Chief Directorate
Chapter 4: Evaluation of the Small Medium Manufacturing Development Program
4.7. Evaluation of Strategic Choice
constraints associated with an unskilled labour force, a training grant would be appropriate.
and to be used as a decision making tool to eliminate requirements of least importance.
To aid in the assessment of these requirements, a study was conducted on a sample selected from a population of participants of the SMMDP, in the Kwazulu Natal region. The sample was selected for convenience from the client-base of a Durban based consulting practice. Some of the findings of this study are included in the assessment below.
4.7.1.1. Monitoring Requirements
Some monitoring requirements that the Board for Manufacturing Development has imposed upon the industrialist are aimed at indirectly facilitating salient objectives such as labour absorption. Other requirements are aimed at ensuring that the project materialises and that incentives are not paid to phantom projects, and further requirements are aimed at ensuring that the projects are sustainable.
Regardless of the purpose of these requirements, they may be enforced to the detriment of deserving projects, causing a hindrance to the achievement of the strategic objectives. Other requirements further the cause of the incentives. The effect of selected requirements is discussed below.
Equity
The ratio of equity to total assets prescribed in the contract is 10%. The effect of this ratio is to ensure that the shareholders of the project have invested a minimum interest of 10% of the total assets in the project, and therefore have placed themselves at risk.
A further requirement in certain instances is that the shareholders loans are sub-ordinated in favour of 3rd party creditors, making it impossible for shareholders to benefit at the expense of creditors in the event of the company closing down.
The effects of forcing companies to achieve minimum equity ratio's are:
• Gearing - Companies that are adequately geared can lever their profits upwards through the use of debt financing. The equity ratio ensures that companies are able to utilise gearing to maximum effect, by allowing up to 90% debt financing
• Risk - Too much debt financing increases the risk of failure in the business, and the board forces industrialists to avoid 100% debt financing, thus reducing the risk of failure
• Subordination - The Board for Manufacturing Development also requires that shareholders loans be subordinated in favour of 3rd party creditors, thus protecting the interests of 3rd parties, and ensuring that the investors are responsible for business failure.
• Financing consequences - When companies have high ratios of equity to total assets, they will find it easier to obtain funding from financial institutions.
On the other hand, the enforcement of the equity ratio can penalise an entrepreneur who has taken a large risk to commence business and make a contribution to the economy. The incentive is aimed at small to medium sized manufacturing concerns. Sourcing funding is an obstacle in the way of the establishment of small businesses by emerging Entrepreneurs. Consider the following scenario:
A start-up company has a viable project, and has a capital structure of 80%
long-term loans and 20% shareholders loans. The company therefore has an equity ratio of 20% at start-up, and is within the Board for Manufacturing Development requirements. After one year of trading, the company has incurred a loss (which is to be expected in the first two years of operations of this project, and is primarily resultant from the utilisation of an accelerated depreciation allowance) that when taken into account reduces his equity ratio to 8%. The contract then converts to an output-based contract, because the industrialist failed to meet the equity requirement at the end of the first year, and is not eligible for any incentive in that year. At the end of the second year he does not make a profit and therefore is not eligible for an incentive in the second year.
The industrialist in this example has a viable project that financial intuitions are willing to fund. Cash flow has not been severely affected by the loss because the loss was resultant from accelerated depreciation allowed for tax purposes. This company has not received incentives in the crucial start-up phase of its existence. The incentive, if granted would have made a significant difference to the companies expected growth path, because while it may not be cash strapped, it is also not able to fund an accelerated growth path.
This Entrepreneur has been adversely affected by the Equity requirement.
What is also of concern is the way in which the ratio was determined.
Interviews with Francois Truter (2002) revealed that there was no scientific basis for arriving at the required equity ratio. The ratio was arrived at by means of a judgement call made by developers of the programme. For the advantages of a sound equity ratio to be truly effective, the ratio should have been much higher, thus ensuring that companies are appropriately geared to lever growth opportunities but sufficiently covered to reduce financial risk.
The result of setting the equity ratio at a low level is that the advantages of sound capital structure are not achieved, and the disadvantages of having the ratio in the first place are still prevalent.
The study found that many industrialists fail to meet the equity ratio at year end, but with assistance from professionals and careful planning, most can overcome this shortfall after restructuring and making additional financial contributions to increase the equity ratio. Ultimately, 4 of 120, or 3.33% of industrialists were unable to meet the equity ratio.
Turnover
The incentive had to be linked to some measure of performance, to avoid the scenario that could potentially result from companies having little to no sales, and receiving incentives that would enrich shareholders at the expense of the economy. The most logical link to performance is turnover, and since this requirement is determined entirely by values projected by the applicant, its implementation is more than justifiable.
The turnover is also utilised to determine in conjunction with other financial ratios whether the project is sustainable into the future. Projects that cannot sustain themselves without incentives should not be subsidised, as the effect of subsidising these projects is to delay the inevitable collapse of an organisation that was not viable in the first instance.
A minimum sales requirement is also necessary to ensure that incentives are paid to companies that are generating income, and not merely to subsidise investments by industrialists in property.
In the study conducted it was found that 5 of 120 or 4.17% of industrialists failed to meet the turnover requirement. Perhaps of more relevance is the fact that 60% of the 5 industrialists that failed to meet the turnover, later closed down their businesses, or lost the incentive due to non-compliance with a later requirement. The non-achievement of the Turnover requirement appears to be a predictor of future failure. More statistical analysis is needed to determine whether this can accurately be applied to the population.
The study also found that 24 of 120 or 20.00% of companies closed down or liquidated during the first 3 years of operation. The incidence of turnover not being achieved is understated due to the fact that many of the 24 liquidated companies would also not have achieve their minimum turnover requirement, but have been counted separately.
Human Resources
The human resource criterion is intended to ensure that industrialists maintain a reasonable mix of labour to capital in the production process. Its intention is sound, and the ratio, when achieved by an industrialist, results in a significant portion of the value added by the manufacturing process, being distributed to the providers of human labour.
The calculation however has the unfortunate effect of penalising companies that are profitable. The simplified illustration Table 4-3 demonstrates how an increase in profitability results in the company not achieving the prescribed 55% ratio. The result of this is that companies that are profitable do not
receive the profit output incentive in the 5th and the 6th years, and are placed at a disadvantage to their competitors who received the incentives during this period.