FINANCIAL RISK MANAGEMENT IN SME

FINANCIAL RISK MANAGEMENT IN SME - THE USE OF FINANCIAL ANALYSIS FOR IDENTIFYING, ANALYSING AND MONITORING INTERNAL FINANCIAL RISKS! MASTER THESIS September, 2011 Aarhus School of Business, Aarhus University MSc. In International Economic Consulting Author: Ann-Katrin Napp Academic Supervisor : Stefan Hirth

Abstract Motivated by the finding that existing literature and research on risk management misses the focus on small and medium sized enterprises (SME), the aim of this thesis was to propose a mean for SME to manage their internal financial risks. Similar to large companies, SME do also face business risks, which in worst case can cause financial distress and lead to bankruptcy. However, although SME are a major part of the German - and also international - economy, research mainly focused on risk management in large corporations. Due to differences in characteristics and resources, in various fields ranging from management over structure and IT systems to specialty of knowledge, large corporations practices cannot easily be adapted to SME. Therefore the aim was to suggest a possible mean for the risk identification, analysis and monitoring, which can be applied by SME to manage their internal financial risks. For this purpose the financial analysis, which has been used in research to identify indicators for firm bankruptcy, was chosen. An overview was developed, which allows identify risks and negative developments in the main critical areas of internal financial risks to SME, namely liquidity, financing and solvency. The identification, analysis and monitoring is based on a set of financial ratios, which have been proven efficient for risk identification in various researches. To enable a classification of the risk situation, the company data is compared to data of two groups. On the one hand data of bankrupt companies marking the critical area, and on the other hand that of successful companies as a positive benchmark. In comparison to those two groups, the actual risk situation of a SME can be analysed and critical aspects from financing, liquidity or solvency can be identified. Especially when using plan data in the overview, critical developments can be observed at an early stage. At this point further research could identify ways and standardized structures for the SME to go deeper into analysing the sources of the identified risks as well as to handle them. For this, as for the whole process, the characteristics of SME have to be taken into account, too. Therefore the suggested overview is a first and comprehensive mean for analysing and monitoring the overall financial risk situation of SME. It is designed to fulfil their needs as it takes their characteristics into account and can be the base for further research in the field of SME risk management. I

Table of contents 1.! Introduction... 1! 1.1.! Context and research question... 1! 1.2.! Methodology and structure of thesis... 2! 1.3.! Delimitations and validity... 3! 2.! Theoretical overview... 3! 2.1.! Definition of main terms... 3! 2.1.1.! Definition of risk... 4! 2.1.2.! Definition and aim of risk management... 5! 2.1.3.! Definition of small and medium sized enterprises... 7! 2.2.! Risk management in theory... 7! 2.2.1.! Process of risk management... 7! 2.2.2.! Risk categories... 13! 2.3.! Financial risk management... 13! 2.3.1.! Financial risks... 13! 2.3.2.! Financial risk management without derivatives... 16! 2.3.3.! Financial risk management with derivatives... 17! 3.! Literature review... 19! 3.1.! Risk management in SME... 19! 3.1.1.! Differences between SME and larger corporations... 19! 3.1.2.! Deficits in literature... 25! 3.1.3.! Important aspects of financial risk management in SME... 27

3.2.! Financial analysis... 27! 3.2.1.! Use of financial data and ratios for risk identification... 27! 3.2.2.! Methods of financial analysis... 30! 3.2.3.! Limitations of financial analysis... 35! 3.2.4.! Financial analysis as a mean for risk management in SME?... 35! 4.! Use of financial analysis in SME risk management... 37! 4.1.! Development of financial risk overview for SME... 37! 4.1.1.! Framework for financial risk overview... 37! 4.1.2.! Evaluation of ratios for financial risk overview... 39! 4.1.3.! Choice of ratios for identifying and monitoring financial risks... 47! 4.1.4.! Comparison data for the risk overview... 49! 4.2.! Example for the use of the financial risk overview: case study... 52! 4.2.1.! Case company... 52! 4.2.2.! Overall financial risk situation of the case company... 53! 4.2.3.! Possible extensions... 57! 5.! Critical review and conclusion... 59!

List of tables Table 1: Ceilings for small and medium sized enterprises... 7! Table 2: Overview of risk categories and ratios... 33! Table 3: Average risk ratios of non-bankrupt group and bankrupt group... 49! List of figures Figure 1: Structure of the thesis... 2! Figure 2: Risk management process... 8! Figure 3: Risk factors of SME, their possible results and matching financial ratios... 38! Figure 4: Development of total debt/ total assets ratio... 40! Figure 5: Development of working capital / total assets ratio... 42! Figure 6: Development of sales / total assets ratio... 43! Figure 7: Development of EBIT / total assets and net income / total assets... 46! Figure 8: Development of net income / sales and operative income / sales... 46! Figure 9: Ratios for financial risk management overview... 48! Figure 10: Case company analysis of debt / total assets... 53! Figure 11: Case company analysis of long-term assets / (long-term debt + equity)... 54! Figure 12: Case company analysis of working capital / total assets... 54! Figure 13: Case company analysis of EBIT / total assets... 55! Figure 14: Case company analysis of retained earnings / total assets... 56!

1. Introduction The first section provides an introduction to the thesis. Hereby the context of the thesis, the research question and the structure of assessing the topic as well as its limitations will be presented. 1.1. Context and research question Risk and economic activity are inseparable. (Liekweg & Weber, 2000, p.277) Every business decision and entrepreneurial act is connected with risk (Stroeder, 2008, p.135). This applies also to business of small and medium sized enterprises as they are also facing several and often the same risks as bigger companies. In a real business environment with market imperfections they need to manage those risks in order to secure their business continuity and add additional value by avoiding or reducing transaction costs and cost of financial distress or bankruptcy (Hermann, 1996, p.38 Oosterhof, 2001, p.2). However, risk management is a challenge for most SME. In contrast to larger companies they often lack the necessary resources, with regard to manpower, databases and specialty of knowledge to perform a standardized and structured risk management. The result is that many smaller companies do not perform sufficient analysis to identify their risk. This aspect is exacerbated due to a lack in literature about methods for risk management in SME, as stated by Henschel (2008): The literature on risk management being available mainly concerns the implementation in very large joint stock companies. (Henschel, 2008, p.48) Although their economic and social impact is important and they differ in many aspects from larger corporations, most empirical studies about corporate risk management focus on the latter ones (Vickery, 2006, p.446; Rautenstrauch & Wurm, 2008, p.106). The two challenging aspects with regard to risk management in SME are therefore: 1. SME differ from large corporations in many characteristics 2. The existing research lacks a focus on risk management in SME The theory about the risk management process is not sufficiently applicable to small and medium sized companies, as it has to consider their characteristics and needs. With focus on German SME and their internal financial risks, this thesis will therefore try to 1

convert the theory of financial risk management into practice in a way that it is applicable for small and medium sized companies. The following research question will be central to this work: How can SME manage their internal financial risk? And further: Which aspects, based on their characteristics, have to be taken into account for this? Which mean fulfils the requirements and can be applied to SME? 1.2. Methodology and structure of thesis The research question is followed in different steps, which are presented in figure 1: Figure 1: Structure of the thesis Source: author s illustration After introducing the topic of the thesis, chapter 2 will provide the theoretical background for this work. Here the main terms will be defined and a theoretical overview of risk management will be given. In chapter three a literature review will give insight into the status quo of research. The focus will be on differences between SME and large companies especially with regard to risk influencing characteristics and the use of risk management. Furthermore financial analysis and the possibility of using it as a mean for risk management will be introduced. Additionally it will be pointed out where there are deficits regarding the applicability of the theory on small and medium sized enterprises and what the requirements, defined by their characteristics, for risk management in SME are. Based on those results the financial analysis and the risk management process will be connected in the fourth chapter in an overview. This overview shows a possible solution 2

of how smaller companies can use the theoretical approaches to identify, analyse and monitor their internal financial risks. Finally, the overview will be applied in a case study of a medium sized company, whose risk situation will be analysed. Chapter five concludes the thesis and provides a concluding and critical review. 1.3. Delimitations and validity The following work presents an overview for internal financial risk management in SME. This overview, however, concentrates on the risk identification, analysis and monitoring on the top level of the SME. It should be seen as a first step for the risk management and point to the relevant categories, which have to be assessed in detail. This further assessment is not part of the work. The same accounts for possible measures to cope with the identified risks. Depending on the company, its specifics and business environment it needs to be decided what to do in next steps. With regard to validity of the data, which is the base for the risk overview, the following has to be stated. The choice of the ratios for the overview has solely been based on the results and data from different research papers. For this part no further data has been collected by the author. The results of the analysis are therefore based on the papers and could change slightly when using datasets from a different country, sector or decade. Nevertheless the ratios have been chosen with regard to maximize their significance and accordance. 2. Theoretical overview In the following the theoretical background for the thesis will be given. For this first the main terms of the thesis will be defined, after that risk management, how it is found in theory, and especially financial risk management will be presented. 2.1. Definition of main terms For a better understanding of the theory, first of all the terms risk, risk management and small and medium sized enterprises, will be defined as they are understood in this work. 3

