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Funding in SME’s and the risk faced.
Risk management and SME
2.1 Definition of SME
Hermann, 1996 ; “Small and medium sized enterprises (SME) differ from large corporations among other aspects first of all in their size. Their importance in the economy however is large”. There are different definition of SME’s but most commonly the firm should have up to 250 employees and jobs in small and medium enterprises accounts of 50% of formal employment in developing countries (Ayyagari et al 2007) .
According to the European commission 2011, SME’s should consist of these following criteria :
Balance sheet total
≤ € 50 m
≤ € 43 m
≤ € 10 m
≤ € 10 m
≤ € 2 m
≤ € 2 m
Table 1 : criteria for SME’s European commission 2010
SME’s play an important role in our Mauritian economy , they are the major source of innovation, employment and entrepreneurial skills. In Mauritius the Small and Medium Enterprise Development Authority (SMEDA ) defines an SME as an “enterprises in all economic sector and a Small Enterprise is defined as an enterprise which has an annual turnover of not more than 10 million MUR and Medium Enterprise is defined as an enterprise which has an annual turnover of more than 10 million MUR but not more than 50 million MUR “ . Small sizes and medium sizes are defined separately due to different support and objectives which these enterprises required.
Section B : sources of finance for SME’s
2.2 Capital structure
SME’s do not have the opportunity to contact business consultants of business specialist with them so they have to rely on their general competence as owners. SMEs have a different characteristics as compared to a big companies (Berger and Udell,1998). Small and medium enterprises suffer from a great lack of financial resources which prevent them from growing . since competitive threats can affect small businesses , they prefer to quickly adapt changes in market demand rather than implementing a long term approach (Jennings and Beaver, 1997). Vos et al,
2007 stated that entrepreneur are forced to use debt as an important financing instrument
2.3 Financing of SME’s
Firms typically need different types of financing measures for different purposes and at different points in their life cycle.SME financing received much attention in recent years from researchers, economists and policy makers (De la Torre et al, 2010). Basically, the level of required financing depends on a firm’s financial performance and its assets (Hillier et al, 2010).
SMEs finance themselves through internal sources such as both from the business owner and through retained profit. Many SMEs also use external sources of finance. It can be in two forms either from informal sources such as family , friends and from Formal sources such as bank loans, leasing, trade credits, factoring and more “formal” Venture Capital, which is important for a select group of high potential SMEs (EIM, 2009). In addition it can be said that SME’s have more problems in acquiring external financing as compared to larger companies. Naturally, SMEs are not able to raise money directly in the capital markets and are hence they need other external sources they primarily depend on traditional bank financing, which is itself limited by constraints due to banks’ refinancing capacity, their risk appetite and capital and equacy (Kraemer-s,Lang, and Gvetadze, 2013)
2.4 Sources of finance
- Retained earnings
Retained earnings are “the profit that a company of business have earned to date less dividend and other distributions paid” Steve B, 2010. “Earnings are cumulative and represent past and present earnings” ( Peaver R, 2012).this earnings can be a good source for SME’s and it is less risky .
- Personal savings
Using your own money to start up is an own satisfaction in itself and you don’t owe anyone . Many owners or managers do not like to use long term debt , so they try to adopt a “pecking order of financing preferences” (Howorth, 2001). The owners use their own personal savings or receive savings from families and friends . Nottingham,20 November 2013 , it was found that one quarter SME’s use their personal savings to finance their own business .
- Angel investors
Collen D, 2010 define Angel investor is an individual who is willing to invest in the early stage of a business in exchange for ownership stake . If owners want quick and aggressive growth they can turn to angel investors for capital they bring both time experience and money “One of the greatest contributions given by angel investors is that they prefer to invest in seed-stage, start-up-stage or early-stage enterprise mayer, 2008” some investors prefer early stages because they can have an important or active role in the business and others may take it as a challenge for them. There is definitely a share of control in the business since an investor is interested in it , this can affect decision making process but on the other hand the riskiness is shared.
Alfonso et al , 1995 defined partnership as “more than simply working together”. Partnership can be relationship with vendors, business alliance , emphasis of teamwork an collaboration. So the collaboration of two of more individuals of firms is an excellent source of providing funds to run a business or to go on a venture. It can be risky as other partners do not have the same way of thinking and taking decision process can be very long as the approval of other partners is required.
Leasing provide SME to have access to short and medium term finance. Fletcher et al ,2005 define leasing as a contract between two parties where the lessor provide an asset to another party for usage for a given time period , in return for a payment by the lessee . In the budget 2012 speech it was announced that the interest rate under leasing of equipment was brought down from from 8.5 % to 7.25 %
2.5 Debt finance
Debt involves that the owner must borrow and payback with an interest . An important aspect of debt financing is that it the owner have complete ownership of his business. According to Aswarth some general characteristics of debt are : commitment to make a fixed payments in the future, the fixed payment are tax deductible and finally failure to make payment lead to either default or loss of control of the business.
