The Pecking Order Theory

Topics: Management, Business, Finance Pages: 5 (2645 words) Published: October 27, 2014

Theoretical Approach
Pecking Order theory
The pecking order theory is a financial management theory that was developed by Donaldson in 1961, and was modified by Stewart and Nicolas Majuluf in 1984 (M.Z Frank and V.K Goyal, 2003). I chose this theory because it is one of the most important theories in financial management, it applicable in my study because it shows how important financial management skills and decisions are in ensuring sustainability and profitability of a business. A business has three sources of finance which are retained earnings (internal funds), equity and debt (external funds). The pecking order theory suggests that businesses prefer internal to external finance. This means that management would rather finance first from retained earnings, then with debt (short term then long term debt) and lastly with externally issued equity. A business will first use up all its retained earnings, then will move on to short term debt and long term debt and will only issue equity when it is no longer wise to issue debt. Internal finance has the least risk, debt is preferred to equity because it has lower information costs. Retained earnings do not have an adverse selection problem, while debt and equity have an adverse selections problem (M.Z Frank and V.K Goyal, 2003). A financial manager needs to have the required skills e.g., management of financial resources, critical thinking, decision making, co ordination in order to apply the pecking order theory. Financial management of working capital determines the direction a business will take, effective management of working capital is essential if the business wants to make a profit. Financial management skills affect the capital structure of the business and are important as they play a key role in achieving better performance. A bad decision about the capital structure may lead to financial problems and even bankruptcy. If a financial manager is able to make accurate and timely decisions he/she is can to reduce the cost of capital and increase the profits of the business. The financial manager shouldn’t depend on one source of finance but should find the best possible combination. There is a positive relationship between capital structure and financial performance. Successful businesses do not depend on external finance. Profitable businesses have low debt levels and high level of retained earnings. According to Li-Ju Chen (nd), “As the business grows, their requirement of finance tends to increase. The capacity to finance the increasing demand depends on internal finance. If a firm relies entirely on internal funds, then the growth may be restricted. Growth is likely to put strain on retained earnings and push the firm into borrowing.’’ The skills of the financial manager are important when the business wants to grow because the manager will now have to decide if he/she is going to continue following the pecking order or slightly adjust it in order to allow the business to grow. Literature Review

I chose these studies because they relate to my research topic as they highlight the financial management skills that are required I to run a profitable business and highlights the problems associated with financial management skills. The literature review will identify and explain the relationship between financial management skills and profitability of a business. “Financial management and profitability of small and medium enterprises”, is a dissertation written by Kieu Nguyen. The dissertation was conducted in 2001 in South Wales. Financial management deals with raising and utilising funds needed for the running of a business, and ensures that the money is used properly in order to achieve the business goal of profitability. Profitability determines the businesses success or failure. Low profits lead to a decrease in retained earnings and this will cause the business to rely on external finance, and this could lead to bankruptcy. The financial...

References: www.businessdictionary.comwww.investopedia.comNieman,G.(2006).Small business management. South African Approach. Pretoria: Van SchaikM.Z. Frank, V.K. Goyal(2003). Journal of Economics
Simon McGrath.(2003).Skills Development in very small & micro enterprises.
Kieu Nguyen.(2001). Financial management and profitability of small and medium enterprises is a dissertation written by.
D.Lakew and Prof.D.Ra.(2009).Effect of financial management practices and characteristics on profitability: A study on business enterprises In Jimma town.
Rab Nawaz.(2012).The impact of financial information on organising and managing a small business.
Dr. A. I. Asuquo and Dr. S.A.(nd).The effect of financial management practices on the profitability of small and medium enterprises in Nigeria.
Abram Phenya.(2011).An assessment of the financial management skills of small retail business managers in Dr Js Moroka Municipality.
Don Hofstrand(nd).Understanding Profitability
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