2.1.1. Definition of risk 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). This uncertainty connected with every kind of business activity is risks. Although this term is of central importance, there does not exist an overall definition of the meaning of risk (Wesel, 2010, p.280). As a first step for the definition, similar terms, which are often used exchangeable in every day s speech, need to be distinguished, namely: uncertainty, danger and risk. Uncertainty is used when the outcomes of future events are uncertain and the different states cannot be connected with probabilities of occurrence (Stroeder, 2008, p.136) The term danger in general stands for unplanned and unpredictable outcomes having a negative impact on something. Like those two terms, risk summarizes events that are uncertain regarding their outcome. The difference is that in the case of risk, the outcomes can be connected with a probability of occurrence (Stroeder, 2008, p.136). Furthermore, risk can be split into two categories. On the one hand there are pure risks or systematic risks, which cannot be influenced by the manager and are independent of business decisions. On the other hand there are unsystematic risks, which are the result of managerial decision-making and can either have a negative or a positive outcome (Stroeder, 2008, p.140; Retzlaff, 2007, p.11). However there are differences in the definitions of risk. First of all some include also possible positive outcomes of a risk, also referred to as upside risks or chances. Other only define the possible occurrence of negative outcomes, or downside risks, as risks because they are more in the focus of the management (Dhanini et al., 2007, p.74). The inclusion or exclusion of chances is not the only difference in the common definitions. They range from (negative) deviations of planned outcomes, over danger of making wrong decisions to danger of losses due to information lacks (e.g. Nassauer & Pausenberger, 2000, p.264; Hermann, 1996, pp.7-11). When focusing on the common features of the definitions, risk is the possibility of deviation from a planned outcome or goal. This implies that all business is connected with risks resulting from the fact that future states of the world and outcomes of decisions can only be predicted. As business activities are uncertain regarding their outcome and this uncertainty implies risks to the profit of the firm, a company needs to manage its risk exposure (Retzlaff, 2007, p.9). 4

2.1.2. Definition and aim of risk management The term management can be derived from the Latin word manus (= hand) and means handling. In a business context management is the organisation, administration and leadership of a company (Duden online, 2011). Risk management is therefore the organisation, administration and leading of risks in the company. The roots of risk management can be found in the insurance sector in the 1960s (Form, 2005, p.109). The acquisition of insurance makes it possible to secure business against systematic risks. Over time the understanding of risk management was extended and now also includes the management of unsystematic risk (Stroeder, 2008, p.142). The inclusion of managing unsystematic risks is in contrast with the theory of Modigliani and Miller. They proposed in their paper from 1958 that in a perfect market financial decisions will not influence the firm value. According to them, companies therefore do not need to manage their risks or hedge to protect against possible losses caused by unsystematic risks (Dhanini et al., 2007, p. 73; Oosterhof, 2001, p.2). The market does not price such actions. The only thing that is priced is the systematic risk of the companies (Miller & Modigliani, 1958, p.296). This is based on the assumption that each investor modifies his portfolio according to his risk preference by diversification. Therefore risk does not need to be managed by the company (Berk, 2009, p.283). Nevertheless management uses risk management to decrease the volatility in earnings (Dhanini et al., 2007, p. 73). This is because of market frictions that are absent in the Modigliani-Miller world, which means that corporate risk management can only be relevant if markets are imperfect. (Oosterhof, 2001, p.2) In real business environment there are market imperfections, which are absent in the Modigliani-Miller assumptions. Corporate risk management can therefore add additional value to the shareholders although the financial theory of Modigliani Miller says it is obsolete (Oosterhof, 2001, p.2). One aspect is that in reality not all investors are likely to have the opportunity to diversify their portfolios. Moreover, under the perfect market assumptions taxes and transaction costs are neglected. These factors are however part of reality and might make risk management reasonable (Berk, 2009, p.384). Furthermore there are costs related to defaulting, like direct costs of bankruptcy or financial distress (Triantis, 2000, p.560). In the long run, which is the perspective of 5

the theory, gains and losses due to volatility might even out. However this might be different in a short-term point of view, which is important to the company. In the short run, losses might lead to financial distress and cause costs to the company, which can be avoided by risk management (Dhanini et al., 2007, p.73). Another aspect are indirect costs associated with difficulties of entering contracts under high risk of defaulting, which can also be avoided or at least reduced (Triantis, 2000, p.560). The indirect costs of entering contracts refer to stakeholders of the company that are neglected in the theory of Modigliani and Miller. Suppliers, employees and banks, might suffer from the occurrence of a risk (Berk, 2009, p.384). Due to that, stakeholders might demand a premium for entering a business relationship with the company (Triantis, 2000, p.560). The premium paid to banks is even more present, since Basel II is in force. The aim of the act is to increase the stability in the banking sector. One way to achieve this is that banks are obliged to have a risk sensitive amount of equity for each loan outstanding. The higher the risk of the debtor the more equity is required from the banks to support the loan. Risky loans cause higher costs to the bank. Therefore interest rates for loans include a risk premium, which depends on the default risk of the borrower (Schönborn, 2010, p.13). Although Basel II does not explicitly demand the implementation of a risk management system, when rating a company the bank will check the existing management instruments and also the risk assessment (Henschel, 2008, p.4). The existence of a risk management can improve the rating of a company and increase the likelihood of access to new capital and decrease the interest rates for credit financing (Jonen & Simgen-Weber, 2008, p.102). Research has shown that risk management can add value to the firm when market imperfections like progressive taxing of the company, expected costs of financial distress or agency problems are present (Oosterhof, 2001, p.2). Therefore risk management can be of value not only to the investors of a company but also to its other stakeholders (Berk, 2009, p.384). Its overall aim is to secure business continuity and support the achievement of the company s goals by preventing dangerous situations in an efficient way (Hermann, 1996, p.38; Retzlaff, 2007, p.14). However, it is not the goal to offset each single risk the company is confronted with, as risk is essential to business activity and risk elimination also decreases chances (Liekweg & Weber, 2000, p.280). Risks are part of doing business, but should be managed appropriately in a risk management process, which will be presented in section 2.2.1. 6

2.1.3. Definition of small and medium sized enterprises 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 (Hermann, 1996, p.3). According to latest statistics of the European Commission, SME represent around 99% of all companies in Germany as well as in the EU. (European Commission, 2011; IfM Bonn, 2011). More than every second employee works for a SME and over one third of the German annual turnover is earned by SME (IfM Bonn, 2011). Those statistics are based on the definition of SME from the European Commission. Their latest definition for SME was established 1.January 2005 and it states three criteria for defining SME: number of employees, annual turnover and balance sheet total. At least one of the financial criteria needs to be fulfilled in addition to the number of employees criteria (European Commission 2011). The ceilings for small, medium sized enterprises are the following: Enterprise category Headcount Turnover Balance sheet total Small sized < 50! " 10 million! " 10 million Medium sized < 250! " 50 million! " 43 million Table 1: Ceilings for small and medium sized enterprises Source of data: European Commission (2011) Next to this definition, there are also others used among researchers in different countries. Some definitions distinguish the branch of business for classifying the company into small, medium or large (Hermann, 1996, p.117). Most often, however, the quantitative EU criteria are used (Wesel, 2010, p.32). 2.2. Risk management in theory The following section will provide insight into the theory of risk management by presenting first the risk management process and then different categories of risk. 2.2.1. Process of risk management The different tasks of risk management are structured in a process of chronological phases (Form, 2005, p.121). Although different researchers define the phases similarly, the definitions to be found in the literature differ in the way the tasks are ordered into the phases. Furthermore the wording differs also, although the tasks to be done in the 7

process stay the same (Hermann, 1996, p.40). Therefore the difference in the definitions does not change the general steps of the process, which are visualized in figure 2. Figure 2: Risk management process Source: author s illustration First of all a company needs to understand the sources of risk it is exposed to, to be able to manage those (Triantis, 2000, p.571). Therefore the process of risk management starts with the identification of risks. This is followed by the analysis and evaluation of risks (Form, 2005, p.122). After that, in the risk assessment, the best ways to handle the identified risks and how this handling can be included into daily business are evaluated (Triantis, 2000, p.571). The final step of the process is the risk monitoring, which becomes part of the daily business until the process is started again from the beginning (Form, 2005, p.122). These phases are presented in detail in the following. Before entering this process however, the goals and expectations of the business need to be specified in order to structure and implement the risk management process (Hartman Schenkel, 2003, p.39). This is especially important due to the fact that when risks are limited, also opportunities might be limited (Liekweg & Weber, 2000, p.280). Maximum accepted risk levels or losses should therefore be defined beforehand. The maximum risk should be set appropriately according to the expected return and opportunities involved (Liekweg & Weber, 2000, p.283). Furthermore it should be defined from which value on, a risk is classified as essential or as problematic and from when on prevailing actions start. Then the risk management process can be started (Wesel, 2010, p.292). Risk identification The first phase is risk identification. The aim of this phase to identify all risks, which could interrupt or damage the business development (Hermann, 1996, p.41; Stroeder, 2008, p.212). The risks that should be identified can either have a negative impact on the balance sheet, the financial statement or the cash flow situation of the company and therefore also on its development (Wesel, 2010, p.282). This identification is of great 8

importance as only identified risks can be handled successfully in the next steps of risk management (Stroeder, 2008, p.212). The uncertainties of the company and critical factors of the business can be identified by checking the business processes with regard to their risk potential (Form, 2005, p.122; Liekweg & Weber, 2000, p.284). Here, two different approaches are possible, referred to as the progressive and the regressive approach. The progressive approach aims to identify possible plan deviations and losses based on typical risk factors (Hermann, 1996, p.41). Those risk factors can be of different origin; as for example they can result from changes in the markets, legal aspects, company intern aspects or financial factors (Liekweg & Weber, 2000, p.284). The second approach is regressive, starting the other way around with the main goals of the company and trying to find possible reasons among the risk factors that could lead to a deviation from the goals (Hermann, 1996, p.41). Risk identifying techniques of the approaches are either creative or analytical. In the group of creative tools, mainly brainstorming, interviews and a subjective assessment of the risk are used. When using analytical tools, for example flow charts or a cause and effect analysis are mainly applied in the regressive approach and checklists of risk categories and factors are mainly applied in the progressive one (Hermann, 1996, p.41). With both approaches, there is no detailed general procedure for identifying the relevant risks. All techniques aim to find the areas where possible deviations from plans or goals can evolve, due to risk factors. The experience and knowledge of the management and their ability to gather relevant information are of main importance in this process (Hartman Schenkel, 2003, p.40). Also with regard to saving resources, based on experience the management can eliminate irrelevant risk factors already in the beginning (Scheve, 2005, p.46). In order to identify all risks and react with an appropriate timeline, the management needs actual and complete data (Stroeder, 2008, p.212). However, a problematic aspect of the risk identification is that while the aim is to use as detailed and accurate information as possible to identify all and also new risks, the identification should not demand too many resources of the company (Hermann, 1996, p.42). The completeness of information is contradicting the aim for economical reasoning of the process 9

