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Sound corporate governance significantly boosts financial performance for Nairobi CBD's retail SMEs, fostering transparency, risk management, and investor trust. In the vibrant Nairobi Central Business District (CBD), small and medium-sized enterprises (SMEs) within the retail sector contend with the complexities of a dynamic marketplace. As these businesses ardently pursue financial success, the pivotal role of effective corporate governance becomes unmistakably evident. In this bustling economic hub characterized by the lively pulse of commerce, the influence of robust governance practices on SMEs' financial performance is a critical factor that shapes their trajectory in the competitive retail landscape.
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Delving into the heart of the matter, it is imperative to recognize the profound impact of transparent and accountable governance structures. In a marketplace where consumer trust is paramount, the clarity and honesty facilitated by well-structured governance frameworks prove instrumental. These practices ensure accurate and timely financial disclosures, fostering customer loyalty and attracting potential investors seeking reliability and transparency in Nairobi CBD's bustling retail scene. The interplay of governance principles becomes the cornerstone for SMEs striving to carve out a niche and thrive amid the challenges and opportunities inherent in this energetic business environment.
Introduction
Adeyeyeon (2016) emphasizes the challenge of obtaining reliable statistics on Kenya's Small and Medium Enterprises (SMEs) due to their informal nature. His estimation suggests over 250,000 formal SMEs in Kenya, shedding light on the sector's scale. Notably, studies have underscored the link between corporate governance and firms' financial performance, prompting a focused examination within the context of SMEs in Nairobi CBD, Kenya. According to the Kenya National Bureau of Statistics (KNBS) September 2016 report, the country housed 584,600 SMEs in 2015, revealing the sector's significance.
Additional data from KNBS outlines the formidable entrepreneurial landscape in Kenya, with approximately 1 million SMEs initiated annually, yet 40% face closure within their first year (KNBS, 2016). Moreover, the report highlights the closure of 2.2 million businesses in the Micro and SME categories over the five years ending September 2016, with an average lifespan of only 3.8 years for closed enterprises (KNBS, 2016). Despite the substantial annual creation of SMEs, the persistently high mortality rate challenges their sustained growth.
This section delves into essential aspects of the subject matter—Small and Medium Enterprises (SMEs), corporate governance, and financial performance. It unravels the economic significance of the SME segment in Kenya, identifies impediments to its growth, and investigates the profound impact of corporate governance on the financial outcomes of SMEs.
Conceptualising Small and Medium Enterprises (SMEs)
SMEs, as per the World Bank's 2020 criteria, encompass businesses employing fewer than 300 workers with an annual turnover not exceeding US$15 million. In alignment with Kenya's Micro and Small Enterprises Act of 2012, SMEs employ between 10 and 50 individuals, with an annual turnover ranging from US$5,000 to US$50,000. Offering another perspective, Wairimu's (2015) report for the United Nations Development Program (UNDP) characterizes medium-sized enterprises as those employing 51 to 100 people, accompanied by a capital investment not surpassing US$300,000 (converted at a dollar exchange rate of 100 Kenya Shillings for every 1 US$). Despite a common thread related to employee count, the definition of SMEs exhibits variation, with the World Bank (2020) setting the annual turnover at US$15 million, while the Nation Media Group (2020) establishes a turnover cap of US$10 million.
The Role and Economic Contribution of SMEs
In the economic development of nations, especially in less developed countries like Kenya, Small and Medium Enterprises (SMEs) play a pivotal role. Their significance lies in their ability to complement larger firms, offering flexibility and adaptability to the economic landscape (KNBS, 2016). This adaptability proves catalytic for entrepreneurial endeavours across various sectors and geographical areas, contributing substantially to socio-economic development and transformation, as noted by the Kenya National Bureau of Statistics (2016).
According to the World Bank (2020), SMEs globally account for 90% of businesses, contributing over 50% to global employment, with formal SMEs alone making up 40% of GDP. Adeyeyeon's (2016) estimation reveals that Kenya's 7.5 million Micro, Small, and Medium Enterprises (MSMEs) contributed 44% to GDP in 2008. In 2016, SMEs contributed approximately 34% to Kenya's GDP, as reported by the International Trade Centre (2019). Notably, Viffa Consult (2018) highlighted that 3% of Kenya's 6.4% economic growth in 2017 was attributed to the thriving contributions of SMEs.
