEV, measured by leverage ratio; LNTA, for firm dimension, measured by the natural logarithm of total assets; and a industry dummy variable. The main variables of this model, operating performance and rating as a proxy to the extent of compliance with international best practices regarding, have similar characteristics to the variables that the study of the relation between operating performance and financial literacy levels of small business owners have. The operating performance as dependent variable is the same and it measure is the return on assets (ROA) which is designed by the division of operating income by the average of beginning-and-ending-period book value of total assets. Where operating income, according to Loughran and Ritter (1997), is defined as OIBD and measured as operating income before depreciation, amortization, and taxes, plus interest income. This is the measure of operating performance most commonly used, among others, by the studies performed by Loughran and Ritter (1997), Deshmukh et al. (2015), and Pearl and Eileen (2014). Although other authors go further by saying: “The ROA is clearly the preferred measure of operating performance because it is less affected by 13 discretionary items than the ROE and the NPM.” - Bauwhede (2009). Where ROE is the return on equity measure, and NPM is net profit margin measure. The most relevant independent variable, a rating proxying for the extent of compliance with international best practices regarding board structure and functioning for firm i in year t, similar to the present study, the rating is measured on a scale of 5 to1. 2.3 Assessment of business owners’ financial literacy levels Around the world, the measurement of financial literacy is mainly concerned with personal finance issue of the general public (Brown et al., 2006). Lusardi and Mitchell (2011), in their work refer the difficulty of measure the financial attitudes and financial behaviors in order to achieve financial literacy levels. Based on that, and keeping in mind four key principles: simplicity, relevance, brevity and capacity to differentiate, they design three questions which provide answers to three important economic concepts that individuals should have in order to make financial decisions, which are: (1) understanding of interest compounding; (2) understanding of inflation; and (3) understanding of risk diversification. These questions have been used in several studies as a benchmark to allow for international comparisons of financial literacy levels, such as, Lusardi and Mitchel (2009); Financial Capability Study (2010); Lusardi et al.(2010); Banco de Portugal (2010); Lusardi and Mitchell (2011a); Atkinson and Messy (2012). And they are: (1) “Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow? More than $102 Exactly $102 Less than $102 Do not know Refuse to answer 14 (2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account? More than today Exactly the same Less than today Do not know Refuse to answer (3) Please tell me whether this statement is true or false. 'Buying a single company's stock usually provides a safer return than a stock mutual fund'. True False Do not know Refuse to answer” Despite the important information provided by the answers of those questions, the authors expressed another concern with the difficulty in establish comparisons about the results of past studies, since the questions differ a lot across countries (Lusardi and Mitchell, 2011b). In order to over pass this difficulty, OECD has made so far the major improvements concerned with benchmarks for financial literacy levels. This organization proposed a complete questionnaire that includes questions about: Financial Knowledge, Financial Behavior and Financial Attitudes (Atkinson and Messy, 2012). This questionnaire was on the base of pilot project which aimed to gauge the levels of financial literacy in 14 countries around the world, and for the very first time, this organization was able to provide to the world a benchmark of financial literacy levels among 14 countries (Atkinson and Messy, 2012). In Portugal, in 2010, Banco de Portugal studied the levels of financial literacy of Portuguese population through a implementation of a questionnaire which include some questions related with the understanding of interest compounding, understanding of 15 inflation and understanding of risk diversification, according to the contribute of the authors Lusardi and Mitchell (2011). And the main goal of this project was to decrease the asymmetric information between citizens and financial institutions since, they believe that “more informed citizens are able to better learn the information that is transmitted to them by financial institutions, helping to monitor markets” – (Banco de Portugal ,2010). Lastly, it is important to note that the questionnaires used at the referred works were designed to assess the levels of financial literacy for personal finance issues, although they are a key reference in the assessment of financial literacy levels among small business owners. 