(Hermann, 1996, p.42; Stroeder, 2008, p.212). Partly standardized processes or setting a level from where on risks should be taken into account can help to solve the conflict of goals. Moreover, the company can focus on certain areas, where it can be expected that more and also more important risks are occurring (Stroeder, 2008, pp.212-214). Risk analysis and evaluation Once the risks are identified, they need to be analysed and evaluated. The separation of the first and the second phase of the risk management process is not clear, as they are directly based upon each other. Furthermore defining a process or position as a risk can already be viewed as an analysis or evaluation (Hermann, 1996, p.42). However, this does not change the process, where after the identification the risks are categorized and then evaluated. The aim of the risk evaluation is to determine the degree of the identified risks and quantify their financial impact on the company. It is therefore necessary to analyse in which way the risk could affect the business (Hermann, 1996, p.42; Liekweg & Weber, 2000, p.285). In order to get a better overview, the identified risks are first clustered or categorized based on the field of risk, for example whether it is market or financial risks. More specifically the source of origin determined by the single risk factors of the risk fields can be used (Stroeder, 2008, p.217; Form, 2005, p.123). The clustering allows for a company to later analyse whether some of the risks are related and whether some of them offset each other (e.g. in and outflows in a foreign currency). Furthermore the clustering will assist to identify the main risks of business, which is of help for future analysis and focus of risk management (Nassauer & Pausenberger, 2000, p.269). Next the influence of the different risks and their potential harm to the company needs to be evaluated. This will require an identification of the costs to the company in case the risk occurs as well as the probability of occurrence (Scheve, 2005, p.46). With help of those values the expected damages of the risk positions can be calculated and the single risks can be evaluated (Hermann, 1996, p.43; Scheve, 2005, p.74). However, a quantification of the impact is in most cases not possible, as the future outcomes are uncertain. Therefore companies need to rely on estimations (Nassauer & Pausenberger, 2000, p.270; Liekweg & Weber, 2000, p. 286). Both quantitative and qualitative methods can be used for this estimation (Boutellier, Fischer & Montagne, 10

2009, p.1). Quantitative methods involve the use of statistical programs in order to simulate, calculate and forecast the influence and occurrence of the risk (Liekweg & Weber, 2000, p. 286). When using qualitative methods, the risks frequency and impact are evaluated based on experience and assessment of the company s management and employees (Boutellier, Fischer & Montagne, 2009, p.2). In both cases the aim of the estimations is to get an overview about the potential loss resulting from the different risks (Form, 2005, p.123). The risks may then be ranked based on the expected loss or visualized in a matrix with regard to the magnitude of their effect and the probability of occurrence (Liekweg & Weber, 2000, p.287). To further assess the importance of managing the single risk positions, the impact of the risk should be compared with the maximum tolerated loss, which should be defined in the risk strategy. At least those positions exceeding the tolerated loss or threaten business continuity need to be assessed in the third phase of risk management (Wesel, 2010, p.295). Nevertheless, determining the accurate damage that can be caused by the risks, as well as the probability of occurrence can be difficult in practice (Hermann, 1996, p.43). In order to determine the possible loss with quantitative methods, objective and large data sets are necessary for statistical analysis. Larger corporations as well as bank and insurance companies have access to those data sets and the IT systems to evaluate them (Boutellier, Fischer & Montagne, 2009, p.8). Smaller companies in most cases do not have those resources and therefore have to rely on qualitative methods (Wesel, 2010, p.300). As those evaluations are subjective, experience from the past is essential and a huge help in this phase of the risk management process (Hermann, 1996, p.43). Risk assessment According to the risk willingness, measures to handle the risk will be chosen in the third phase (Wesel, 2010, p.300; Hartman Schenkel, 2003, p.42). Those measures range from risk avoidance or prevention, over risk reduction, to transfer of risks and finally acceptance of the risk (Henschel, 2008, p.7). A simple measure to handle an identified risk position is to decide to avoid the risk (Form, 2005, p.124). However, the company has to accept that avoiding single risks eliminates besides the risk also all activities and chances connected with it (Stroeder, 2008, p.250). The abandonment of possible gains of risky activities is not always 11

possible and also not aimed when doing business (Hartman Schenkel, 2003, p.42). Instead the company can decide to keep the chances and reduce the expected damage (Hermann, 1996, p.45). This can be achieved by either decreasing the probability of occurrence of the risk or limiting its financial impact (Form, 2005, p.124). The probability of some risks can be reduced by strategic handling and surveillance. In case the risk cannot be reduced within the company, external parties are needed and the reduction is achieved by transferring the risk to a third party (Stroeder, 2008, p.250; Form, 2005, p.124). Those can be institutions as insurance companies or markets, where opposed risks can be matched or are transferred to someone who can better handle them (Hartman Schenkel, 2003, p.42). The last possibility is to fully accept the risk of a position (Form, 2005, p.124). This is the opposite of risk prevention and can be an alternative when for example the risk is not regarded dangerous and the benefits from insurance are smaller than the costs (Hermann, 1996, p.45). Furthermore not all risks can be insured. When the risk is closely connected to the core business, eliminating the position is not possible and the company can decide to accept the risk (Stroeder, 2008, p.251) In order to choose the appropriate measure for each risk position, the importance of the risk position for the company and the urgency to mange it need to be considered (Wesel, 2010, p.296). As a result, most companies employ a mix of all four risk measures (Henschel, 2008, p.7). Risk monitoring At the last phase of the risk management process it should be checked with a risk monitoring whether the risk identification, evaluation and assessment have been successful (Hermann, 1996, p.48). This phase is crucial for taking appropriate measures in time in case deviations between the actual and planned risk situation are identified (Henschel, 2008, p.54). The monitoring should therefore include developments of the risk positions and measures to control them (Form, 2005, p.126). Moreover the overall risk situation of the company should be compared to the plan and the risk strategy and deviations should be documented (Liekweg & Weber, 2000, p.290). When identifying differences, the risk management process should be started all over again. In iterative learning the next circle of the risk management process will start (Hermann, 1996, p.48). 12

2.2.2. Risk categories In general risks can occur everywhere within the company or its business environment. Operational risks, financial risks and organizational and management risks are internal risks as they have their source within the firm (Henschel, 2008, p.8). External risks occur in the business environment of the company and can be economical, technological, political, legal or cultural changes (Scheve, 2005, p.26). Economic risks apply to all companies, as they include the influence of macroeconomic variables on the company, its input factors and demand for the firm s products (Triantis, 2000, p.558). As this category covers risks, which depend on changes in financial markets, it is also often referred to as external financial or market risks. The main risk factors in this category are changes in interest rates, exchange rates and commodity prices (Triantis, 2000, p.559; Eckbo, 2008, p.542). However financial risks can also occur independent of the development of international markets. Also the way of financing, liquidity and equity consumption due to losses can become risks to the company. All three risks are internal financial business risks (Hermann, 1996, p.153). According to a study of Henschel (2008), the most relevant risk categories for SME are internal and external financial risks, strategic risks and business process risks. His findings are also confirmed by other studies (Henschel, 2008, p.106). In the following, internal and external financial risks will be specified while the other risk categories will not be assessed any further. 2.3. Financial risk management The focus of the next sections is on financial risk management. First, the different financial risks and then possibilities of managing them will be presented. 2.3.1. Financial risks Financial risk management has received increased attention over the past years (Glaum, 2000, p.373). The reason for this is that financial risks, though they are not a core competency of non-financial firms, also influence their business operations to a large extend (Triantis, 2000, p.559). Financial risks can be of different forms. On the one hand there are external financial risks depending on changes on financial markets. On the other hand there are internal financial risks, where the company itself is the source of the risks (Eichhorn, 2004, p.43). 13