Factors Hindering Growth of SMEs in Kenya
Gallardo et al. (2005) found that the access to financing for SMEs from both banks and micro-finance institutions is constrained, primarily due to the absence of formal business structures, including corporate governance frameworks. Their research highlighted that SMEs, often family-owned and operated, lack adequate structures for formalization and sustainable growth, leading to significant succession challenges. These challenges span from governance and accounting to human resources, exerting a substantial impact on SMEs' growth potential and sustainability, potentially culminating in business failure.
Shlefer and Vishny (2017) align with this perspective, emphasizing the challenges SMEs face in developing countries, particularly in accessing finance from local and international sources. The absence of robust corporate governance exacerbates this challenge, hindering the assurance required for successful performance on investments or financial obligations. In essence, these factors underscore the potentially adverse effects of corporate governance on the financial performance of the targeted firms. Mahmood (2014) adds that, despite recognising the importance of corporate governance and good business management practices, apprehensions persist due to the perceived high costs associated with their implementation.
According to KNBS (2016), the primary reasons for the closure of Kenyan SMEs include a shortage of operating funds, reduced income, diversion of returns, losses incurred, and inadequate operating capital. Personal reasons, from social matters to health issues, were also significant contributors. Deloitte (2016) further asserted that the growth of the SME sector in Kenya faces impediments such as poor infrastructure, limited capital, knowledge and skills gaps, poor market access, and rapid technological change. Consequently, the study of governance for businesses and SMEs emerges as a critically important field of study, given its potential to address and mitigate these challenges.
Interventions in Kenya Aimed at Improving the Performance of SMEs
Over the past two decades, the Kenyan government has implemented numerous initiatives to bolster and oversee the SME sector. A landmark move in this regard was the introduction of the Micro and Small Enterprises Bill in 2012, which represented a significant intervention. This legislation was designed to facilitate the development, promotion, and regulation of Micro and Small Enterprises (MSMEs). While the MSE Act of 2012 doesn't specifically address the regulation of "medium enterprises," various private and non-governmental organizations have been established to support SMEs within the framework of this act. Additionally, the East African Common Market protocol, indirectly influenced by the MSE Act of 2012, has expanded opportunities for Kenyan SMEs to engage actively in regional trade, positioning them as potential regional players.
Literature Review
This report section examines various studies investigating the correlation between corporate governance and the financial performance of firms, concurrently assessing its connection with overall business performance. The literature review aims to pinpoint gaps in existing research, identifying areas where further exploration or study is warranted.
Defining Corporate Governance
Shefler and Vishny (2012) characterized corporate governance as a control mechanism over business management, emphasizing its role in safeguarding a business's ability to generate shareholder returns on investment. According to the OECD (1999) Principles, corporate governance is the internal framework guiding business operations. Effective corporate governance ensures the efficient utilization of capital. It considers an organisation's internal and external interests, with the board accountable to the company and its shareholders.
The Capital Markets Authority of Kenya (2015) defines corporate governance as the process and structure employed to manage and direct a company, aiming to enhance business prospects and accountability while realizing shareholder value and accounting for the concerns of long-term stakeholders. These definitions underscore the pivotal role of corporate governance in overseeing management activities, ensuring the security and efficient utilization of a company's resources, and safeguarding the interests of all stakeholders in the context of a business.
Defining Financial Performance
Webster (2020) defines finance as“Money or other liquid resources of a government, business, group or individual or the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking or the science or study of the management of funds”.
Webster (2020) also defines the word “performance” as “the ability to perform: efficiency” or how a mechanism performs”. It can be concluded from the above statements that financial performance is the extent of achievement of an entity’s financial targets. Various measures of financial performance, such as profitability, revenues, returns and several others, could be used depending on the interest of the business. Bhagat and Black (1997) assert that there is no agreement on the most suitable measure for financial performance.
Corporate Governance and Financial Performance
Several studies have examined various aspects linking corporate governance to financial performance. This literature reviews a few global and local studies undertaken and their conclusions. Aksoy & Bozkus, studied 47,063 Turkish SMEs. They established a positive link between credit usage, trade openness, financial performance, and corporate governance implementations.
