INFLUENCE OF FINANCIAL LITERACY ON PERFORMANCE

OF SMALL AND MEDIUM ENTERPRISES IN NANYUKI

ALI SHARIFF ABUBAKAR

D66/43324/2022

A RESEARCH PROPOSAL SUBMITTED IN PARTIAL FULFILMENT OF

THE REQUIREMENTS FOR THE AWARD OF MASTER OF SCIENCE IN
FINANCE, FACULTY OF BUSINESS AND MANAGEMENT SCIENCES,
UNIVERSITY OF NAIROBI

JULY 2024
 CHAPTER ONE: INTRODUCTION

1.0 Background of the Study

Small and Medium Enterprises (SMEs) are crucial to global economic development, comprising
approximately 90% of businesses and over 50% of employment worldwide (World Bank, 2020).
SMEs foster innovation, drive economic diversification, and contribute significantly to GDP
growth. However, SMEs face numerous challenges, such as limited access to finance, regulatory
obstacles, and insufficient managerial skills. Financial literacy, which encompasses
understanding financial concepts and effective financial decision-making, is essential for
overcoming these challenges and ensuring the sustainability and growth of SMEs. Research
indicates that higher levels of financial literacy correlate with better business performance, as
owners with financial knowledge can make more strategic and informed decisions (Lusardi &
Mitchell, 2014).

In Sub-Saharan Africa, SMEs are a cornerstone of economic development, contributing over

50% to GDP and more than 60% to employment (International Finance Corporation, 2022).
Despite their significance, SMEs in this region struggle with high levels of financial exclusion,
limited access to credit, and inadequate business support services (Beck & Cull, 2014). Financial
literacy remains a significant barrier, with many SME owners lacking the skills to manage
finances effectively. This deficit hampers their ability to secure funding, manage operational
costs, and invest in growth opportunities (Agyei, 2018). Regional initiatives such as the African
Development Bank's (AfDB) "Boost Africa" program aim to improve financial literacy for
SMEs, recognizing that enhanced financial capabilities can lead to better business outcomes and
economic resilience (AfDB, 2020).

In Kenya, SMEs are pivotal to the economy, contributing approximately 33.8% to the GDP and
providing about 80% of employment opportunities (Kenya National Bureau of Statistics, 2019).
Nanyuki, a dynamic town in Laikipia County, reflects this national trend with a diverse array of
SMEs, ranging from retail shops to agro-based enterprises and tourism-related businesses.
Despite their critical role, SMEs in Nanyuki face numerous challenges such as limited access to
capital, high operational costs, and inadequate business management skills (Mwangi & Ngugi,

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2019). A key issue impacting their performance is the low level of financial literacy among SME
owners. Without adequate financial knowledge, these entrepreneurs struggle to maintain accurate
financial records, make informed investment decisions, and manage cash flow effectively
(Gitonga, 2021).
Financial literacy programs tailored to the needs of SME owners in Nanyuki can bridge this
knowledge gap. Such programs can empower business owners with the skills to navigate
financial challenges, secure financing, optimize business operations, and enhance overall firm
performance. Studies indicate that financial education positively impacts business performance
by enhancing decision-making capabilities and fostering sustainable business practices (Atieno
& Kipsang, 2020).

This study will be guided by Human Capital Theory, which emphasizes the importance of
investing in education and training to enhance the capabilities and productivity of individuals
(Becker, 1964). Improving financial literacy among SME owners aligns with this theory, as it
involves investing in the human capital of business owners. Entrepreneurial Orientation Theory
focuses on the strategic orientation of a business, highlighting the importance of innovativeness,
risk-taking, and proactiveness (Lumpkin & Dess, 1996). Enhanced financial literacy can support
entrepreneurial orientation by providing the necessary knowledge to undertake strategic
initiatives. The study of financial literacy's influence on the performance of SMEs in Nanyuki is
crucial given the significance of SMEs. Enhancing financial literacy can address some of the key
challenges faced by SMEs, promoting their growth and sustainability, and ultimately
contributing to economic development at various levels.