16 3. Study Objectives and Hypothesis There are two main objectives for this study: to assess the literacy levels among the small business owners in the North of Portugal and to analyze the relation of financial literacy levels with the firm performance. The assessment of the levels of financial literacy among small business owners intends to fill in a gap in the literature review by creating an index, similarly to the work developed by Banco de Portugal, in 2010, when studying the financial literacy levels of Portuguese population, which enables the comparison between every small business owner. This index will be presented further on, as well as, the explanation about its construction. For this part of the analysis the study hypothesis are as follows. Hypothesis 1: “Male small business owners present higher financial literacy levels than female gender” According to the study of Atkinson and Messy (2012), despite being focused in personal finance issues, these authors stated that male gender present higher financial literacy levels. Couto (2013), in her investigation of financial literacy levels among entrepreneurs, also tested the differences between male and female entrepreneurs financial literacy levels and, although on average the female entrepreneurs presented a lower levels of financial literacy compared to male gender, she did not found statistical significance in her tests. 17 Hypothesis 2: “Small business owners with higher education present higher financial literacy levels” Brown et al. (2006), Atkinson and Messy (2012), Banco de Portugal (2010) and, also, Couto (2013) found evidence that low levels of education were associated with lower levels of financial literacy. Hypothesis 3: “Small business owners with education in/or related with economics present higher financial literacy levels” Brown et al. (2006) conducted a study where it was demonstrated the increase of financial literacy levels among owner managers, through a year program of financial education. Couto (2013) found also evidence that entrepreneurs with education in economics area presented higher levels of financial literacy. Hypothesis 4: “Younger small business owners present lower financial literacy levels”. The evidence in the literature about this hypothesis it is not consensual. Brown et al. (2006) and Banco de Portugal (2010) found evidence of lower levels of financial literacy among young entrepreneurs, in the case of the first author, and among younger individual, in the case of the second. Instead, Couto (2013) considered her sample composed with a majority of younger entrepreneurs and her major findings where that they possess good levels of financial literacy. 24 In relation to gender, the majority of the respondents are male, 71% of the sample, against 29% that represent the female gender. The majority of the respondents have more than 35 years old (86%), although with a higher concentration in the group age between 35 and 44 years (32%), as can be observed in Chart 1. The majority of the respondent’s presents an education level lower than the higher education (70%), and only 30% presents an education level with First Degree and Master Degree or higher (Chart 2). And only 9% of the respondents have higher education in economics. 0% 14% 32% 26% 24% 4% 0% 5% 10% 15% 20% 25% 30% 35% < 25 26 - 34 35 - 44 45 - 54 55 - 65 > 65 Chart 1 - Age of small business owners' respondents 25 Less than Compulsory Education 11% Compulsory Education ( 9th year) 23% Highschool (12th year) 36% First Degree 24% Master's Degree or higher 6% Chart 2 - Education Level of Small Business Owners In relation to the trust of financial area of the companies, the majority of the business owners take that responsibility, although ¼ of small business owners’ respondents trust the financial area to their accountants (Chart 3). 66 28 9 Business Owner Accountant Financial Department Chart 3 - Financial area responsible 26 4.3 Financial Literacy Index In order to assess the financial literacy levels of small business owners at the various dimensions considered in the questionnaire it was built an index using the methodology in Banco de Portugal (2010). It is important to refer that the index should not be interpreted in absolute values for the evaluation of financial knowledge, behaviors and attitudes of small business owners. It can only be interpreted in relative terms when comparing values among different groups of individuals. The questions about the respondent characterization were not included in the index construction. The answers to the questions of financial knowledge, behavior and attitudes were classified in a scale of (-2, -1, 0, 1, 2), in order to produce a global indicator of financial literacy. But, not all the questions are able to have this scale, due to the variability of acceptable answers. In the financial knowledge questions, the correct