Financial Risk Management in Small and Medium Enterprises (SMEs)

Background

Risk is an inevitable part of any business or economy. Whenever a business makes any decision or entrepreneurial action, there is a risk involved (Hampton 2011). Globalization has amplified the importance of financial risk management in businesses. It applies to all forms of businesses: large, medium, and small enterprises. Some individuals share the idea that, due to the size of the small and medium enterprises, they may not be facing the financial risks as the large firms are. However, as they engage in similar operations, but at a smaller level, they face similar economic issues. The real business environment has marketed the flaws, which require the management teams to manage the risks in order to ensure the endurance of their business.

 

It also promotes the addition of value through the avoidance and reduction of the operation costs, as well as, costs associated with economic distresses and bankruptcy (Oosterhof 2001). Risk management is a challenge for most of the SMEs. As compared to the large enterprises, SMEs lack the required resources with regard to manpower and knowledge specialty for the performance of structured and standardized management of risks (Gao, Oreal & Zhang 2014).

They also have inadequate human resources who possess enough expertise to control the risks (Henschel 2008). Therefore, most of the SMEs fail to conduct adequate analysis in order to find the risks facing them. It is further exacerbated by the inadequacy of research relating to the risk management that works best for the SMEs (Henschel 2008). The SMEs have a significant impact on the social and economic status of the globe, and they differ from the large corporations in numerous aspects. However, most empirical studies focus on the risk management aspects of the large business entities (Roggi & Altman 2013).

Therefore, it is clear that regarding the risk management in SMEs, two major problems exist. First, SMEs differ from large organizations significantly, and second, there is inadequate research focusing on risk management in SMEs. The existing theories on risk management can be sufficiently applied to SMEs as it is vital to make considerations of their needs, as well as, characteristics (Gao, Oreal & Zhang 2014). By focusing on SMEs in the Gulf Cooperation Countries and their internal financial risks, the research shall attempts to identify how financial analysis can be incorporated.

Verbano & Venturini (2013) highlight the importance of risk management by identifying it as the one that enables the risk minimization by spreading it across various independent events. The risk can also emanate from the internal factors, such as human resources and infrastructure, as well as technology and processes. It can also be attributed to the external factors including, social, economic, environmental, political, and technological aspects. Verbano & Venturini (2013) state that financial risk management is the process followed in the creation of economic value in a company through the use of fiscal tools and methods for risk exposure management.

All companies, whether large or small, engage in the activities that expose them to various factors creating financial risks (Verbano & Venturini 2013). The clear understanding of the research issue requires the definition of the terms risk, SMEs, and risk management. It will also cover the perspective that the research paper shall take in regard to these terminologies.

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Definitions

In business, various decisions are made when the probable outcomes are uncertain, as a result of incomplete information. The uncertainty is common in all forms of business, and it is referred to as a risk. In Verbano & Venturini (2013), the risk is seen as the possibility of an economic gain or loss due to the uncertainties associated with the pursuance of a given course of action. Usually, the terms danger and uncertainty are used in everyday speech for depicting the risk, although they differ to a given level. When the future outcomes of an event are vague, and the various states cannot be linked to the possibilities of its occurrence, the term uncertainty is used (Weeks 2014).

The danger is the unplanned and unforeseen consequences that have an adverse impact on something. Risk summarizes the uncertainty of the outcomes of the given events and also links the possibility of occurrence. There are also systematic risks, referred to as pure risks, which are independent and beyond the control of the management. There are also unsystematic risks, which emanate from the managerial decision-making, and they may impact the business either positively or negatively (Aven 2012).

It can be traced back to the insurance sector in the 1960s, as through the acquisition of insurance, it became possible to protect the businesses against risks (Aven 2012). Risk management involves organizing, administering, and leading in relation to the risks within a company. The management of risks involves both pure and random risks, but it contrasts with the Modigliani & Miller’s model (Titman 2001). It suggests that a perfect market’s financial decisions cannot influence the value of the entity. They did not include unsystematic risks in the risk management of the businesses.

There is no particular universally approved definition of the SME. Diverse aspects, such as sales, assets’ worth, and the number of workers, are taken into account in an effort to identify small businesses and medium enterprises. However, most literature has adopted the definition given by the European Commission, according to which SME is a business that has less than 250 workers or its revenue per annum does not surpass fifty million euros (European Commission 2005). The USA uses a dissimilar criterion, with constituting SMEs those companies that have less than five hundred employees (Henschel 2008).

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Financial Risk Management

Financial risks affect all the companies regardless of whether financial operations are their core business or not. Financial risks take different forms. They may emanate from the external financial risks, which rely on the changes in the financial markets, and internal financial risks where the company is the source of the risk (Wehinger 2009). The significance of SMEs in the global economy is evident; therefore, focusing on their management of financial risk is vital. They represent almost the entire private sector and employ more than fourteen million people or fifty-nine percent of all the employees of the private sector, and it has about forty-eight percent of the private sector’s revenue.