External financial risks are based on the risk factors of exchange and interest rates as well as commodity prices (Schönborn, 2010, p.3). These three risks will be assessed in the following: Exchange rate risk Exchange risk occurs when a company is involved in international business and the cash in or outflows are in a foreign exchange rate. As this rate is not fixed and cannot be fully anticipated a possible change in a foreign exchange rate leads to the risk of changes in the amount of a payable / receivable and by that a change in the amount of money the company has to pay / will receive. This risk is measured by the concept of transaction exposure (Glaum, 2000, p.375; Armeanu & Bãlu, 2007, p.65). Furthermore economic exposure can be included in the evaluation of exchange rate risk. This includes changes in the quantity of future sales due to changes in the exchange rate and therefore relative competitiveness of the company (Nassauer & Pausenberger, 2000, p.271). However, the prediction of this sensitivity is difficult and hardly measurable and thus the company cannot manage this risk actively. Most firms therefore concentrate on transaction exposure and by that on the price change and not the quantity change caused by the exchange rate volatility (Smithson, Smith & Wilford, 1995, p.6). Interest rate risk Interest rate risk is based on changes in interest rates and can be observed in different forms. The first form refers to changes in interest rates in connection with variable loans and short-term financing. A rise in the interest rate leads to higher interest payments for the variable rate loan and more expensive follow-up financing. This decreases the company s earnings and can in worst case it is lead to financial distress. Second, the vice versa case refers to cash positions of the company with a variable interest rate. A fall in this rate leads to a loss in earnings. Thirdly, also fixed rate debt contracts can be a risk for the company. In times of declining interest rates those contracts cause higher payments then a variable loan would do and are disadvantageous for the company. However, these costs are opportunity costs and not real costs to the company (Dhanini et al., 2007, p. 74). Therefore it can be summarized that the more corporate debt and especially short-term and variable rate debt a company has, the more vulnerable it is to changes in the interest rate (Dhanini et al., 2007, p.71). Finally demand sensitivity caused by interest rate changes can also be regarded as part of the interest rate risk. However, similar to economic exposure of foreign exchange rate risk, also the 14

prediction of this sensitivity is also difficult and hardly measurable. It is therefore in practice ignored for most products and companies (Schönborn, 2010, p.4). Commodity price risk A risk on the procurement market is the price volatility of commodities. This can become a significant risk for the company if the commodities are relatively important inputs with regard to price and/ or quantity (Stroeder, 2008, p.219). Fluctuations can then cause much higher (or also lower) procurement costs than anticipated and decrease (increase) the profit margin of the firm. In worst case the company makes a loss with the production (Eckbo, 2008, p.544). The group of internal financial risks consists of risks regarding the financing of the firm, liquidity risks or the solvency risk (Hermann, 1996, p.153). In the following, the three risks will be specified. Financing risk Firm financing can become a risk for the company due to different reasons. The choice between fixed rate and floating rate debt, the duration of the debt and the overall amount of debt financing are possible sources of risks, which already have been assessed in the paragraph about interest rate risk. The firm wants to be flexible and at the same time lower the costs for financing (Börner, 2006, p.298). The duration of loans is important in connection with the assets, which are financed with the loan. Here, often a mismatch between the durations can be observed. Longterm assets are then financed with short-term and adjustable rate loans, leading to a shortfall in cash flows in times of rising interest rates. This fact again can lead to a worse ranking of the company and worse conditions to get future loans. Furthermore difficulties regarding follow-up financing over the rest of the lifetime of the asset can occur. Vice versa long-term financing of short-term assets might lead to access financing when the asset is no longer existent. This causes unnecessary interest payments for the company (Vickery, 2006, p.447). Finally, a high amount of debt financing can become a risk to the company. In case the return decreases and is lower than the demanded interest rate, the company is not able to pay the interest without making a loss in that year. This consumes part of the equity and might lead to an even more dramatic situation in the next period (Hermann, 1996, p.156). 15

Solvency risk The partly or whole consumption of equity is another financial risk of a company when the company is not able to earn a profit for the year. However this is the result of other risks, which influence the business. Reasons can be a decrease in sales or an increase in costs for example the financing of the firm and high interest rates, which lead to a deviation from the plan and a loss. The result is a partly or whole consumption of equity in the period and loss of solvency (Hermann, 1996, p.154). Liquidity risk As well as consumption of equity, liquidity risk is mainly the result of other risks, which cause a deviation of the planned outcome and might lead to lower cash inflows or higher cash outflows. 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, p.121). A lack of financial funds can cause problems in the ability of the firm to pay its bills on time and by that lead to additional costs (Börner, 2006, p.298). On the one hand costs occur for arrears fees. On the other hand the rating of the company can be lower and therefore future financing leads to higher interest payments (Eichhorn, 2004, p.44). Due to that the financing risk becomes more urgent and can lead to higher liquidity and solvency risks. As external and internal financial risks can have a huge impact on the company and its business continuity, a management of these risks is essential also for non-financial companies. 2.3.2. Financial risk management without derivatives The reasons for managing financial risks are the same as those for implementing a risk management, as financial risks are a subcategory of the company s risks. One of the main objectives is to reduce the volatility of earnings or cash flows due to financial risk exposure (Dhanini et al., 2007, p.75). The reduction enables the firm to perform better forecasts (Drogt & Goldberg, 2008, p.49). Furthermore this will help to assure that sufficient funds are available for investment and dividends (Ammon, 1998, p.12). Another argument for managing financial risks is to avoid financial distress and the costs connected with it (e.g. Triantis, 2000, p.560; Drogt & Goldberg, 2008, p.49) Finally also managerial self-interest of stabilizing earnings or the aim to keep a constant tax level can be motives for financial risk management (Dhanini et al., 2007, p.76), 16

Depending on which of the arguments is in the focus of the company, the risk management can be structured. The focus is either on minimising volatility or avoiding large losses (Ammon, 1998, p.2). Internal financial risks Reduced volatility in cash flows or earnings and prevention of losses allow better planning of liquidity needs. This can avoid shortcuts of available funds and consumption of equity (Eichhorn, 2004, p.44). However, in order to maintain financially liquid and avoid end of period losses, it needs to be analysed which the maximum tolerated loss is. The focus of the risk management should therefore be in correspondence with the actual financial situation of the company. Then, by managing, among others, internal and external financial risks, also the liquidity risk and solvency risk are taken care of. Financing risk, which needs to be managed directly, mainly depends on a mismatch between the duration of assets and their financing. The company should therefore try to match the two durations in order to avoid problems with and high costs of follow-up loans. Furthermore this reduces the risk of having more debt than needed after the asset s lifetime and by that it saves interest costs (Vickery, 2006, p.447). External financial risks External financial risks depend on changes on the financial markets. One possibility to secure against price or exchange rate volatilities would be to buy or sell the amount, which is needed or will be received in the future, already today. However the organization of the transactions requires administrative work.. Furthermore this is sometimes not possible as the commodities cannot be stored or keeping them causes high costs. Foreign funds or debt causes work and costs in similar ways. Finally, the possibility to secure the interest rate exposure or change the conditions of the contract is often limited. This is because the specifics of debt contracts to a large extend depend on the credibility of the company and are not flexible (Brünger, 2008, p.122). 2.3.3. Financial risk management with derivatives For the management of external financial risks financial instruments have been developed, which match the characteristics of the different risks and can be used to assess these. As the instruments are derived from an underlying asset, as for example commodities, metals and oil or financial assets, they are called derivatives. (Chisholm, 17

2010, p.1) Futures, forwards, options and swaps are the first generation of derivatives (e.g. Armeanu & Bãlu, 2007, p.65; Berk, 2009, p.287). Other derivatives are mainly based upon the four main categories. However, they are more complicated and require mathematical tools and computer programs to analyze their effects (Armeanu & Bãlu, 2007, p.65). Therefore more advanced derivatives are not widely used by companies (Chisholm, 2010, p.112). The four derivatives have in common that the contract s performance is moved to a future date while the specifications are agreed upon today (Berk, 2009, p.287). By using them, the risk can be fully or partly moved to a third party that has the capacity for that risk or faces the opposite risk exposure so the two risks neutralize (Triantis, 2000, p.563). When the company has decided to hedge a risk position fully or partly, it needs to be evaluated which instrument suits best the purpose of the company. The group of linear instruments includes forwards, futures and swaps. They are used when the development of the cash flow is a linear function of the development of the risk factor, as for example when securing import and export transactions and interest rate exposures (Bartram, 2004, p.2; Brünger, 2008, p.122). All three instruments are binding for both parties of the contract. This means that by the day the contract is made, both parties exactly know when they will receive what (Chisholm, 2010, p.44; Albrecht & Maurer, 2008, p.577). In case of forwards and futures this includes a single transaction, while swaps are agreements between two parties to exchange streams of future payments. Therefore the first two are used to secure against volatile prices of the underlying assets and the latter to change the leg of a payment stream (Chisholm, 2010, p.2). Options, however, are nonlinear and mainly used for securing financial portfolios. Here the development of the cash flow is nonlinear and for example depends on price and quantity changes due to volatility of the risk factor (Bartram, 2004, p.2, Brünger, 2008, p.122). Another important difference to the other derivatives is, that only the person selling the option is obliged to fulfil the business stated. The buyer buys the right to decide at expiration date whether he wants to exercise the option and sell (buy) a financial position etc. (Chisholm, 2010, p.2). The advantage of using options is that losses at the date of maturity are limited but possible gains are not limited (Glaum, 2000, p.377). 18