answer received the maximum punctuation (2) and all the others the minimum (-2). In the questions that evaluate the behavior, the maximum punctuation is attributed to the most appropriated behavior. As a result, the index is constituted through the arithmetic sum of collected punctuation and then transformed in a scale from 0 to 100, being 0 the potential minimum and 100 the potential maximum of punctuation. Further on, the results are displayed in a global index and a partial index, using the same methodology in Banco de Portugal (2010). The global index includes the sum of the punctuation in the three pillars of financial literacy: financial knowledge, financial attitudes and financial behavior. And, the partial index exhibit three sub-index for each of mentioned pillars. 27 4.4 Operating Performance Model The operating performance model was adapted from Baudwhede (2009) to analyze the relation between the financial literacy levels of the small business owner and the performance of their firms. The analysis also controlled for the leverage, dimension and the activity sector of the firm. The model that as used is: Performance i = β 0 + β 1 Rating_FLI i + β 2 LEV i + β 3 LNTA i + β 4 X i + ε i Where: Performance i = ROA of firm i; Rating_FLI i = a rating from financial literacy index for firm i; LEV i = leverage ratio for firm i; LNTA i = the natural logarithm of total assets for firm i; X i = a vector of industry dummies, i. e. indicator variables for the Portuguese business activity classes. ROA is the ratio between the operating income and the average of beginning-andending-period book value of total assets. The operating income is measured by the operating income before depreciation, amortization, and taxes, plus interest income. The rating financial literacy index was scaled from 5 to 1, according to the information in Table 5. Table 5 – Financial Literacy Index (FLI) and corresponding rating level FLI Rating Level Between 0 and 25 1 Between 26 and 50 2 Between 51 and 70 3 Between 71 and 85 4 Between 86 and 100 5 28 Leverage ratio meant to measure the company’s debt levels, through the sum of shortterm and long-term debt divided by total assets. LNTA is a proxy for the dimension of the firm measured by the natural logarithm of total assets. X includes 12 dummy variables for the every class of industry of tested sample (Table 6). Table 6 – Industry Dummies Variables Class Industry Number of Firms C Manufacturing industries 13 F Construction 6 G Wholesale and retail trade; repair of motor vehicles and motorcycles 41 H Transportation and storage 1 I Accommodation, restaurant services and similar 9 J Activities of information and communication 3 K Financial and insurance activities 3 L Real estate activities 1 M Advisory activities, scientific, technical and similar 5 N Administrative activities and support services 4 P Education 1 R Artistic activities, shows, sport and leisure 1 88 29 5. Results analysis 5.1 Descriptive analysis of results – Financial Literacy Index The companies that made part of this study mainly belong to trade industry, being 24% from the retail industry and 18% from the wholesale industry. Table 7 exhibits the descriptive statistics of firms’ revenue and number of workers. Although the maximum values are very high, the medians are comparably lower, due the sample be composed mainly for micro enterprises. Table 7 – Descriptive Statistics: Firms Revenue and Number of Workers Maximum Minimum Mean Median Total Revenue 10.160.221€ 8.122€ 630.000€ 224.000€ Number of Workers 42 1 7 4 The majority of the companies have more than 10 years in the market, having 35% more than 20 years. The average of the maturity found on the sample is of 19 years, although the median is lower in 14 years, and the oldest company has 89 years and the younger 3 years. It is important to note that 15 of the companies are registered as sole traders and those financial statements are not available on SABI platform, as well as general information, so 15 % was excluded from the total revenue, number of workers and maturity information give above. In relation to global financial literacy index, which comprise the three components of financial literacy definition (financial knowledge, behavior and attitudes), the minimum punctuation observed is 3 and maximum almost hits the 100 with 91, as is possible to see in table below about the descriptive statistics of the obtained financial literacy index (Table 8). 