At the same time, SMEs account for forty-seven percent of all jobs in the private institutions and revenue of thirty-three percent (Yiannaki 2012). In the contemporary business world, the SMEs have joined the global business due to globalization. It leads to some external financial risks, which include exchange rates, interest rates, and commodity prices.

The exchange rate risk occurs once a business gets involved in the international operations, and its cash inflows and outflows are in a foreign exchange rate. Since the rate is not fixed, and one cannot fully anticipate it, a possible change in the rate results in risk in the amount of money payable or receivable. It also alters the amount of money that the company is expected to pay or receive (Yiannaki 2012).

The interest rates on the loans and short-term financing also vary. When it increases, the entity has to pay more money, and the follow-up financing becomes expensive (Yiannaki 2012). There may also be the commodity price risk, which entails the volatile changes in the price of commodities. The variations affect the quantity and the prices; thus, the procurement costs rise. There is also a decrease in the profits of the business, and it may even lead to losses.

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Financial Analysis and Models

In theory, the process of risk management entails risk identification, analysis, evaluation, assessment, and monitoring. In general, all models utilize this sequence in their attempt to manage the risks. It is vital to understand the concept of fiscal analysis so as to comprehend the models used by other researchers. It entails the use of financial data and ratios so as to manage the financial risks in the organizations. When an entity keeps analyzing their financial records, it is easy to identify an anomaly that may lead to bankruptcy if not checked. Analyzing the balance sheet and other financial records is critical to the assessment of risks. Different researchers have attempted to identify the set of ratios that can be applied in risk management.

In 1967, Beaver used the univariate model, which estimates an optimal cut-off point for every measure; thus, separating the businesses into those with the default and those without default risks (Danielsson 2011). There is also the risk index models used by Tamari in 1966, and they assign points to the companies and use the results of various ratios as their basis (Danielsson 2011). Moreover, there is also the multivariate discriminant analysis, which is based on the five financial ratios, and it estimates the risk of insolvency in the subsequent one or two years (Danielsson 2011).

Research Gap

Even though there has been an increasing number of literature on risk management and SMEs recently, it is still incomplete, and it does not focus on fiscal risk control. The current research aims at filling the existing void by providing the information relating to financial risk management, and the manner in which the SMEs can use financial analysis in order to prevent the risks. The existing literature focuses, primarily, on the large entities and fails to recognize the small and medium enterprises. As indicated earlier, there are numerous differences between the SMEs and large businesses; therefore, the current research will seek to close the void by researching on the SMEs in the GCC. Different authors and researchers have identified that there is a missing focus on SMEs in risk management. For instance, Verbano & Venturini (2013) compared and analyzed thirty-five empirical studies and found out that they mainly focused on large organizations and only a few of them discussed the financial risk management.

Industry Background

The Gulf Cooperation Council consists of the Arab states located in the Persian Gulf. Its member states include the UAE, Saudi Arabia, Kuwait, Qatar, Bahrain, and Oman (Ashoor 2013). The council is influential in different aspects of the region including the social, political, and economic development. The SMEs are significant within this region. They provide innovation and vitality, skilled and unskilled employment, promote economic stability, and diversify economic competition. Official data indicate that there are more than 800,000 SMEs operating in the GCC (Fisher n.d.).

The countries in the GCC have implemented different programs aimed at supporting the development of SMEs due to their importance in the economy. They aim at assisting the SMEs in overcoming some of the challenges that they face. They require financial assistance so as to develop and test the new business models. Consequently, the current research aims at identifying the use of financial analysis as a tool for financial risk management among SMEs in the region. The purpose is to provide adequate information that can be applied by the SMEs so that they can improve their performance by overcoming their financial risks.

Research Aim

In general, the current research aims at providing adequate information on the use of internal financial analysis by the SMEs in order to manage their financial risks.

Research Questions

  1. What are the impacts of financial risks on the small and medium enterprises in the GCC?
  2. How can financial analysis be applied in the management of financial risks by the SMEs in the GCC?

Hypothesis

The use of financial analysis by SMEs will assist them in identifying, analyzing, and monitoring internal financial risks.

Objectives

  1. To establish the effect of financial risk management on the SMEs operating in the GCC.
  2. To explore the gap in the existing research relating to financial risk management in SMEs.
  3. To provide a solution for financial risk management in SMEs through financial analysis.

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Research Methodology

Sometimes, methodological issues make it difficult to determine the particular knowledge, skills, and major characteristics that are essential for accomplishing responsible work that predetermines performing creative tasks. The methodology applied in this study will be based on the questionnaires for gathering the primary data. The data of the research will be qualitative and quantitative. They will be systematized and analyzed, and some proper classifications will be derived, as well as appropriate advice will be developed. The research methodology will outline the research design, philosophy, and data collection methods. It will also clarify the importance of the study and the sectors of the market, on which it will focus. Finally, it will explain the approaches to be used in order to ensure validity and reliability. It will also justify the importance of triangulation in the research.

