Executive Summary
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Small and medium-sized enterprises (SMEs) are increasingly important to long-term regional, national, and global economic prosperity.
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While growing, many SMEs encounter periods that require investment in assets and/or research and development (R&D) in advance of any resulting increase in turnover and associated profits.
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During this period, known as the “valley of death,” key performance indicators such as return on investment (ROI) can be adversely impacted and limit the scope for future investment.
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To manage growth, SMEs must determine the right timing and response to customer demands.
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To recover ROI, SMEs must control costs and balance long-term prospects with short-term profitable opportunities.
Introduction
Small and medium-sized enterprises (SMEs) are, more than ever, the lifeblood of regional and national economies. The structural shift from goods to service sectors favors the creation of more small firms, where a smaller size is an economic choice for a business vehicle. This shift was exacerbated by technological changes such as the extensive use of microchip technology, which now makes smaller-scale production more economically viable.
SMEs can be more flexible and responsive to new market opportunities and economic recessions. In periods of high unemployment many former employees start their own enterprises, relying on their experience, education, and managerial skills. Furthermore, large firms increasingly place part of their work outside the organization—providing a further incentive for the creation of new small firms, since subcontracting and outsourcing can reduce production costs. However, as SMEs grow and develop, they face strains on their profitability that impact on a key performance indicator—return on investment (ROI). Furthermore any deterioration in ROI will compromise a firm’s ability to obtain finance for further expansion.
Definition of Return on Investment
Return on investment, often abbreviated to ROI, is a ratio that takes the firm’s profit for a given accounting period (normally one year) and divides this by its invested capital, as measured by the balance sheet. The capital invested is calculated as stock and long-term debt. ROI is a measure that demonstrates the effectiveness of the management to use the capital available to generate profit, and hence a return for those investing in the company. The higher the ROI, the better the performance, and the happier existing investors will be. A higher ratio will also improve the company’s ability to find new investors.
The Valley of Death
A problem occurs for SMEs during their growth and development phase, when expenditures on asset acquisition and R&D need to be funded and financing obligations must be serviced. Debt finance, in particular, adversely impacts profitability because interest payments reduce the net profit available for distribution to equity investors. This difficult period, known as the “valley of death,” or “death valley curve” (see Figure 1), is experienced by all SMEs as their need for funds increases and they rack up large accumulated losses before profits from sales can be realized. SMEs that engage in technology transfer and new product development face the greatest difficulties in making it through these challenging times.
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