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  • Laura Freschi and Tim Ogden

The Consequences of Volatility for Small Firms

When, where, and why fluctuations in income and expenses matter

This fall, when we began to dig into early data coming out of the Small Firm Diaries’ first two countries, Ethiopia and Colombia, we weren’t surprised to see a lot of volatility in both revenues and expenses for these firms with 1 to 20 non-family employees.

We expected this in part because the Small Firm Diaries is standing on the shoulders of the early household financial diaries studies, notably Portfolios of the Poor, which re-set our understanding of the prevalence of income volatility in the lives of low-income households. Portfolios of the Poor brought this issue into clear view for the first time, sparking much needed attention to helping families manage volatility.

Unlike with households though, income volatility is expected in firms. In fact, that is part of the purpose of a firm—to manage a mismatch between expenses and revenues, and engage in production processes that are more complicated and time-consuming than an individual household could manage. So when we turn to firms, we should expect to see a lot of volatility. The key question isn’t so much whether there is volatility present, but how much does volatility matter? What tools do firms use to manage volatility, and for those that manage it better than others, how are they doing it? Are there firms that are severely constrained by volatility; if so, how are they different from firms that are not so constrained?

The key question isn’t so much whether there is volatility present, but how much does volatility matter?

The following graphs, which we created to share with our global advisory board when they met last quarter, show 10 and 5 weeks of revenue flows respectively for small firms in our sample in Ethiopia and Colombia.

And these are zoomed in versions of those same graphs—the detail gives a clearer picture of pronounced fluctuations in revenue from week to week.

So indeed, the firms in the study do see a large amount of volatility in their revenues.

Theoretically firms could cope with this volatility in a number of ways. They could build up cash reserves—liquidity—so that they could spend as needed regardless of a particular week’s income. They could borrow to meet short-term cash needs if revenues dipped too low in a particular week (if such a liquidity product, often called a Line of Credit, existed and was available to them). They could time their expenses to when they had cash on hand, especially if the volatility was reasonably predictable (e.g. a lot of sales the last week of every month, but few in the first week of the month). Or, they could simply scale expenses up and down to match recent revenues.

Determining which of these is the case is quite difficult. First of all, they are not exclusive—a firm could be doing all three, partially. Second, inputs and expenses are likely “lumpy” and not fixed on a daily or weekly basis, so we would expect a lot of volatility of expenses as well, even if a firm had cash sufficient that revenue volatility didn’t matter at all.

Two members of our advisory board, Chris Wheat and Chris Woodruff, raised the issue that unpredictable volatility matters a lot more than predictable volatility when it comes to firms. There remains a question of what is theoretically predictable and what is practically predictable. As Abhijit Banerjee has noted, the household finance literature often talks about “health shocks” but a substantial portion of those health shocks are the birth of a child, and most households have more than a few months warning to prepare for the shock of a birth.

Another key question lurking under the surface of volatile revenues and expenses is the effect of varying expenses to match revenues. A firm that doesn’t have the ability to manage volatility and is therefore constrained in its expenses to recent revenues is likely to miss out on a lot of opportunities—it may not have the inventory or raw materials necessary to fulfill a new order, for instance. But there is another piece of the puzzle—one of the key expenses of firms of this size is employees. Cutting expenses may mean cutting wages—either forgoing paying workers or reducing the number of hours that employees work. That may allow the firm to manage volatility—but it simply pushes the cost of managing volatility onto the employee, who is in most cases going to be less well-off than the firm owner.

There may be some types of volatility that are easier to pass on to employees than others, dependent on whether the source of the delay in payment is the government, a large client, or simply the accrued effect of many small late payments (something advisory board member David McKenzie is noticing in an ongoing study of outsourcing in Nigeria).

Over the remaining months of the study, we expect to develop insight into these questions, to see from the data how firm owners are responding, whether proactively or reactively, to volatility.

The difficulty of answering these questions is ultimately why we’re doing financial diaries over the course of the year. You have to see how firms behave before and after ups and downs in revenue. You have to see how they actually react, not just how they think they would (or even how they think they did) manage volatility. Over the remaining months of the study, we expect to develop insight into these questions, to see from the data how firm owners are responding, whether proactively or reactively, to volatility. We’ll be tracking the use of formal and informal financial tools like savings and credit. We’ll be watching whether, when, and how revenues predict expenses, or vice versa. In each country we’ll also be devoting several modules (deep dives that go beyond cash flows) to the topic of employees. We’ll be asking firm owners how they make hiring, lay-off, and firing decisions. We’ll ask how employees are paid (e.g monthly salary, per-piece, per-hour), and whether they have formal contract or “handshake” agreements, and then we’ll track payments per employee. We’ll talk to employees as well, seeking to understand their perception of income volatility, and more generally what role employment in the firm plays in the financial lives of employee households.

Stay tuned for the next post in this series, where we continue to explore early data from Ethiopia and Colombia to discuss the challenges of calculating firm profitability,

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