30 Table 8 – Descriptive Statistics: Original and Global Financial Literacy Index Minimum Observed Maximum Observed Mean Median Standard Deviation Original Financial Literacy Index -32 28 2 3 14 Global Financial Literacy Index 3 91 53 54 21 The average and the median are very near of each other with, respectively, 53 and 54, suggesting that, on average, the Portuguese small business owners present rather low financial literacy level. Table 9 presents the distribution of respondents across financial literacy rating levels showing that 44% of the respondents have extremely low financial literacy levels. Table 9 – Rating equivalence of Financial Literacy Index Punctuation in % Rating Level % of Small Business Owners Between 0 and 25% 1 11% Between 26 and 50% 2 33% Between 51 and 70% 3 31% Between 71 and 85% 4 19% Between 86 and 100% 5 6% The reason why behind the fact that punctuation in percentage (first column of table 4) does not present a uniform distribution is because only above 50% the small business owners presented a positive punctuation at the original index, meaning that the correct answers are above the wrong answers. The comparison of these results with the self-evaluation question about the respondents’ financial literacy level: “On a scale of 1 to 5, where 1 is bad and 5 is very good, what do you consider to be your level of financial literacy? (Financial literacy is a combination of awareness, knowledge, skills, attitudes and behavior needed to make sound financial 31 decisions, in order to achieve individual financial well-being.)”, is presented at the Table 10. Table 10 – Small Business Owner’s Rating: Index Results vs. Self-Evaluation Punctuation in % Rating % Respondents Index Results vs % Respondents Self-Evaluation Between 0 and 25% 1 11% 0% Between 26 and 50% 2 33% 11% Between 51 and 70% 3 31% 52% Between 71 and 85% 4 19% 34% Between 86 and 100% 5 6% 3% The results suggest that the respondents tend to overestimate their financial capabilities. This only not happen in the group with higher knowledge and is particularly accentuated in the lower level of financial literacy where none of the 11% of entrepreneurs recognize to be in that situation. Considering the partial financial literacy level, divided by the three components of financial literacy definition, the highest punctuation is reached in Financial Attitudes and Behaviors. The Financial Knowledge did not go further than the 89 points as a maximum, according to the Table 11. Table 11 – Descriptive Statistics: Partial Financial Literacy Index Minimum Observed Maximum Observed Mean Median Standard Deviation Knowledge 0 89 50 56 24 Attitudes 0 100 80 83 25 Behavior 0 100 41 33 30 The Financial Knowledge questions are divided in two groups. The first five questions are related to standard financial literacy issues for personal finance (interest compounding, inflation and risk diversification) by the authors Atkinson and Messy (2012), but transformed for the business environment. 32 The last four questions are about knowledge of financial statements given that, according to authors Brown et al. (2006) and Pearl and Eileen (2014), financial literacy among small business owners is defined by their level of use and understanding of financial statements and analysis of financial ratios in order to make sound management decisions, analysis of financial ratios. According to the Chart 4, on average small business owners present a reasonable knowledge about interest compounding, inflation and risk diversification, but a rather low understanding about financial statement matters, which is a problem that only can be solved with education. The Financial Behavior has the lowest punctuation average, with 41, contrasting with the highest average on Financial Attitudes, with 80. Although it is important to note that the questions about Financial Attitudes and Financial Behavior were presented at the same group of questions due to its connection between each other, so on average the small business owners have the right attitude towards determined subject, but in practice their actions or behavior do not reflect their intentions. For example, considering three questions addressed in the work of Couto (2013) related with the elaboration of the business plan at the beginning of the activity, many respondents considered it very important, but in practice, before the opening of their 63 34 Personal Finance Issues Business Chart 4 - Average Financial Knowledge Index 33 companies they did not elaborate a business plan. Only 37% of the business owners elaborate the business plan at the beginning of the activity, while 80% of the respondents considered important or very important it realization not only at the beginning of the activity but also facing the need of an investment (Chart 5). A similar analysis can be made for de questions 25 e 26 of the questionnaire (see Appendix A), which are respectively: “Do you consider important the periodic analysis of company's profitability, in order to minimize costs and maximize profits?” and “How often do you it?”, and are related with a crucial periodic business procedure which results in an important warning concerned with business financial health (Pearl and Eileen, 2014). Almost the totally of the respondents (90%) considered important or very important the periodic analysis of company’s profitability, but more than half of the respondents (51%) have the wrong behavior towards this business procedure since they never or only once a year do the company’s profitability analysis, as it is possible notice from the Chart 6. 