1.1.1 Financial Literacy

Financial literacy refers to the ability to understand and effectively use various financial skills,
including personal financial management, budgeting, and investing. It encompasses a wide range
of financial knowledge and competencies that enable individuals to make informed and effective
decisions regarding the use and management of money. According to Lusardi and Mitchell
(2014), financial literacy involves not only the acquisition of financial knowledge but also the
application of that knowledge to real-life financial decisions, which is crucial for ensuring
economic stability and growth.

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Financial literacy is measured through various dimensions that assess both financial and non-
financial aspects. These dimensions provide a comprehensive understanding of an individual's
financial capabilities and their ability to navigate financial systems and processes effectively.
Knowledge of financial concepts includes understanding basic financial principles such as
interest rates, inflation, risk diversification, and the time value of money. Individuals with higher
financial literacy can comprehend and apply these concepts to make informed financial decisions
(Huston, 2010). Financial behavior measures how individuals manage their finances, including
budgeting, saving, investing, and debt management. It examines whether individuals practice
sound financial behaviors that contribute to their financial well-being (Atkinson & Messy, 2012).
Financial attitude dimension assesses individuals' attitudes towards money and financial
planning. Positive financial attitudes, such as a proactive approach to saving and investing, are
indicative of higher financial literacy (OECD, 2013).

Looking at non-financial aspects, we have entrepreneurial orientation that includes the

knowledge and skills necessary to identify business opportunities, innovate, take risks, and
manage business operations. Financial literacy in this context enables SME owners to make
strategic business decisions that enhance performance (Lumpkin & Dess, 1996). Access to
information aspect measures the ability of individuals to seek and utilize relevant financial and
business information. It encompasses understanding financial statements, market trends, and
regulatory requirements (Agyei, 2018).

This research will use a multi-dimensional approach to measure financial literacy among SME
owners in Nanyuki. The key measures include financial knowledge, financial behavior, financial
attitude, entrepreneurial orientation, and access to information. Understanding and measuring
financial literacy is crucial for improving the performance of SMEs. By assessing both financial
and non-financial aspects, this research aims to provide a comprehensive evaluation of the
financial literacy levels among SME owners in Nanyuki.

1.1.2 Firm Performance

Firm performance refers to how well a company achieves its objectives, which can include
profitability, growth, and market share, among others. It encompasses both financial and non-
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financial dimensions and is often used as a measure of a company's success and sustainability.
For SMEs, firm performance is particularly critical as it determines their ability to survive and
thrive in competitive markets. According to Richard et al. (2009), firm performance is a
multidimensional construct that includes various indicators of operational and financial health.

Empirical studies have employed various metrics to measure the performance of SMEs. These
metrics can be broadly categorized into financial performance indicators, operational
performance indicators, and overall business performance indicators. Financial performance
includes Profitability, one of the most commonly used indicators of firm performance. It includes
measures such as net profit margin, return on assets (ROA), and return on equity (ROE). Higher
profitability indicates better firm performance and efficient management of resources (Rauch,
Wiklund, Lumpkin, & Frese, 2009). Another one is revenue growth, this measures the increase
in a firm’s sales over a specific period. It is a critical indicator of market acceptance and demand
for the firm's products or services (Zimmerman, 2010). Liquidity ratios, such as the current ratio
and quick ratio, assess a firm’s ability to meet its short-term obligations. Maintaining adequate
liquidity is essential for the smooth operation of SMEs (Gitman & Zutter, 2012).

Operational Performance of firms includes efficiency, this metrics focuses on aspects such as
inventory turnover, receivables turnover, and asset turnover ratios indicate how well a firm
utilizes its assets and manages its operations. Higher efficiency often translates into better firm
performance (Neely, Gregory, & Platts, 2005). Productivity measures the output generated
relative to the input used. For SMEs, productivity can be measured in terms of sales per
employee or production per unit of input (Coelli et al., 2005).

