External Environment and Small Business
External environment includes social, political, legal and economic conditions.
In a social context, the external environment presents a significant obstacle because small businesses are a diverse, disorganized group that lack cohesiveness. Small businesses often have industry specific representation such as a restaurant or manufacturing association. However, these industries may not talk to each other and cannot provide the broad level of management information required by their members. Movement of skills, knowledge and management expertise between industries or even between local companies appears to be very low. This issue is significant because local companies in the same industry see each other as competitors and are therefore unwilling to share information. This protectionist view has likely caused many small businesses, and in fact entire industries, to remain below their potential levels of financial performance, although I was not able to locate any specific research to support or refute my assumption. For example, private restaurants in Canada generate between 1% and 4% of their revenue into an after-tax net income, according to general industry standards. The risks and long hours of owning a restaurant barely meet or beat the current guaranteed savings rates of risk free investments.
Another important social dimension is that many people may feel working for a larger company or organization has more prestige and less risk than working for a smaller company. This increases difficulty in recruitment and retention for a small business. The lack of formal HR practices observed in many small companies may support some of these beliefs. Improving the basic HR practices is one of the opportunities for businesses to improve financial performance. However, some HR informality can also create a competitive advantage within the small business (Hornsby, 1992). In a small firm, an employee’s relevance to overall results and his or her ability to impact performance are usually more visible than in a larger, perhaps bureaucratic, organization. This likely results in higher job satisfaction (CFIB, 2004).
A significant demographic factor is the urbanization of the workforce. Young people are harder to recruit and retain for many small businesses because they are leaving their home towns for larger centres to become more educated and then remain in the larger centres for employment. The out-migration of people, talent and future managers is a significant challenge for many smaller centres and smaller provinces such as Saskatchewan. Part of the educational problem impacting the workforce supply, in my opinion, is that large educational institutions (universities, colleges) primarily train people to become employees of large organizations such as corporations and governments who typically employ more than 500 people.
Another demographic factor is that the workforce supply is affected by the aging baby boomers and increased competition for all workers. A significant opportunity in the labour supply in Saskatchewan is the increase in the aboriginal workforce. Labour supply is an important issue for small business but is beyond the scope of this paper.
The political environment is a part of the external environment. Unfortunately, small business owners have low political power and low representation because of their lack of cohesiveness mentioned above. The thousands of small businesses are not strongly united and fail to operate from a single voice, in my opinion. Perhaps if the small business sector increased their support for the organizations mentioned earlier such as CFIB and others, then the power of these organizations would increase and their effectiveness and representation would be even stronger.
Another political issue is taxation. From an internal financial perspective, many small business owners practice a strategy of tax minimization due in part to advice from accountants and due in part to their general dislike of paying taxes. The main problem with tax minimization is that it reduces borrowing power, limits growth and reduces ROI. The owner legally avoids paying tax within the corporation by pulling all profits out and paying the tax personally on the salary. This may save some tax costs in the short term although the long-term tax savings are minimal due to the equalization of corporate and personal taxes at certain levels of income. If a business pays out all of its profits, it reduces its taxable income and it does not build up retained earnings, or equity, on the balance sheet. To fund growth, a business will often desire to borrow money from a bank. The bank will lend to the extent of a business’ debt-to-equity ratio and other key factors such as strength of management, cash flow, reputation and history. However, a banker has to follow the banks strict guidelines which typically restrict the debt-to-equity ratio at approximately 2:1. If a business does not have equity on the balance sheet because all earnings are paid out as salary or dividends, then its borrowing capacity is significantly reduced. This condition is a common irritant to many bankers who want to help their small business clients but are restricted in their lending due to the owner’s tax minimization strategy. If business owners realize this, and let some of the profits remain in their businesses, then banks will lend them money so that the owner’s can grow their business and increase their profits.
This is a significant hurdle to overcome for some under-performing businesses who seem to have a strategy of tax minimization. This situation is unfortunate considering the low cost of debt and the high opportunity to maximize Return on Investment (ROI) through improved working capital and expansion capital financing from banks, credit unions and other small business financing agencies.
The next external factor is the legal environment. Legally, most small businesses operate as corporations. Some professional groups may operate as partnerships. Many start-ups, some very small businesses, and some professionals operate as sole-proprietors.
The over-riding statutory responsibilities of the small business owner are contained in provincial regulations relating to labour standards. Employees are free to organize themselves, however unions are not very interested in small businesses due to the low number of employees per location. Business owners are required to comply with all laws and employment regulations including occupational health and safety standards, and the avoidance of discrimination.
The final external factor is the economy. Small and medium businesses play a significant role and generate most of the new jobs in the Canadian economy (CFIB, 2004). However, the small business sector does not receive its proportionate respect and does not harness its proportional clout, either politically or economically, despite its economic significance. Again, this lack of recognition may be due to the sector’s lack of organization or unification and its inability to gather and channel resources effectively and efficiently to compete with big business.
The small business sector is a large and significant part of the Canadian economy. Unfortunately, it is not treated as such by governments, education institutions and big business. As a result, the entire economy suffers because of the under-performance of many small businesses.