37% 63% Yes No Chart 5 - Realization of the business plan at the beginning of the activity 40 Table 16 – Hypothesis 4:” Younger small business owners present lower financial literacy levels” – Kruskal-Wallis test Category: Business Owner Age Mean Ranks P-value 26 – 34 years 55,18 0,187 35 – 44 years 50,27 45 – 54 years 58,46 55 – 65 years 50,00 Over 65 years 15,33 Hypothesis 5: “The financial literacy levels of small business owners are higher in bigger firms.” The company dimension of the present study hypothesis is measured by the amount of revenue in 2014 and the entire sample was not included for this specific test, excluding the sole proprietorship businesses because their financial statements are not available at SABI.  H 0 : The medians of global financial literacy index of small business owners from companies with different sizes are equal.  H 1 : The medians are different. On the referred sample, which excludes the sole proprietorship businesses, on average the financial literacy levels increases with the size of the company and those differences between the revenue categories presented at the below table are statistically significant, for a confidence level of 95%. With this result it is possible to state that the needs for financial education are concentrated in the owners of smaller companies (Table 17). 41 Table 17 - Hypothesis 5: “The financial literacy levels of small business owners are higher in bigger firms.” – Kruskal-Wallis test Category Revenue Mean Ranks P-value Until 10.000€ 2,50 0,0004 Between 10.001 and 100.000€ 29,61 Between 100.001 and 500.000€ 45,06 Between 500.001 and 2.000.000€ 55,25 Over 2.000.000€ 73,42 Hypothesis 6: “Small business owners responsible for companies’ financial area present higher financial literacy levels than those who trust the financial area to accountants.”  H 0 : The medians of global financial literacy index of small business owners responsible or not for financial area are equal.  H 1 : The medians are different. At the literature was found as a common practice the trust of financial area to accountants (Brown et al., 2006). The test results exhibit a difference statistically significant between the financial literacy levels of small business owners who are responsible for their financial area and those who trust this area to their accounts. As a result, the needs for financial education should rely on business owners who are not liable for their companies’ financial area since they present lower levels of financial literacy (Table 18). 42 Table 18 - Hypothesis 6: “Small business owners responsible for companies’ financial area present higher financial literacy levels than those who trust the financial area to accountants.” – Kruskal-Wallis test Category : Financial Area Responsible Mean Ranks P-value Business Owner 54,75 0,007 Accountant 39,04 Financial Department 72,17 Hypothesis 7: “There is a positive relation between the financial literacy levels of small business owners and the performance of their firms.”  H 0 : The medians of global financial literacy index of small business owners with a positive or a negative ROA are equal.  H 1 : The medians are different. The results (Table 19) highlight a positive relation between financial literacy levels and firms’ performance, measured by ROA, which statistically evidence a higher concentration of low levels of financial literacy among entrepreneurs whose firms have a negative or null ROA. Table 19 – Hypothesis 7: “There is a positive relation between the financial literacy levels of small business owners and the performance of their firms” – Kruskal-Wallis test Category :Firms’ Performance Mean Ranks P-value ROA negative or null 21.63 0,00000002 ROA positive 54,62 43 The results exhibit that in all study hypothesis was possible to prove the difference between the medians of respondents’ characteristics, except for gender and groups of age. The hypothesis 7 result strengthens the needs for study the relation between financial literacy levels and firms’ operating performance, measured by ROA as proxy. 5.3 Operating Performance Results In this section is exhibited the statistical analysis and results of the adapted operation performance model described at Methodology chapter. As already referred the entire sample was not included for this part of the study, excluding the sole proprietorship businesses because their financial statements are not available at SABI, so instead of a sample of 103 companies, it was used a sample of 88 companies. Table 20 - Descriptive Statistics Variable N Mean Std Dev Min. Median Max. ROA 88 -0,050 0,065 -3,204 0,042 1,894 ROE 87 -0,197 0,228 -18,023 0,034 6,331 LEV 88 1,343 0,365 0,043 0,602 118,2 LNTA 88 12,143 0,165 8,474 12,179 15,691 The Table 20 presents descriptive statistics for dependent and independent variables of the operating performance model. The ROE (return on equity) was introduced as a independent variable because this variable was also used in former studies as a measured of operating performance, according to the literature, but not as the preferred one. The mean of ROA is negative of -5% (median 4.2%). The mean of ROE is smaller, with -20% (median 3.4%), and also has one less observation because the sample has an outlier with a huge impact at results. The leverage mean is very high about 134% (median 60%), which can be justified by the existence of some companies in the sample technically bankrupt (18%). 