Research Strategy

There are different strategies that can be applied in the research. However, the most appropriate strategy is the one that suits the research objectives and questions. The current study will undertake a case study perspective. It is an extensive approach to most small-scale qualitative research, and it is often applied in the investigation of the key issues in a given problem (Denscombe 2010). It is a useful strategy in business research when there is a need to analyze a given sector, industry, or industries. The strategy fits appropriately in the current research as its main aim is to explore the subject area in depth so as to gain understanding, as opposed to, mere confirmation or quantification.

Research Philosophy

The applied research philosophy will be based on human beliefs, as well as values that exist in the natural business environments (realism), management and those that affect the managerial interpretations of financial analysis. Humans tend to be vigorously responsive to any change in the behavior or environment. The study will comprise an intentional change in the mode of response from the individuals involved in the study. The organizational financial documents indicate the reality of the business operations, and it the best basis to identify the risks that it could be facing. The alterations in the industry also affect the risk level of the organization, and it is vital to understand this effect. The research also aims at describing the reaction of organizations to different situations in the real-life and any change that they face, whether it is positive or negative.

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Research Approach

The applied research approach will be in an inductive form; it means that the research will begin with the particular observations, the formulation of a hypothesis, and lastly the evaluation of the data to come up with a conclusion. The applied systematic model means that the procedure will not take much time as compared to other procedures because it has specified time frames, as well as allocated slots for each process. It is very applicable as it starts with a specific sample and theories to prove it and merge with general theories and a sample conclusion that represents the whole population. The raw data texts will be condensed to form a summary format, after which they will help to model the underlying processes that are evident in the purpose of the study.

Time Horizon

The analysis that is to be used in this study is a cross-sectional one, which means that the research will comprise a collection of data from a well-chosen population within the population space at a given time. The approach implies that the data, with which the research comes up, are reliable to represent the entire population that is to be studied. The research is guided by the step-by-step approach that is designed to assist in achieving the final results. It clearly determines the data to be collected, the scope of the study, and the methods that should be followed as discussed further in other areas of this document. The data will be collected only once from every distinct source, but the results will be used in making the conclusion that holds over time unless proved wrong.

Data Collection

It will use both first-hand and secondary data. The secondary data comprises the review, scrutiny, and discussion of the obtainable information that had been gathered from the previous research. Primary data consist of the information that has been collected for the following research goal and questions. It is vital to understand the managements’ perspectives on the research issue in addition to conducting the case studies. Such data is usually first-hand and is usually not manipulated. The data required for the study will be useful in the provision of the recommendations.

The respondents will be approached to respond to the direct and straightforward questions on the application of financial analysis in the management process. It happens that there are other studies that might have been conducted on the same topic or closely related to it. These sources can be of help because it is easy to analyze the data that has already been compiled, and one goes straight to what he/she wants rather than contacts a large number of respondents for their replies. The fact that they do not provide the first-hand information does not mean that they are compromised or should be avoided.

There are several websites that may be of assistance, and surfing the web pages will be one of the key secondary sources of data in this research. There are also several books and documents, for example, the company records, which can be of great assistance when it comes to understanding the research issue. The data will later be analyzed, before the actual interpretation. The analytical presentation methods are always easy to comprehend and, thus, should be embraced. They include the arrangement of data in terms of the similarities and differences, as well as their relationship levels. Responses from the questionnaires can be arranged in the tabular forms, with the positive and negative columns being distinct. Data from these sources can also be computed as per numbers put on a particular side, which makes it easier to compute the level (in percentage form) of how effectively different parties perform their responsibilities.

Sampling

In the study, the selection of the participants will focus on SMEs in the GCC. The study will use stratified unsystematic sampling as the target populace is divided into divisions, which include the service, commercial, trade, and manufacturing SMEs. The samples will include different SMEs whose managers will be used as participants in the study. However, after the sampling, only the willing individuals will be included in the study. Their confidentiality will also be assured, and the information will not be used for any other purpose except for the research.

Equipment

The equipment to be used for collecting the primary data will be the well-developed questionnaires. In order to develop questionnaires that will collect adequate information, there will be references to the previously used questionnaires. The respondents will be allowed to respond to the questionnaires during their free time.

Gulf Cooperation Council

The GCC was formed so as to promote unity and harmony. It has supported the regions’ commercial, societal, and political power. It is formed by the UAE, Saudi Arabia, Kuwait, Qatar, Bahrain, and Oman. The region’s economic power is dependent upon various economic factors, and the SMEs are vital in promoting success. However, limited research has been conducted in relation to the issues facing SMEs in the GCC region. It is also shown that the SMEs are not exploited to their full potential. However, the region lacks a clear definition of SMEs. They use different definitions provided by the individual countries (Ashoor 2013). Mainly, their definitions use three main criteria, which include the number of employees, annual turnover, and assets of the company.

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