Mang’unyi (2011) found that corporate governance has supported progress in countries like Kenya, given that the inward structure serves the necessities of investors and others by organising business processes with objectivity, obligation and accountability. McGee (2009) suggests that business leaders, proprietors and corporate administrators are starting to appreciate the benefits of implementing decent corporate governance practices. Murithii (2014) evaluated 44 companies on the Nairobi Stock Exchange (NSE) between 1999 and 2003 and found a strong and direct link between company performance and corporate governance. These aspects highlight corporate governance's impact on SMEs' financial performance in Nairobi CBD.
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In an investigation of 11,736 firms studied on the United States stock exchange between 1990 and 2004, Bhagat & Bolton (2008) established that splitting roles between the CEO and the chairman significantly and positively affects operating performance. Similarly, Sanda et al. (2005) examined 93 companies on the Nigerian Stock Exchange from 1996 to 1999 and established that separating the Chairman and CEO roles directly impacts a company's performance positively. These studies indicate the importance of separating oversight and day-to-day operational roles.
Paniagu et al. (2018) analysed 1,207 companies across 59 countries from 2013 to 2015. They established that increasing the board by one member would decrease the return on equity by 3.55% and 5%, keeping all other factors constant. Sanda et al. (2005) established that a company’s financial performance and the board size are inversely proportional. Yermack (2011), in an investigation of Forbes’s largest 500 companies from 1984 to 1991, established that limiting board size improved the effectiveness of that board. Eisenberg et al. (1998), in an investigation of Finnish SMEs (785 healthy and 94 bankrupt firms), established a negative correlation between the profitability of SMEs and board size. These studies indicate the impact of board size on business performance.
Drobetz et al. (2003) surveyed 91 German firms and highlighted the connection between firm performance and corporate governance. They learned that great corporate governance directly and positively affects firm valuation, while poor corporate governance showed the reverse. Boubaker and Nguyen (2014) undertook a study of 374 firms in 14 nations, finding a strong positive correlation between the value of the firm and corporate governance practices. These show that financial performance is positively linked to corporate governance.
Boubaker et al. (2015) studied 597 French-listed companies from 2001-2007. It was established that firms with more effective boards accumulated fewer cash reserves than less effective boards. This is evidence that corporate governance creates efficient and effective use of financial resources, thereby claiming a positive Impact of corporate governance on the firm's financial performance. Klapper and Love (2017) analysed 374 firms in 14 nations and determined a positive relationship between fairly estimated worth, return on asset and corporate governance. Similarly, Maranga (2014) revealed that the relationship between corporate governance and Return on Assets in SMEs is positive.
Ujunwa (2012) examined 160 small firms in Nigeria from 1991 to 2008. The study found that firm performance was positively linked to firm performance and that higher PhD qualifications at the board level negatively affected the firm’s performance. While skills at the board level are critical, this finding raises doubts about whether PhDs at the board level negatively affect the financial performance of SMEs. Afande (2015) studied 30 SMEs in the assembling segment in Kariobangi Light Industries, Nairobi, Kenya, implementing some corporate governance practices. The disclosures indicated a positive association between corporate governance practices and the efficiency of SMEs. Afande concluded that corporate governance can help SMEs in Kenya by instilling better administration routines that ensure more grounded interior scrutiny of entities.
Ongore & K’Obonyo (2011) investigated 54 firms listed on the Nairobi Stock Exchange. They established that management performs better if they have more latitude to make decisions than if the principals of the business closely monitor them. This indicates that having an independent corporate governance structure could help ease the friction between owners and managers and improve performance.
Ndagu&Obuobi (2010), in their survey of 111 companies in three East African countries (Uganda, Kenya, and Tanzania), established that while SMEs did not generally have robust corporate governance structures, they appreciated their effect on business performance and showed a willingness to learn more about business governance. They further established that some of the reasons why enterprises have not developed corporate governance practices included a lack of awareness of corporate governance, its importance, and time and financial constraints, a lack of understanding of the value addition from non-executive directors to the business and the impact of directors’ fees on the cash flows and profitability of their businesses.
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As noted in the literature above, most studies proved that corporate governance substantially impacts companies' financial performance by reviewing the various aspects of corporate governance and comparing them to financial performance. These were board composition, the board size, board skills and the existence of a board to financial performance aspects such as profitability, firm value, return on assets, sales and several other measures.