However hedging in most cases also eliminates possible chances. Further the security achieved through hedging has its price due to fees for the instrument and the management s time involved in the process (Brünger, 2008, p.66). However, the administrative costs will decrease over time and with increasing routine. Furthermore the price for the hedge is lower the less specialized the instrument and the less volatility involved (Eckbo, 2008, p.550). 3. Literature review In the following chapter a review of the literature on risk management in small and medium sized enterprises and the financial analysis will be given. 3.1. Risk management in SME SME and larger companies differ in many aspects, also in risk management practices. The differences are discussed in the following. Furthermore deficits in literature are pointed out and important aspects for risk management in SME are derived. 3.1.1. Differences between SME and larger corporations The official EU definition of small and medium sized enterprises was presented in section 2.1.3. It concentrates on differences in size - of headcount, turnover and balance sheet sum - to distinguish between small, medium sized and large companies. However, SME differ from larger corporations not only in size but also in aspects of management structure, specialty of knowledge and position on procurement and financial markets. Furthermore - at least in Germany - a different legal framework applies to them. Those factors influence the business risk and also the risk management of the company (Krey & Rohman, 2008, p.363). Therefore they will be presented in the following. Management structure and specialty of knowledge In contrast to larger corporations, in SME one of the owners is often part of the management team. His intuition and experience are important for managing the company (Hermann, 1996, p.119; Pfohl, 2006, p.18). Therefore, in small companies, the (owner-) manager is often responsible for many different tasks and important decisions (Hermann, 1996, p.128). Two reasons for this can be found. First of all the concentration of power and competences might be due to structure of the company. Second, a lack of resources in SME often forces the management to fulfil other 19

positions in addition to the management of the company (Krey & Rohman, 2008, p.363). Most SME do not have the necessary resources to employ specialists on every position in the company. They focus on their core business and have generalists for the administrative functions (e.g. Retzlaff, 2007, p.37; Pfohl, 2006, p.20). Rautenstrauch & Wurm state that every second German SME lacks the resources to employ a risk manager (Rautenstrauch & Wurm, 2008, p.111). This is supported by findings of Henschel, who showed that the management is mainly responsible for financial planning and risk management (Henschel, 2008, p.117). However, the management often lacks the time, the information management systems and also the theoretical knowledge to go deep into the financial information of the company. The result is that many SME do not exercise a structured and standardized risk management (e.g. Hermann, 1996, p.119; Henschel, 2008, p.27). Position on Procurement Markets In contrast to larger companies, most SME offer a narrow and / or specialized product catalogue. Due to that, they demand only small amounts of input factors on procurement markets and cannot benefit from economies of scale (Hermann, 1996, p.148). Furthermore, SME are due to their size not in a dominant position on the procurement markets and can only marginally affect the conditions in contracts with their suppliers. In most cases they are dependent on them and receive worse conditions than larger companies (Krey & Rohman, 2008, p.364). This dependency is increased by the fact that SME use more external sources for their input factors than larger companies (Hermann, 1996, p.149). Capital Markets and Equity Another difference between large companies and SME can be found with regard to the financing of the firm. In contrast to larger companies, most SME do not have access to equity of capital markets, as they often do not fulfil the required standards. The main reason for this is that they are not as transparent as larger corporations, which publish their financial statements and annual reports. Furthermore, the amount of money that many of SME need is too small for this type of financing (Börner, 2006, p. 299). The limited possibilities for obtaining equity capital lead to relatively much lower equity ratios in SME than in larger companies. Behr and Güttler (2007) find that SME on average have equity ratios lower than 20% (Behr & Güttler, 2007, p.194). For 20

German SME, Börner (2006) finds that three quarters of them have an equity ratio of less than 30% and around one third of the companies has an equity ratio of less than 10% (Börner, 2006, p.302). These low ratios make bank loans the most important source of funding for SME (Behr & Güttler, 2007, p.194; Hermann, 1996, p.154). However, this funding can be costly due to the fact that banks evaluate the business, its risk and risk management to structure the lending conditions. Here, again the difference in transparency and management instruments in comparison to larger firms is a disadvantage for SME. For Belgian SME, van Caneghem and van Campenhout (2010) find that firms providing more and higher quality information to their banks are facing lower interest rates than those companies not providing the desired information material (van Caneghem & van Campenhout, 2010, p. 14). Without sufficient information, banks often associate loans to smaller companies with a higher risk. This higher risk assumption is based on the fact that SME in contrast to larger corporations do not diversify their risk in different business activities. A downturn in their field of business affects the whole company in a large degree and in general they face higher volatility in earnings than larger companies (Everett & Watson, 1998, p.373). The result is that banks decrease the maturity of loans and increase the interest rate (Anastasov & Mateev, 2010, p.273). The lower duration of debt for SME can lead to a mismatch between the duration of the assets and their financing, as long-living assets have to be financed with short-term loans. The need for follow up loans for the rest of the lifetime of the assets increases the bank dependency of SME and the risk of being credit constraint (Vickery, 2006, p.447). With regard to credit constraints Levenson and Willard (2000) find that especially young and small firms face financing problems (Levenson & Willard, 2000, p.83). In general, by being the largest creditor of the company, banks can gain a huge influence on the business and dominate the relationship (Hermann, 1996, p.155). The bank can exercise this power, as a change to another bank is difficult and costly for the company. The costs occur because the other institute does not possess the same information level as the former one and might therefore demand a higher risk premium on the interest rate for entering the business relationship (Behr & Güttler, 2007, p.195). Furthermore small amounts of equity in the SMEs balance sheets and their reliance on debt financing lead to the financing risk, which was explained in section 2.3.1. 21

Legal Framework For joint stock companies the Kontroll und Transparenz Gesetz (KonTraG), the German law of control and transparency, defines what has to be done with regard to risk management and control mechanisms (Henschel, 2008, p.3). The KonTraG highlights the management s responsibility to manage corporate risk and decides which aspects should be included in the risk management process (Nassauer & Pausenberger, 2000, p.266). However, this act only applies to joint stock companies and even excludes the small ones (Henschel, 2008, p.4). The only other German guideline for risk management is the German accounting standard number 5. This, however, only applies to corporations. In contrast to corporations and large stock companies, which are obliged by law in Germany to install and maintain a risk management system, SME do not find legal obligations to do so (Rautenstrauch & Wurm, 2008, p.106). The only legal framework, which directly affects SME, is the Basel II accord, which influences all types of companies via conditions for bank loans. However, Basel II does not demand the implementation of a risk management system and cannot force a company to do so. Nevertheless, when evaluating a company before giving out a loan, the bank will check the existing management instruments and also the risk assessment. Their presence and quality will affect the availability of capital and the conditions for it (Henschel, 2008, p.4). The changes in the legal environment as e.g. Basel II, have a major impact on the risk awareness of SME as they directly influence their business (Hartman Schenkel, 2003, p.60). Therefore SME should, even when not obliged to do so, implement a risk management and use the legal frameworks applying to large companies as a guideline for their risk management (Rautenstrauch & Wurm, 2008, p.107). Risk Management The different characteristics of management, position on procurement and capital markets and the legal framework need to be taken into account when applying management instruments like risk management. Therefore the risk management techniques of larger corporations cannot easily be applied to SME (Henschel, 2008, p.53). In practice it can therefore be observed that although SME are not facing less risks and uncertainties than large companies, their risk management differs from the practices in larger companies. The latter have the resources to employ a risk manager and a professional, structured and standardized risk management system. In contrast to 22

that, risk management in SME differs in the degree of implementation and the techniques applied. (Jonen & Simgen-Weber, 2008, p.98 f.) For example a study among small Swiss companies finds that many small companies have no explicit picture of business risk and that their risk management is often not well structured nor systematic or standardized (Hartman Schenkel, 2003, p.47). This is supported by Reuvid, who points out that a quarter of all companies is not ready to handle the risks they face (Reuvid, 2009, p.vi). Furthermore the picture in Germany is similar. Henschel (2008) finds in his study, that two thirds of the companies are not able to identify and measure the influence and impact of their business risks on their business. Surprising findings are also that around 40% of the surveyed companies do not identify their business risks and in addition to that 64% do not evaluate their risks properly (Henschel, 2008, p. 111-112). With regard to firm size and the use of risk management, Beyer, Hachmeister & Lampenius, (2010) observe in a study from 2010 that increasing firm size among SME enhances the use of risk management (Beyer, Hachmeister & Lampenius, 2010, p.116). This observation matches with the opinion of nearly 10% of SME, which are of the opinion, that risk management is only reasonable in larger corporations (Rautenstrauch & Wurm, 2008, p.111). Not only the general use of risk management but also its specifications and details differ between SME and larger companies. As Beyer, Hachmeister & Lampenius (2010) observe, the size of the company influences the variety of methods applied. Larger SME use on average one method more for the identification than small ones. On average each firm uses 3 to 4 different techniques for the risk identification. Astonishing is the fact, that around one third of the observed small and medium sized companies only applies one method to identify its risks (Beyer, Hachmeister & Lampenius, 2010, p.118). With respect to the methods used in the risk management process, the majority is subjective and only 4,8% of the surveyed companies use quantitative methods (Rautenstrauch & Wurm, 2008, p.110). Beyer, Hachmeister & Lampenius (2010) find that most of the surveyed SME identify risks with help of statistics, checklists, creativity and scenario analyses (Beyer, Hachmeister & Lampenius, 2010, p.118). Henschel (2008) reveals similar findings and state that most companies rely on key figure systems for identifying and evaluating the urgency of business risks. Next to that interviews and 23

checklists are used (Rautenstrauch & Wurm, 2008, p.109; Henschel, 2008, p.117). However, according to Henschel (2008), these methods are appropriate for SME. They should avoid estimations of probabilities of occurrence and instead concentrate on checklists and experience of management and key employees. Furthermore he says, they should state critical values and limits for acceptable deviations for evaluating and monitoring their business risks (Henschel, 2008, p.51). With regard to technical support, Henschel observes that the risk management process is supported in two out of three enterprises by standard IT programs such as Microsoft office. Special risk management software and other database programs are used by less than 2,5% of the asked companies (Henschel, 2008, p.119). After all risk have been identified and evaluated, small and medium sized companies decide in more than one third of the cases to bear the risk and do not use other measures to manage it (Rautenstrauch & Wurm, 2008, p.110). Supported are these findings by Henschel (2008), who states that SME to a large degree accept the risk they face in their business. Furthermore, when not bearing the risk, SME, in contrast to larger corporations, mostly only use insurances to manage it (Henschel, 2008, p.29). Larger companies use different methods and approaches to access and manage the different risk positions. One of them are derivatives to manage commodity price, exchange rate and interest rate risks (Henschel, 2008, p.29). Different studies show that larger firms are more likely to hedge as they can take advantage of economies of scale related to the price of the instrument. For example states Oosterhof (2001) that small firms face higher costs of hedging than larger corporations. This fact is reducing the benefits from hedging and therefore he advises to evaluate the usage of hedging for each firm individually (Oosterhof, 2001, p.12). The high costs as a decreasing factor in the usage of derivatives are also identified by Milo# Spr$ic (2007) in Slovenian and Croatian small and medium sized firms. The costs occur on the one hand when buying derivatives but on the other hand also when evaluating their benefits and managing them due to small expertise on that field (Milo# Spr$ic, 2007, p.409). The lacking expertise to decide about hedges in SME is also identified by Eckbo (2008). According to his findings, smaller companies often lack the understanding and management capacities needed to use those instruments (Eckbo, 2008, p.553). 24