Bank Loans to SME’s
One of the most important source of debt finance for small and medium enterprises is to take out a bank loan Yesseleva, M. (2010).
Bank support to SME’s in Mauritius :
- New measure announced in Budget speech 2012 by honorable Xavier luc duval. The scheme includes new overdrafts and bank loans as well as renewal of existing.
- 35% guarantee provided by Equity Fund
- Interest rate at 7.9 percent (repo + 300 basis points)
- SMEs apply directly to banks
(sources : SME portal mauritius).
2.6 NON-bank sources of debt finance
- Asset base lenders – “usually smaller commercial banks, commercial finance companies, or specialty lenders, allow small businesses to borrow moneyby pledging otherwise idle assets such as accounts receivable, inventory, or purchase orders as collaterals”
- Discounting accounts receivables – a small business pledges his account receivable as collaterals.
- Inventory financing – “a small business loan is secured by its inventory of raw materials, work in process, and finished goods”.
- Vendor financing – Borrowing money from vendors and suppliers in the form of credit
- Commercial finance companies – a second option if the owner did not obtain a loan from a bank.
- Stock brokerage houses – brokers also give loans and it’s interest rate are often lower than banks.
- Insurance companies – these companies offer policy loans and mortgage loans.
- Credit unions –“ these are nonprofit financial cooperatives that promote saving and provide loans to their member”
Sources : Michael wolff “sources of debt and equity finance”.
Some institutions that provide debt finance in Mauritius :
- Development bank of Mauritius (DBM)
- The Mauritius Leasing Company Limited
- SBM Lease Ltd
- SICOM Financial Services Ltd
- MAURITIUS POST COOPERATIVE BANK (MPCB)
Section C : Risk and risk management
2.7 Definition of risk
“Risk appetite refers to the amount of exposure to potentially negative occurrences that an organisation is willing to accept” (Baek et al., 2005). “Constructed from an investment management perspective, the crucial aspect of risk appetite that impacts on our theoretical position is that traditionally, risk, rather than being seen for its potential opportunities has been conceptualised to reflect a perception of being undesirable” (Hansson, 1996, 1999, 2005; Campbell, 2006). When doing business, constantly decisions, where the outcomes cannot be foreseen with certainty due to incomplete information, have to be made (Stroeder, 2008, p.135) .
Risk can be of two types . it can be either systematic , which is also called the market risk or undiversifiable risk, these risk are independent of business decisions. The second type of risk is unsystematic risk (also called diversifiable risk or specific risk) which are result of managerial decisions (Retzlaff, 2007, p.11) .
2.8 Risk management
Head , 2009 define risk management as “the process of planning, organizing, directing and controlling resources to achieve given objectives when good or bad events are possible” .according to Vaughan and Vaughan (2001) “the main objective of risk management is to ensure that the organisation is not prevented from achieving its primary objectives as a result of losses that might arise from its operations. ”
Henschel and Gao (2010) affirm that a “risk management system is necessary for SMEs not only because it is required by law but rather because it is in the essential interest of the SME”. Smith and Watkins, 2002 further support that risk management should be of a main concern to small businesses as they are sensitive to business risk and competition . It is the responsibility of the owner manage these risk and he will be accounted for risk decision made for the business.
2.9 Application of risk management
Bajaj (1997) reported that ”if a risk is not identified it cannot be controlled , transferred or otherwise managed.” Risk management should be applied throughout the whole life of a business or a project. Accordind to jaafari et al , 1995 , there are three stage of risk management :
- Risk identification
- Risk analysis and
- Risk respond
2.9.1 Risk identification
This is the first stage of risk management, it is a process which can reveal and determine the possible risk . the correct risk should be identified effectively by risk managers . if those risk are not successfully identified , then losses or gains could not be found and in time it will become non-manageable by the organisation (greene and trieschmann, 1984) . “the inability to identify possible gains is as inappropriate as non-identified risk related to loss” Dickson et al , 1986. So ignoring a good possibility is the same as bearing a loss .
According to William et al , 1998” risk identification can be described through the following elements”:
- Sources of risk
- Hazard factor
- Exposure to risk
- Sources of risk
“Elements of the organization environment that can bring some positive or negative outcomes” lubka 2002. For example , if a firm undertake to produce a new good , this decision is barely influenced by the market. So the matket condition , availability of competitors , customers , quality of raw materials is the sources of the risk .