Overall business performance includes customer satisfaction, this metrics evaluate how well a
firm meets the needs and expectations of its customers. High levels of customer satisfaction can
lead to repeat business and positive word-of-mouth, which are critical for the growth of SMEs
(Anderson, Fornell, & Lehmann, 1994). Market share on the other hand is the percentage of an
industry or market's total sales that is earned by a particular company over a specified time
period. It is a vital indicator of competitive performance (Buzzell, Gale, & Sultan, 1975).
Innovation performance measures a firm’s ability to develop new products, services, or

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processes. It is an essential driver of long-term growth and competitiveness for SMEs
(Hagedoorn & Cloodt, 2003). Measures of firm performance in this research include: financial
performance, operational performance, and overall business performance. Employing both
financial and non-financial performance indicators will provide a comprehensive assessment of
the factors that influence the performance of SMEs in Nanyuki.

1.1.3 Small and Medium Enterprises in Nanyuki

Small and Medium Enterprises (SMEs) are businesses whose personnel numbers or revenue fall
below certain limits. The specific definitions of SMEs vary from country to country. In Kenya,
the definition provided by the Kenya National Bureau of Statistics (KNBS) categorizes SMEs
based on the number of employees and annual turnover. Typically, SMEs in Kenya are defined
as businesses with fewer than 100 employees and an annual turnover of less than KES 150
million (KNBS, 2016).

Nanyuki is a vibrant town located in Laikipia County, Kenya, situated on the equator and serving
as a gateway to Mount Kenya. The town is approximately 195 kilometers north of Nairobi and
acts as a commercial and tourism hub for the surrounding regions. Nanyuki is known for its
picturesque landscapes, diverse wildlife, and rich agricultural activities. Nanyuki's economy is
primarily driven by agriculture, tourism, and retail trade. The town is a crucial center for the
production and distribution of agricultural products, including vegetables, fruits, and dairy.
Additionally, Nanyuki benefits from tourism due to its proximity to various wildlife
conservancies, national parks, and luxury resorts, attracting both local and international tourists
(Laikipia County Government, 2021). The town's strategic location along the A2 road,
connecting Nairobi to the northern parts of Kenya, enhances its commercial significance. It also
hosts several military bases, including the British Army Training Unit Kenya (BATUK),
contributing to the local economy.

SMEs in Nanyuki play a vital role in the local economy, contributing significantly to
employment and economic growth. These enterprises span various sectors, including retail,
hospitality, agriculture, and manufacturing. SMEs in Nanyuki are essential to the town's

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economic landscape. Enhancing the financial literacy of SME owners can significantly
contribute to their success and, by extension, to the economic development of Nanyuki.

1.2 Statement of the Problem

Small and Medium Enterprises (SMEs) are critical drivers of economic growth, employment
creation, and innovation in both developed and developing countries. In Kenya, SMEs constitute
a significant portion of the economy, contributing approximately 40% to the GDP and employing
around 80% of the workforce (Kenya National Bureau of Statistics, 2016). Despite their
importance, SMEs face numerous challenges that hinder their growth and sustainability. One of
the most pressing issues is the low level of financial literacy among SME owners, which
negatively impacts their ability to make informed financial decisions, access credit, and manage
their businesses effectively (Mwangi & Ngugi, 2019).

Empirical studies have highlighted the importance of financial literacy in enhancing the
performance and sustainability of SMEs (Lusardi & Mitchell, 2014). Financial literacy equips
SME owners with the necessary skills to manage finances, understand financial statements, and
make strategic business decisions (Lusardi & Mitchell, 2014). However, there is a significant gap
in understanding how different aspects of financial literacy, specifically in the context of SMEs
in Nanyuki, influence firm performance. While some studies have explored the general impact of
financial literacy on SME performance, there is limited research that focuses on specific
financial behaviors and attitudes that contribute to business success in this region (Gitonga,
2021).

Nanyuki, a town located in Laikipia County, Kenya, serves as a commercial hub with a diverse
economy driven by agriculture, tourism, and retail trade. The town's strategic location and
economic activities provide a unique environment for SMEs. However, SMEs in Nanyuki face
several challenges, including limited access to finance, inadequate business management skills,
and a lack of market information (Laikipia County Government, 2021). These challenges are
exacerbated by low levels of financial literacy among SME owners, which hinders their ability to
secure funding, manage cash flows, and grow their businesses sustainably (Mwangi & Ngugi,
2019).