In general lacking expertise and knowledge about risk management can be observed in SME. (Henschel, 2008, p.30) This lack, however, can itself become a huge business risk for SME. Almus (2004) and Wildemann (2005), point out that one of the most important reasons for insolvency of SME is the lack in the ability to identify critical developments of their business (Almus, 2004, p.192; Wildemann, 2005, p.235). Everett & Watson (1998) find that although a large degree of small business failures depend on external risk factors, the two main internal reasons for business failure are a lack of management skills and insufficient capital (Everett & Watson, 1998, p.372). 3.1.2. Deficits in literature Although their economic and social impact is important and they differ in many aspects from larger corporations, SME are not for long in the focus of researchers (Wesel, 2010, p.16; Henschel, 2008, p.2). Most empirical studies about corporate risk management focus on large corporations. Publications regarding SME s risk management are seldom, although this is the size of the majority of companies (Rautenstrauch & Wurm, 2008, p.106). Different researchers identified the missing focus on SME in the risk management research. For example, Vickery (2006) has compared and analyzed 18 empirical research studies in 2006. He finds that: Empirical research on corporate risk management has generally focused on large public companies, most often studying firms use of financial derivatives. (Vickery, 2006, p.446) For German publications of empirical research in the field of risk management, Rautenstrauch and Wurm (2008) show in an overview that from 2000 until 2007 only three publications deal with small and medium sized companies. The other ones either focus on larger corporations or on the rating of companies without a special focus on risk management (Rautenstrauch & Wurm, 2008, p.108). The summary of their overview of the different studies is that risk management in SME is not widely used and elaborated (Rautenstrauch & Wurm, 2008, p.111). The only empirical study on risk management in German SME was exercised by Henschel in 2008 (Rautenstrauch & Wurm, 2008, p.110). Accordingly, Henschel states that: The literature on risk management being available mainly concerns the implementation in very large joint stock companies. (Henschel, 2008, p.48) 25

Although in general the literature on risk management is extensive, with focus on risk management in SME there are only few publications available (Henschel, 2008, p.48). The results of the literature reviews of the different researchers have been verified for the theoretical background of this thesis. Especially the question whether there was a shift in the focus of research within the last years was of interest. This is because the latest review ends with the year 2007. As SME and their risk management are subject of this work, the review concentrated on database search and abstract review of the four major journals for SME research. 1 The overview of publications in International Small Business Journal, Journal of small business and enterprise development, Journal of small business management and Small Business Economics for the period 2000-2011 with the topic of risk management was subject of investigation. This investigation shows, that although 41 articles in those four journals about SME were published, which are somehow connected with risk, only 4 of them focus on risk management. 2 Furthermore those articles rather discuss business risks and financial risk factors of SME often in connection with their specific characteristics. Those characteristics and results are introduced in the former chapter. However, the articles do not present possible forms of risk management, their requirements and ways of implementation for SME. This verifies the results of Henschel, Rautenstrauch & Wurm, Boutellier, Fischer & Montagne (2009) and Vickery that especially for SME, practical and applicable solutions for the use of risk management are still missing and that further research should focus on how SME can efficiently and easy apply risk management in their business (Rautenstrauch & Wurm, 2008, p.111; Boutellier, Fischer & Montagne, 2009, p.1; Henschel, 2008, p.22; Vickery, 2006, p.446). This is of main importance as SME do not have sufficient equity capital to bear major risks and risk occurrence can be a danger for their business continuity. Due to that risk management should be in the focus of SME and they should try to implement an easy and comprehensive risk management (Rautenstrauch & Wurm, 2008, p.111). 1 This is based on the Handelsblatt Ranking Betriebswirtschaftslehre (2009), where the business and economic papers are ranked with regard to the quality and importance of their articles. Therefore the journals: International Small Business Journal, Journal of small business and enterprise development, Journal of small business management, Small Business Economics can be considered to be important and reliable sources. 2 García-Teruel & Martínez-Solano (2007); van Caneghem & van Campenhout (2010); Levenson & Willard (2000); Everett & Watson (1998). 26

3.1.3. Important aspects of financial risk management in SME A risk management for SME has to take the characteristics of SME into consideration, which can also be risk factors for the business. Their organisation, structure and also management differ from those in larger companies. Therefore the latter s risk management cannot easily be transferred to SME. One important aspect and general risk factor is the management of the company. SME often lack the necessary resources expertise, as well with regard to IT systems as also experts among the employees and management, for establishing and performing an in depth risk management. A risk management should easily be integrated into the existing management of the company and understandable also without special knowledge of risk management. As Rautenstrauch and Wurm (2008) point out that additional costs and resource intensity are among the main reasons for SME not to exercise risk management, the additional costs should be as low as possible (Rautenstrauch & Wurm, 2008, p.111). This can be achieved when using existing data for identifying risks and integrating the risk management into the existing structure. Summarized a risk management for SME needs to be understandable and simple in the way that neither special theoretical knowledge nor large resources nor new statistical databases are needed for exercising and understanding it. The management should be able to see and understand how the risk situation of the company is. 3.2. Financial analysis Financial data and ratios as a basis for financial risk management and the possibility of analysing them are presented in the next sections. In that context also different methods, their limitations and usability in SME risk management are discussed. 3.2.1. Use of financial data and ratios for risk identification The most important reason for bankruptcy of SME is the lack of identifying critical developments of their business (Almus, 2004, p.192; Wildemann, 2005, p.235). A firm needs to be able to identify risks and critical developments and their impact on its financial situation as for example shown in the balance sheet, the financial statement or cash flow situation. That can prevent financial distress and also bankruptcy (Wesel, 2010, p.282). This is because negative impacts on the cash flow can cause a decrease in the financial funds, leading to deficits in the firm s ability to pay its current and future 27

bills. Additionally the success of the company in form of a return is important as losses lead to a decrease in the company s equity and in worst case to bankruptcy (Coenenberg, 2005, p.949). One mean of identifying financial risks is to analyse the financial statements of a company. There the results of risks and also weak points of the financial situation of the company can be found (Smithson, Smith & Wilford, 1995, p.120). The aim is to identify the result of risks and critical developments via analysing the balance sheet and other financial data. It should be assessed how the company was and will be able to be economically successful. This financial analysis has to be reliable in assessing the insolvency or bankruptcy risk of a company and at the same time it should be easy to apply (Baetge & Brüggemann, 2006, p.570). When analysing a company from an external perspective, the analysis is limited by the data and information the company is obliged to or willing to publish. Therefore an analysis from an internal perspective can go deeper and in most cases more reliable than an external one (Coenenberg, 2005, p.949). In both cases it needs to be decided which data and what ratios are best for the purpose of analysing the situation of the company (Baetge, 2002, p.2281). Different key figures and ratios can provide information about the situation of the company. There are plain figures, which give only limited information, and ratios, setting two figures in a relation to each other. When using ratios it is important that the connection of figures in the ratio is meaningful. Furthermore it is possible to use an index to show the development over time (Coenenberg, 2005, p.971). First of all the balance sheet delivers many different figures about the assets and liabilities of the company. They range from short over long-term assets to information about equity, debt and accruals. With help of this information the capital structure of the company can be examined. Here the relation between equity and debt is of interest as debt includes the commitment to pay interest, which can be a financial burden for the company. Furthermore, next to the total amount of debt also the split into long and short-term debt and the matching of its maturity with the assets maturity is important. The interest rate terms are also of interest, however they cannot be obtained from the balance sheet and are only available in internal documents. Transaction exposure due to possible changes in receivables or payables might be indicated by footnotes to the 28

balance sheet and in further detail in internal documents about past and future international business (Smithson, Smith & Wilford, 1995, p.122). Next to the capital structure an important figure is the liquidity of the company. It measures the percentage of current liabilities that are covered by current assets and by the ability of the firm to cover its expenses. Therefore it also shows whether the company is able to cope with some losses due to risk occurrence. In general it can be stated that the higher the liquidity of a company, the lower the danger of shocks on interest and exchange rates (Smithson, Smith & Wilford, 1995, p.121-122). Liquidity is also closely connected to the revenue and profit of a company. Generated revenues imply liquid funds, which in turn are needed to fund future business leading to revenues and profit (Coenenberg, 2005, p.950). However revenues and profits cannot be observed in the balance sheet, therefore for further information also the income statement is needed (Smithson, Smith & Wilford, 1995, p.129). In the income statement the revenues and profits of the company are stated. Furthermore different key figures with regard to earnings can be derived as for example the earnings before interest and tax (EBIT) and in addition to that before depreciations and appreciations (EBITDA). The statement provides information about how the company earned its profit. Of interest are the sources of the revenues. They show whether the revenue was earned due to single events or in the core business and therefore can also be expected in future periods. Depending on the depth of information also a clustering of revenues in geographical terms can be included. This can provide information about the degree of exchange rate risk the company is exposed to (Smithson, Smith & Wilford, 1995, p.129). In total a large number of different figures and ratios is available for the financial analysis. However, not all of them deliver the same degree of information. Furthermore they focus on different aspects and possible sources of risks of the company. A single figure or ratio can be misleading and even when choosing different ones, they have to be chosen carefully to assess the different aspects and risks of the business. Furthermore a too large set of figures and ratios can cause confusion and hide important aspects in the mass of information. Therefore a set of key figures has to be chosen, which provides a consistent and overall but at the same time understandable picture of the financial situation of the company (Baetge, 1999, p.274). 29