44 Table 21 – Pearson correlation coefficients ROA ROE RATING_FLI LEV LNTA ROA 1,000 ROE 1 0,435 1,000 RATING_FLI 0,433 0,131 1,000 LEV -0,750 -0,025 -0,321 1,000 LNTA 0,348 0,172 0,489 -0,373 1,000 The Table 21 presents the Pearson correlation coefficients between the dependent and independent variables of the operating performance model. The dependent variable ROA is positively correlated with RATING_FLI, as well as the dependent variable ROE, although less correlated with the this independent variable. Only the correlation of ROA and RATING_FLI is statistically significant. The highest absolute value of the correlations among the independent variables is 0.75, which is indicative that the regression results might not be affected by multicollinearity. According to Pearl and Eileen (2014), the financial difficulties of small business owners fall into three categories: loss of revenues, insufficient cash-flow, and excessive debt. Generally, in most companies the loss of revenue is related with the economy recession, which, of course, is not controllable by business owners. However, insufficient cash flow and excessive debt are both areas that small business owners can manage, given sufficient Financial Literacy. In the sample of the present work, excluding sole proprietorship businesses, 31% have negative ROA in 2014, however only 37% were experiencing historical losses of revenue, in the last 3 years, on average higher than 5% per year. 1 ROE: Return on Equity for firm i, and is measured by the net income divided by the book value of stockholders’ equity 45 And, the majority of the referred sample (58%) has excess of debt, with a leverage ratio higher than 50%, however only 27% of those companies were facing historical losses of revenue, in last 3 years, on average higher than 5% per year, which means that the remaining 73% companies with excess of debt and the remaining 63% with negative ROA can possibly improve it with appropriate financial education. Table 22 reports two columns of results of the OLS regression analysis, using as the independent variable the ROA, the first with the inclusion of 12 variables dummies for industry activity and the other without the inclusion. The ROE was not included due to its non-statistically significant correlation with the dependent variable RATING_FLI according to Pearson correlation coefficients. Table 22 – Results of OLS Regression of Adapted Operating Performance Model Variable ROA Coefficient estimate (t-statistic) Intercept -0.226 (-0.433) -0.144 (-0.395) RATING_FLI 0.103** (2,308) 0.118*** (2.755) LEV -0.110*** (-8.124) -0.121*** (-9.131) LNTA -0.004 (-0.133) -0.006 (-0.192) Industry dummies Included - R 2 71.3% 60.4% Adjusted R 2 65.3% 59% Std Deviation 0.36 0.39 N 88 88 Degrees Freedom 72 84 Note: ** and *** denote statistical significance at the 5% and 1% level respectively. Results on the industry dummies are not reported for parsimony. 46 At both regressions, the variables RATING and LEV are statistically significant. The exception is in the variable LNTA, although it was also regressed this model replacing this variable by the total assets of firms and the results also did not evidence statistical significance. The doubt of whether or not include the dummy variables for industry activity was solved by the F test of quality improvement of the adjustment (Table 23), with the following hypothesis tests. H o : Coefficients associated to the 12 dummies all simultaneously equal to zero. H 1 : At least one is different of zero. Table 23 – Quality Improvement of the Adjustment – F test F obs F crit 2.28 1.92 For a confidence level of 95%, is rejected H o (F obs > F crit ), which allow to conclude that the introduction of the 12 industry dummies significantly contributes for the quality improvement of the adjustment The regression of the adapted model (Table 22, column 1) exhibit a good explanatory power, with an adjusted R-squared of 65%, and the independent variable, RATING_FLI, has a positive relation with the ROA, also statistically significant, for a confidence level of 95%. These results evidence that a higher financial literacy level of small business owners contribute for a better performance of their firms, alongside with the rather low financial literacy level of entrepreneurs found at this research, this increases the need for financial education. 