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Given the critical role of SMEs in economic development and the challenges they face, it is
imperative to investigate the influence of financial literacy on SME performance in Nanyuki.
This study aims to fill the existing knowledge gap by examining how financial knowledge,
behavior, and attitudes impact the performance of SMEs. By focusing on Nanyuki, this research
will provide contextual insights that can inform targeted interventions to improve financial
literacy among SME owners in the region. Such interventions can enhance the financial
management capabilities of SME owners, leading to improved business performance,
sustainability, and overall economic growth. This study addresses a significant gap in the
literature by exploring the specific influence of financial literacy on SME performance in
Nanyuki.

1.3 Research Objective

To investigate the influence of financial literacy on performance of small and medium

enterprises in Nanyuki

1.4 Value of the Study

The proposed study on the influence of financial literacy on the performance of Small and
Medium Enterprises (SMEs) in Nanyuki, Kenya, holds significant value in several dimensions,
including theoretical contributions, practical implications, and policy recommendations. The
study will contribute to the existing body of knowledge by filling the identified gap regarding the
specific influence of financial literacy on SME performance in a localized context. Although
numerous studies have explored the general impact of financial literacy on business
performance, there is limited research focusing on SMEs in Nanyuki. By examining the unique
financial behaviors and attitudes of SME owners in this region, the study will provide new
insights and enhance our understanding of the relationship between financial literacy and
business success. Additionally, the study will apply relevant theories, such as the Resource-
Based View (RBV) and Human Capital Theory, to explain how financial literacy serves as a
critical resource and capability for SMEs.

The findings of this study will have several practical implications for SME owners, financial
institutions, and business development service providers in Nanyuki and beyond. The study will

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provide empirical evidence on the specific aspects of financial literacy that are most influential in
enhancing SME performance. This information can help SME owners identify areas where they
need to improve their financial knowledge and skills, leading to better financial management
practices and business outcomes. Business development service providers and financial
institutions can use the study’s findings to design and implement targeted financial literacy
training programs that address the specific needs of SME owners in Nanyuki. Improved financial
literacy can enable SME owners to better understand financial products and services, prepare
more robust business plans, and make informed decisions about borrowing and investment. This,
in turn, can enhance their ability to secure funding from financial institutions, thereby supporting
business growth and sustainability.

The study will also provide valuable insights for policymakers and government agencies
involved in SME development and economic planning. Policymakers can develop incentives for
financial institutions to provide financial literacy training as part of their service offerings to
SMEs. This can include tax breaks, subsidies, or recognition programs for institutions that
actively promote financial literacy among their SME clients. The broader socio-economic impact
of this study lies in its potential to enhance the performance and sustainability of SMEs in
Nanyuki. By improving the financial literacy of SME owners, the study can contribute to Job
Creation and Economic Growth. This can have a positive multiplier effect on local communities,
improving living standards and reducing poverty.

REFERENCES

Agyei, S. K. (2018). Culture and Financial Literacy: Evidence from Sub-Saharan Africa.
International Journal of Social Economics, 45(5), 807-824.

Atieno, R., & Kipsang, G. (2020). Financial Literacy and SME Performance: Evidence from
Kenya. Journal of Financial Management and Analysis, 33(1), 29-43.

Barney, J. (1991). Firm Resources and Sustained Competitive Advantage. Journal of

Management, 17(1), 99-120.
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Beck, T., & Cull, R. (2014). Small and Medium-Sized Enterprise Finance in Africa. African
Development Review, 26(1), 44-59.

Becker, G. S. (1964). Human Capital: A Theoretical and Empirical Analysis, with Special
Reference to Education. University of Chicago Press.

Becker, G. S. (1964). Human Capital: A Theoretical and Empirical Analysis, with Special
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Gitonga, E. (2021). The Role of Financial Literacy in the Sustainability of SMEs in Kenya: A
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Mwangi, W. M., & Ngugi, P. K. (2019). Factors Affecting Growth of Small and Medium
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