3.2.2. Methods of financial analysis Different researchers tried to find sets of ratios according to these requirements. Their aim was to find a reliable method for predicting the default risk of a company based on a set of key ratios. By comparing a company s ratios to a group of other companies a classification of the company as at default risk or not should be possible. Different methods have been developed to evaluate the usability of different ratios in assessing a company s insolvency risk (Baetge & Brüggemann, 2006, p.573-579; Baetge, 2002, p.2284). In the beginning the research concentrated on analyzing different ratios separately and combining the single outcomes to an overall picture of default risk (Balcaena & Ooghe, 2006, p.70). One method for this is the univariate model, which was used for example by Beaver in 1967. The method estimates an optimal cut-off point for each measure, separating the companies into those with default and those without default risk (Beaver, 1966, p.101). The advantage is that this is a very simple method, which can be applied without special statistical knowledge or software. However the drawback is that the method assumes a linear relationship between the ratios and the default risk, which must not be the case in reality (Balcaena & Ooghe, 2006, p.65). Similar to this so-called risk index models - as used by Tamari in 1966 - assign points to the company based on the outcomes of the different ratios. Added up, the sum states a higher or lower default risk of the company. A weighting system allocates more weight to more important ratios - which are identified to be the financial structure, the development of profitability and the firm s liquidity (Tamari, 1978, p.191). This division into groups is based on subjective criteria and the method is analysing the different ratios independently. With the development of more advanced methods, which evaluate the ratios simultaneously, it was aimed to overcome these drawbacks and obtain more reliable and objective models (Balcaena & Ooghe, 2006, p.66). Among the main tools are multiple discriminant analysis (MDA), logit regressions and neural analyses. They have in common that they evaluate the risk of a single company by comparing different financial ratios to a large data set of ratios of solvent and insolvent companies. This delivers in most cases a reliable picture in which group the evaluated company belongs. By either evaluating it as solvent or likely insolvent the 30

financial situation of the company of interest is assessed (Baetge & Brüggemann, 2006, p.575; Baetge, 2002, p.2284). The first one to use the multivariate discriminant analysis (MDA) was Edward I. Altman in 1968. Based on five financial ratios he estimates the risk of getting insolvent within the next one or two years for a set of companies. His model has a high predictive power of 95% correct predictions one year to bankruptcy. This shows that the chosen key figures are a powerful mean to assess the financial situation of a company and also the overall riskiness (Coenenberg, 2005, p.977). Altman (1968) finds that especially liquidity and profitability of a firm but also its financial structure with equity as a measurement of the buffer for possible losses are reliable indicators for the insolvency risk of a company (Altman, 1968, p.597). Nearly 40 years later Porporato & Sandin (2007) come to similar conclusions as Altman. They also identify ratios of liquidity and the financial structure (debt/equity) measuring the solvency of the firm to be important when predicting bankruptcy. Additionally they find that at least in emerging markets also profit margins are of importance for the risk evaluation (Porporato & Sandin, 2007, p.309). Chijoriga (2011) also uses a MDA and highlights the importance of liquidity and financial structure ratios as indicators for insolvency risk (Chijoriga, 2011, p.144). A drawbacks of the model is its assumptions of linear relationships between insolvency and the ratios and the normality of the input data (Khong, Ong & Yap, 2011, p.554). Therefore from the 1980s on and based on the work of Ohlson (1980) conditional probability models, as e.g. the logit model, slowly took the leading position of MDA. Depending on the data set the predictive power of the ratios can be increased by using conditional regressions. Nevertheless MDA is still used today and actual research shows that it still has high explanatory power with regard to insolvency risk (Balcaena & Ooghe, 2006, p.70; Cerovac & Ivicic, 2009, p.375). Despite of the differences in the applied model, Ohlson also finds that profitability, liquidity and the financial structure are relevant when predicting the default risk. Those findings are consistent with the results of the MDA studies. However Ohlson additionally uses information about the size of the firm to predict the default risk and finds that larger firms - measured by the amount of total assets - have a lower risk than smaller firms (Ohlson, 1980, p.123). 31

Based on a logit regression, Baetge (2002), together with the rating agency Moody s, developed a rating tool for evaluating a company s default risk. The analysis of ca. 110.000 annual reports showed that especially information about the financial and debt structure and the profitability have high explanation power (Baetge & Brüggemann, 2006, p.575, Baetge, 2002, p.2284). Cerovac & Ivicic (2009) and Khong, Ong & Yap (2011) also applied in logit regressions and come to the same conclusion about these ratios. Therefore they have the biggest influence on the rating of a company in the tool of Moody s - in total they make about 53% of the rating group (Baetge, 2002, p.2285). For predicting the default risk of SME, Altman and Sabato (2007) use in their logit model ratios of liquidity, profitability and financial structure, as different researchers identified these ratios to be most powerful (Altman & Sabato, 2007, p. 343). They find that despite all differences between larger and small companies, the same ratios can be used for the risk assessment of both groups (Altman & Sabato, 2007, p.353). Although statistical software is needed to apply MDA and conditional models, the tools are transparent and relatively easy to understand. The latest development in the insolvency prediction is the use of artificial neural networks, which deliver even more reliable results. Neural networks include a learning algorithm to constantly improve the results of the prediction. Furthermore also qualitative information can be included in the analysis. Nevertheless, Angelini, di Tollo & Roli (2008) concentrate on information on financial structure, profitability and liquidity on similar ratios as they were already used in MDA and logit regressions (Angelini, di Tollo & Roli, 2008, p.747). The critical factor of neural networks is the high level of complexity and the lack of transparency of the basis for the result. Neural networks are considered black boxes and it is not possible to obtain information about the single parts of the analysis. Therefore their use is still limited (Baetge, 2002, p.2285; Angelini, di Tollo & Roli, 2008, p.741). Although different approaches can be used for evaluating the default risk of a company, huge similarities between the different methods are visible and since the 1960s the chosen variables did not change significantly. The following table 2 shows the ratios and categories used by researchers in 11 different studies and with different methods. The ratios have been clustered into six different categories based on the clustering applied by the researchers. (For further information see appendix I.) 32

Information Category liquidity profitability Financial Structure x% of all ratios* amount used 38 % of all ratios 5 use 1 or 2 6 use more 29 % of all ratios 2 don t use any** 5 use 1 or 2 4 use more 18 % of all ratios 9 use 1 or 2 2 use more Category of Ratio (used in x out of 11 studies) cash, quick or current assets / current liabilities (8) working capital (6) cash, quick or current assets to total assets (3) others (6 different others) return on assets, liabilities, sales (8) sales to assets (5) retained earnings (4) equity to debt or total assets (8) debt to assets (6) debt cost & structure Growth further information 5 % of all ratios 7 do not use any 4 use 1 or 2 5 % of all ratios 7 do not use any 4 use 1 or 2 6 % of all ratios 7 do not use any 4 use 1 or 2 cost of debt (3) debt structure (1) growth in profit or value (4) sector, size, staff cost (4) *deviation from 100% due to rounding; ** growth in profit or value added is used instead Table 2: Overview of risk categories and ratios Source: Data from papers, author s clustering and illustration Some of the ratios differ slightly in their definition. For example sometimes the market value of equity, most of the times the book value and once the owner s equity are used for examining the capital structure. Similar to that the studies use slightly different durations of debt or assets for some of the ratios. The result of this is a difference in the degree of liquidity. Another difference is the order of key figures is in the nominator and denominator of the ratio. However, the basic idea and meaning of the ratios remains the same. Therefore the ratios from the different studies can be compared and clustered into groups or categories. The examination shows that the category with the most ratios used (38% of all ratios) is liquidity. All studies use at least one ratio to measure liquidity and 6 of them use more than two ratios for this category. The focus of the ratios is on measuring liquidity by mainly comparing current assets (in different degrees of maturity) to current liabilities or measuring the available working capital of the company related to some figures measuring the size of the company like total assets or sales. Despite of the different 33

degrees of liquidity, all of them can be used for the prediction of default without changing the general idea of including liquidity levels of the company. Next to liquidity all eleven studies include information about the financial structure of the company to assess its insolvency risk. The ratios used for that are either equity to debt or assets, or debt to total assets. Both groups deliver the same kind of information as in a balance sheet equity and debt equal total assets, so there is not a difference in the general meaning when you combine those three figures in different ratios. This also explains why most studies only use one or two ratios in this category and only a few split the duration of debt or assets more in detail. However some (4 out of 11) studies further focus on information about the debt structure or the costs related to the debt of the company. By that they include also information about the interest rate the company is paying and the maturity of the debt in their prediction of default. Profitability is the next main category accounting for a total of 29% of all ratios in the ten studies. Although two studies do not include pure profitability ratios, they use similar information in the growth ratios. These ratios observe the growth in earnings or value, which are also closely connected to profitability. Therefore all studies include information about the profitability or earning situation of the company with at least one ratio. Mostly they use measures about the return - again in relation to assets, liabilities or sales. Furthermore the sales generating ability of the company is used by half of the studies. Finally retained earnings ratios are part of 4 models showing how much earnings the company was able to generate. However these ratios can also be seen as ratios measuring the buffer for risks occurring. High levels of retained earnings make up for possible losses and prevent bankruptcy. The other ratios are used only in a minority of the studies. In total, 4 studies use the sector of the company, its size or staff costs to assess the overall risk. 34