47 6. Conclusions This research has twofold objective: to assess financial literacy levels of small business owners of the North of Portugal and correlate this results with the performance of their firms. In order to achieve the first goal was used a questionnaire methodology, similarly to the major works developed so far for personal finance issues. Being the questionnaire (Appendix A) composed by four major areas: respondent characteristics; financial knowledge, financial behavior and financial attitudes. The last three components provide from financial literacy definition world widely accepted (Atkinson and Messy, 2012). The second goal was achieved through the adaptation of the operating performance model of Bauwhede (2009). The sample used to assess the financial literacy level sum 103 respondents, a number that ensures its representativeness, and they where mainly from Porto region, following the distribution of firms across the North of the country. The results evidence that small business owners tend to overestimate their capacities, since only 11% admitted to have a rather low level of financial literacy, when the results exhibited to be four times higher in number of small business owners in this situation. Also it showed that small business owners have the right attitude towards financial matters, however their financial behavior does not follow this trend. The lower financial literacy levels are associated with firms with null or negative ROA, measure used as a proxy for firms’ performance. This result strengthened the need for a deeper analyze of the relation between financial literacy levels of small business owners and their firms’ performance. The regression of the adapted model using exhibits a positive correlation between financial literacy rating and ROA, with statistical significance. This allows to conclude that a higher financial literacy level of small business owners contribute for a better performance of their firms. And, alongside, with the rather low financial literacy level of entrepreneurs found at this research, this strengthens the needs for financial education for this specific public. 48 The major contributes of the present research are the improvements at evaluation methodology in assess the financial literacy levels among small business owners; study for the first time the relation between financial literacy levels and firms’ performance, and, considering the evidence of a positive relation between this two variables, aware for the needs of adequate financial education for small business owners on the expectation of improving their performance as business leaders. With an adequate program of financial education is expected an improvement of financial literacy levels, a reduction of the risk of small business owners experience financial difficulties due controllable factors, like excessive debt, and minimize the number of small business owners that are mere employees of their companies to become business leaders. 49 Bibliography Atkinson, A., and Messy, F.-A. (2011). Assessing Financial Literacy in 12 Countries: An OECD/INFE International Pilot Exercise. Journal of Pension Economics and Finance, 10(4), 657-665. Atkinson, A., and Messy, F. (2012). Measuring Financial Literacy: OECD Publishing. Atkinson, A., and Messy, F.-A. (2011). Assessing Financial Literacy in 12 Countries: An OECD/INFE International Pilot Exercise. Journal of Pension Economics and Finance, 10(4), 657-665. Atkinson, A., and Messy, F. (2012). Measuring Financial Literacy: OECD Publishing. Banco de Portugal 2010. Relatório do Inquérito à Literacia Financeira da População Portuguesa. Banco de Portugal (2014). Análise Sectorial das Sociedades não Financeiras em Portugal 2009-2014. Banco de Portugal – Online Statistics: http://www.bportugal.pt/EstatisticasWeb/(S(u3vb3v55zjxy0x45qahsul45))/Defa ult.aspx Bauwhede, H. V. (2009). On the relation between corporate governance compliance and operating performance. Accounting & Business Research (Wolters Kluwer UK), 39(5), 497-513. Beal, D. J., and Delpachitra, S. B. (2003). FINANCIAL LITERACY AMONG AUSTRALIAN UNIVERSITY STUDENTS. Economic Papers, 22(1), 65-78. Brown, R. B., Saunders, M. N. K., and Beresford, R. (2006). You owe it to yourself: The financially literate manager. Accounting Forum, 30(2), 179-191. doi: 10.1016/j.accfor.2006.03.001 Cochran, W. G. 1963. Sampling Techniques, 2nd Ed., New York: Jonh Wiley and Sons, Inc. 56 Financial Behavior & Financial Attitudes 20. On a scale of 1 to 5, where 1 is nothing important and 5 very important, the preparation of a business plan at the beginning of the activity is? 21. Was the business plan made at beginning of your activity? 22. Facing the need for an investment, do you consider important the business plan update (or elaboration)? 23. Do you know how to make a cash flow forecast? 24. In your company, how often it is prepared a cash flow forecast? 