However, few studies have been done in Nairobi, particularly in the retail sector. Nairobi, the capital city of Kenya, is exposed to various skills that could be valuable at the board level. It seems to be a natural place to get a more detailed study of corporate governance's impact on SMEs' financial performance.
Purpose of the Study
As noted earlier, SMEs in Kenya have a high mortality rate. It has also been shown that some of this mortality is attributable to poor performance from poor governance. This research will highlight some elements associated with corporate governance's impact on corporate enterprises' financial performance. These should provide some input for SMEs to effectively apply good corporate governance practices that improve business performance and reduce mortality in the sector.
Decision Problems
Owners and managers of SMEs need to address their enterprises' governance practices to ensure SMEs' sustainable financial performance. SMEs do not often have deep pockets for directors’ costs, and it is, therefore, imperative to ensure that the board is fairly compensated but that its size and cost do not negatively impact the profitability of SMEs.
It is in the interest of the Government, at both the national and county levels, to establish some measures that will ensure SMEs are well governed and that loopholes that may lead to poor governance are removed. This will ensure more sustainable gains for the government concerning government revenue and sustainable employment in Kenya.
Research Aims and Objectives
The research aims to investigate corporate governance's impact on SMEs' financial performance in Nairobi CBD's retail sector. Objectives include assessing governance structures, analyzing their influence on financial outcomes, and identifying areas for improvement in fostering sustainable growth for these businesses.
Aim
The study aims to establish corporate governance's impact on SMEs' financial performance in the retail industry in Nairobi Central Business District (NCBD).
Objectives
The primary objective is to conduct a literature review to glean insights from prior research on the correlation between corporate governance and the financial performance of SMEs in Nairobi CBD. This review aims to identify existing knowledge, unanswered queries, and research gaps. Specifically, the study seeks to:
- Examine the influence of board meeting frequency on the financial performance of SMEs in Nairobi CBD.
- Evaluate board compensation's impact on SMEs' financial performance in Nairobi CBD.
- Assess the effects of CEO duality on the financial performance of SMEs in Nairobi CBD.
- Investigate the impact of the number of board members on the financial performance of SMEs in Nairobi CBD.
Additionally, the research aims to provide recommendations for implementing effective corporate governance strategies by SMEs in the region.
Research Question
How do corporate governance practices impact SMEs' financial performance in the retail industry in Nairobi CBD?
Research Methodology
A descriptive research design will determine the association of study variables and summarize the revelations to a greater population. This study will summarize the findings of all the retail business SMEs in Nairobi CBD. The choice of tools and techniques will depend on the aim of the research. The research will be carried out through mixed research in which qualitative data will be collected from the previous studies' foreseen data and existing findings. In contrast, primary data collection will be done through questionnaires from the owners and managers of randomly selected SMEs.
Primary data will be significant to the research since it will be directly collected from the SMEs and is expected to be precise. Qualitative data will be collected to support the quantitative data. Questionnaires will be administered through a drop-and-pick procedure, giving the respondents one week to respond. Data collected from the study will be analysed using the SPSS tool, applying various statistical measures such as averages, means, frequencies and percentages. The results will be presented in the form of charts and tables.
Significance of the Research
This study's output, lessons and advantages will be critical to the various stakeholders related to SMEs in Nairobi CBD, such as owners, directors, managers, lenders and investors. These stakeholders will be faced with information on how corporate governance can arrest declining financial performance in SMEs in Nairobi CBD.
The research will positively impact the appreciation of policymakers makers by proving that corporate governance has a directly proportional relationship to the financial performance of SMEs. This will enable policymakers to plan and execute educated strategies to ensure the effective implementation of corporate governance to accomplish the best possible financial performance of the retail business of SMEs.
Researchers will also benefit from the study as they obtain meaningful data on the relationship between SMEs’ performance and corporate governance.
Conclusion
In the heart of Nairobi CBD, where the retail industry pulses with energy, the impact of corporate governance on SMEs' financial performance is undeniable. Transparency, risk management, accountability, and investor confidence are the building blocks of a successful governance framework that propels these businesses toward prosperity. As SMEs in the retail sector continue to shape the economic landscape of Nairobi CBD, embracing and implementing effective corporate governance practices will undoubtedly be a defining factor in their journey toward sustained financial success.
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