- Hazard factor
This is the conditions and circumstances that increase chances of gains and losses. An error in the firm management about the market of a product can be a hazard factor .
Peril can cause unknown and unpredictable loss and it can happen any time.”A peculiarity of peril is that it does not include a positive meaning , as the peril always cause losses” hance et al , 1991 .
- Resources exposed to risk
“These are objects facing possible losses or gain . they will normally be affected if a risk event occurs” .
2.9.2 Risk analysis and evaluation
“Each event may be a single incident or an aggregation of incident” (Williams, 1995). There are several analysis techniques to quantify risk. These techniques are code optimization , sensitivity analysis , probability analysis .
2.9.3 Risk response
This means to manage the risk using proper techniques to minimize risk or to eliminate it .
2.10 Business risk faced by SME’s
Both large companies and SME’s operates in the same business environment but they “derive different benefits and opportunities”, they are also expose to different type of risks . “ this is because of their differences in economic capacity including asses to human capital and material resources . Kelkar (2008) ”theorizes that SMEs are weak in terms of business plan, management structure and in decision making when compared to large organizations. This further increases SMEs’ inability to absorb most business uncertainties and risks”. According to suh , 2010 the SME sector is more affected by economic environment and is the first to bear external shock so there are more SME’s closing down than being established.
2.11 Specific Business risk In which SME’s are exposed to
- Liquidity risk
“Liquidity measures the ability of the firm to cover its’ expenses and therefore it also shows whether the company is able to cope with some losses due to risk occurrence” (Smithson, Smith & Wilford, 1995) . A lack of liquidity will prevent the firm to pay its bill and day to day expenses.
- Continuation of business
“The business entities under SME sectors are mostly proprietorship and partnership concerns. Few in the joint stock companies are private limited or closely held public limited companies. Thus, the very constitution itself may prove to be risky due to lack of professionalism and overdependence on one or two key persons for running the show. Lenders and other stakeholders in SME sector cannot afford to forget this fact” R.s . Rahavan (2005) .
- Leverage of financial structure
The limit to which small business can raise capital and due to this disadvantage this affect their capacity to leverage on the financial structure R.s . Rahavan (2005)
- Tough competition
Due to intense competition on the market , SME have to cut down their product cost and reduce their profits. Therefore they absorb higher input cost.
- Account receivables
Salima et al, 2011 stated that “the supply of trade credit by SMEs is the product of both customer demand and the possibility of strategic advantage, but it is subject to risk.” Business who provide credit facilities always suffer the risk that customer do not pay their debt .
- Incapacity to go for technological advance
“Technological innovation is a key factor in a firm’s competitiveness. Technological innovation is unavoidable for firms which want to develop and maintain a competitive advantage or gain entry in to new markets” (Becheikh et al. 2006) . with poor financial resources SME cannot go for sophisticated technological advancement which make them lose competitiveness and optimization of available resources.
- Employees turnover
“As growth prospects are very limited in SME sector, it is prone to high degree of employee turnover and this may involve lot of wastage of manpower and additional cost in the form of training and knowledge updating, affecting continuity besides lowering the productivity” R.s . Rahavan (2005).
2.12 How to manage these specific business risk arising to SME’s
- Proper cash flow to prevent lack of liquidity – Maintain a proper cash flow managements and make accounts up to date .
- Research and development
- Following market changes
- Hedging – the owner can hedge against inflation changes , exchange rate and commodity price change which is a very important risk management tool in finance.
- Proper mode for collection of receivables – take legal action to recover your money back and use agencies specialised to recover bad debts.
2.13 Financial risk
It is the risk associated to financing. It is the loss in financing method. Eichhorn, 2004, said that financial risk can be in two forms, it can either be internal financial risk where to business itself is creating those risk or external risk which depend on financial market .
Schönborn, 2010, assesses external risk on 3 risk factors namely exchange rate risk, interest rate risk and commodity price risk
Exchange rate risk
“Exchange rate risk management is an integral part in every firm’s decisions about foreign currency exposure” (Allayannis et al , 2001). Currency risk can be reducer eliminated by using hedging strategies . Selecting hedging strategies is often a discouraging task because of the “complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered”. (Papaioannou, 2001).
Interest rate risk
If small businesses is using a lot of debt to finance his business. The risk of fluctuations in the interest rate is an important factor to be taken into consideration . A rise in interest rate can raise the amount of interest pain. To prevent interest rate risk , business owners could request the borrowers to fix the interest rate for a certain period (CPA Australia 2008) .
Commodity price risk
It is the threat of the change in price of a production input which could have a negative impact on the producer .To manage this risk producers should be less reliant on one commodity. producers can diversify their products and income source . They can also use fixed price contracts arrangements .