1 Nothing important 2 3 4 5 Very important Yes No 1 Nothing important 2 3 4 5 Very important Yes No Never Once a year At least every six months At least every single month 57 25. Do you consider important the periodic analysis of company's profitability, in order to minimize costs and maximize profits? 26. How often do you it? 27. If you have a bank loan, do you monitor its credit conditions and compare them with existing alternatives? 28. If you have a bank loan, do you renegotiates its credit conditions? 1 Nothing important 2 3 4 5 Very important Never Once a year At least every six months No Yes, whenever I have difficulty in paying some responsibility Yes, once a year Yes, at least every six months No Yes, whenever I have difficulty in paying some responsibility Yes, once a year Yes, at least every six months At least every single month 58 (Versão Portuguesa) Características dos Entrevistados 1. Nome 2. N.I.F. – Número de Identificação Fiscal (da empresa) 3. Género 4. Idade 5. Nível de Escolaridade 6. Tem alguma formação específica na área financeira? 7. Se sim, por favor descreva o tipo de formação. Masculino F eminino Ensino Primário Ensino Obrigatório – 9º ano Ensino Secundário – 12º ano Licenciatura Mestrado ou grau superior Sim Não 59 8. É o(a) responsável pela área financeira da empresa? 9. Se não, em quem confia a gestão da área financeira da sua empresa? 10. Numa escala de 1 a 5, em que 1 é mau e 5 muito bom, qual considera ser o seu grau de literacia financeira? (Literacia Financeira é a combinação de consciência, conhecimento, habilidade, atitude e comportamento necessários para tomar decisões financeiras sólidas e alcançar o bem-estar financeiro individual.) Conhecimento Financeiro 11. Imagine que tem de esperar um ano para obter o reembolso de IVA no montante de 5.000€. Daqui a um ano será capaz de comprar: Sim Não Contabilista Subcontrata Outro 1 Mau 2 3 4 5 Muito Bom Mais O mesmo montante Menos do que poderia comprar hoje Não sei Departamento Financeiro 60 12. Suponha que coloca 100€ numa conta poupança com uma taxa de juro garantida de 2% ao ano. Não faz nenhum aumento de capital nesta conta e também não procede a qualquer resgate. Quanto é que deverá ter na conta ao fim de um ano? 13. E quanto é que deveria de estar na conta poupança ao fim de 5 anos? Seria: 14. Elevada inflação significa que o custo de vida está a aumentar rapidamente? 15. Normalmente é possível reduzir o risco de investir no mercado de ações através da compra de uma ampla gama de ações. 16. Uma empresa tem mais dinheiro hoje quando: [Resposta Aberta] Mais de €110 Exactamente €110 Menos de €110 É impossível saber a partir das informações dadas Não sei Verdadeiro Falso Não sei Verdadeiro Falso Não sei Os clientes pagam mais cedo O lucro aumenta A conta de clientes aumenta Os resultados transitados aumentam Não sei 61 17. O EBITDA é uma importante ferramenta para as empresas porque: 18. Qual a melhor descrição da informação fornecida no Balanço? 19. Qual a demonstração financeira que mostra de forma mais precisa se uma empresa se apresentou rentável num determinado período de tempo? Representa o fluxo de caixa livre Ao lucro é-lhe subtraído impostos e depreciações para obter uma imagem verdadeira do negócio É um indicador de fluxo de caixa operacional futuro É a principal medida de lucro antes de juros e redução da dívida Não sei Uma lista do que a empresa possui e do que deve Flutuações dos ativos ao longo de um determinado período de tempo Número de empregados que a empresa tem Todas as acima Não sei Demonstração de Fluxo de Caixa Balanço Demonstração de Resultados Mapa de Origem e Aplicação de Fundos Não sei 62 Atitudes e Comportamentos Financeiros 20. Numa escala de 1 a 5, em que 1 é nada importante e 5 muito importante, a elaboração do plano de negócios no início da atividade é? 21. Foi realizado um plano de negócios no início da atividade? 22. Perante a necessidade de realizar um investimento, considera importante a atualização (ou a elaboração) do plano de negócios? 23. Sabe como se elabora um mapa previsional de fluxo de caixa? 1 Nada importante 2 3 4 5 Muito importante Sim Não 1 Nada importante 2 3 4 5 Muito importante Sim Não 63 24. Com que frequência elabora na sua empresa o mapa previsional de fluxo de caixa? 25. Considera importante a análise periódica da evolução da rentabilidade da sua empresa, por forma a minimizar custos e maximizar proveitos? 26. Com que frequência o faz? 27. No caso de recorrer a crédito bancário, acompanha as suas condições e compara-as com as alternativas existentes? Nunca Uma vez por ano Pelo menos semestralmente 1 Nada importante 2 3 4 5 Muito importante Nunca Uma vez por ano Pelo menos semestralmente Não Sim, sempre que possuo dificuldades em pagar alguma responsabilidade Sim, uma vez por ano Sim, pelo menos semestralmente Pelo menos mensalmente Pelo menos mensalmente 64 28. No caso de recorrer a crédito bancário, renegoceia as suas condições? Não Sim, sempre que possuo dificuldades em pagar alguma responsabilidade Sim, uma vez por ano Sim, pelo menos semestralmente