3.2.3. Limitations of financial analysis Overall the studies demonstrate that a limited amount of key figures can give a precise picture of the company s situation. However, the results must not be overestimated, as the insight from a financial analysis is limited. First of all, the analysis gives only a general picture of whether business continuity is in risk and it does not show where the source of risk lies. This has to be found with help of more specific analysis (Coenenberg, 2005, p.978). Furthermore the ratios can never deliver a completely reliable picture of the financial situation of a company, although they aim to eliminate effects in balance sheets, which are based on balancing choices. Next to the use of key figures and ratios also an understanding of business processes and economic developments is needed (Baetge & Brüggemann, 2006, p.580). In addition to that it has to be taken into account, that the database is from the last period and only partly useful for evaluating future prospects. It has to be assumed that past developments are a valid indicator for future ones. (Coenenberg, 2005, p.954) Furthermore the static picture of the financial situation can only deliver an approximation of the liquidity of the company and the duration of the single positions in the balance sheet. Next to that it does not show the follow up financing possibilities of the company, either (Coenenberg, 2005, p.1003). Furthermore the presented methods of financial analysis are in their form not applicable for the use in a company - especially not a SME. All of them require a large data set of annual reports as basis for the computer based analysis - especially neuronal nets are highly complex. Therefore they are used in banks and rating agencies but not in other companies. 3.2.4. Financial analysis as a mean for risk management in SME? Though, some of the drawbacks, which result from the past and limited data, do not fully occur when using the ratios internally in a company. Companies themselves also have access to data covering shorter periods of time, which is therefore more reliable with regard to trend estimations. Furthermore they can also use the ratios on plan data and include information about the duration of the assets and liabilities as well as the future financing for the risk analysis (Coenenberg, 2005, p.954). 35

Moreover, even when not performing an intensive analysis of a company, the financial ratios used for the calculations in the papers can be of interest for the risk management of the company. It can be assumed that the key figures have high explaining power with regard to insolvency risk of a company even when used separately from one of the models. This is because intensive empirical research has shown, that they are reliable in assessing the risk of insolvency of a company. In the papers the focus was on estimating bankruptcy risk and chose a set of ratios, which can be used for indicating bankruptcy. A company could therefore use in its risk management a similar set of ratios for analysing its financial situation. This enables the company firstly to assess its overall risk of insolvency and secondly to better understand its rating and loan conditions. By that its bargaining power in their bank relationship can be increased (Behr & Güttler, 2007, p.210). Finally, the company is able to identify changes in its risk and can act accordingly to that. Overall, a set of financial ratios similar to those used in the different studies can be used as a simple approach to assess the overall risk of the company. It is also applicable to risk management in SME. The financial ratios used in the financial analysis are available in every company and not complicated to understand. Furthermore they give a comprehensive overview on a single sight, as most of the ratios are concentrated figures. When detecting a critical development or deviation the figures can be evaluated more in detail and split into their components to identify the source of the risk. Therefore the ratios are an uncomplicated and comprehensive way of showing the risk situation of a company. A strong benefit, next to the good applicability, is that different research has shown the ratios effectiveness when evaluating the risk situation and overall default risk of a company. 36

4. Use of financial analysis in SME risk management The next chapter presents the development of a financial risk overview as a possibility of how financial analysis can be used in SME risk management. Moreover the overview will be applied to a case company. 4.1. Development of financial risk overview for SME The following sections show the development of the financial risk overview. After presenting the framework, the different ratios will be discussed to finally present a selection of suitable ratios and choose appropriate comparison data. 4.1.1. Framework for financial risk overview The idea is to use a set of ratios in an overview as the basis for the financial risk management. As they are used internally next to the historical data also actual and plan data can be integrated into the overview. This provides even more information than the analysis of historical data and allows reacting fast on critical developments and managing the identified risks. However not only the internal data can be used for the risk management. In addition to that also the information available in the papers can be used. Some of them state average values for the defaulted or bankrupt companies one year prior bankruptcy - and few papers also for a longer time horizon. Those values can be used as a comparison value to evaluate the risk situation of the company. For this an appropriate set of ratios has to be chosen. The ratios, which will be included in the overview and analysis sheet, should fulfil two main requirements. First of all they should match the main financial risks of the company in order to deliver significant information and not miss an important risk factor. Secondly the ratios need to be relevant in two different ways. On the one hand they should be applicable independently of other ratios. This means that they also deliver useful information when not used in a regression, as it is applied in many of the papers. On the other hand to be appropriate to use them, the ratios need to show a different development for healthy companies than for those under financial distress. The difference between the values of the two groups should be large enough to see into which the observed company belongs. 37

The main financial risk factors can be found in the difference to larger companies. The financial structure of SME is due to lower levels of equity financing and liquid funds more fragile than that of larger companies. Furthermore the availability of financial funds might be limited such as financing risks occur. Therefore liquidity and capital structure need to be monitored. As low levels of equity also imply a low buffer against losses, the firm s profitability and ability to build up such a buffer should be in the focus, too. Also external risk factors as interest rate, exchange rate and commodity price risk might be of importance to SME. However the importance also depends on the field of business and the business relations of the company. Furthermore, as those external factors lead to internal risks, the main focus should be on the internal ones. In the literature only internal risk factors are included in the analysis. The ratios mainly cover the risk categories of financing, liquidity and solvency with ratios about the financial structure, the liquidity and profitability of the firm. Additional information is only used by few researchers. However those categories also match the main internal financial risk factors of SME, as presented in figure 3: Figure 3: Risk factors of SME, their possible results and matching financial ratios Source: author s illustration 38

In summary, the main internal financial risks in a SME should be covered by financial structure, liquidity and profitability ratios, which are the main categories of ratios applied in the research papers. Next to that for the external financial risks, which also influence the internal ones, some further information are needed. 4.1.2. Evaluation of ratios for financial risk overview When choosing ratios from the different categories, it needs to be evaluated which ones are the most appropriate ones. For this some comparison values are needed in order to see whether the ratios show different values and developments for the two groups of companies. Furthermore comparison values enable the management to evaluate their own company s risk by comparing its ratios to the values from healthy and distressed companies. The most convenient source for the comparison values are the research papers as their values are based on large samples of annual reports and by providing average values outweigh outliers in the data. However, only five of the papers provide some values. Especially Altman (1968), Porporato & Sandin (1997) and Ohlson (1980) are of interest, as their papers contain average values for the last 5, respectively 4 or 2 years prior bankruptcy for the group of distressed companies and some values for the healthy ones. Therefore those values allow seeing a development of the ratios over time, while the companies situations worsen. This development can be used as an indicator for an early warning in the SME s risk management. When detecting a similar development, it is obvious that a risk is evolving. Knowing this something can be done to manage it in order to avoid financial distress or bankruptcy. Altman (1968) shows a table with the values for 8 different ratios for the five years prior bankruptcy of which he uses 5, while Porporato & Sandin use 13 ratios in their model and Ohlson bases his evaluation on 9 figures and ratios. Khong, Ong & Yap (2011) and Cerovac & Ivicic (2009) also show the difference in ratios between the two groups, however only directly before bankruptcy and not as a development over time. Therefore this information is not as valuable as the others. Nevertheless also those ratios with more data are not equally useful for risk identification. Different reasons account for that. Therefore the ratios with comparison values from the papers will be discussed in the following. 39

Financial structure A ratio used in many of the papers is the total debt to total assets ratio, analyzing the financial structure of the company. Next to the papers of Altman (1968), Ohlson and Porporato & Sandin also Khong, Ong & Yap (2011) and Cerovac & Ivicic (2009) show comparison values for this ratio. Those demonstrate a huge difference in size between the bankrupt and non-bankrupt groups. From the time series also a clear trend in the development can be seen, which is visualized in figure 4. The closer a company gets to bankruptcy the larger the difference in the ratio to financially healthy companies and the larger the debt to asset ratio gets. Figure 4: Development of total debt/ total assets ratio Data source: Altman (1968), Porporato & Sandin (2007) and Ohlson (1980), author s illustration Although the average value one year prior bankruptcy differs between the datasets, the difference to the values of the healthy companies is obvious. Therefore the information value of the figures is high. The higher the amount of debt of a firm and by that its obligation to pay interest, the higher the financing risk and due to that also the bankruptcy risk. The same conclusion accounts for the next ratio, which sets equity and debt into a relation. This is only a different way of showing the financial structure of a firm, as the balance sheet of a firm says that equity and total debt are together as high as total assets. Therefore it does not matter which combination of components of the equation are set in relation to each other. The general conclusion about the financial structure stays the same. According to that also this figure shows a relevant time trend and significant difference between the groups. However, although 3 out of 5 papers use the ratio, the values are not perfectly comparable as the ratios differ slightly in their definition. The 40

difference lies in the equity definition, as either the book value, the market value or the shareholders equity are used. Therefore the information of total debt/total assets is more reliable and should rather be used for the overview. The other ratios analysing the financial structure are only used in one of the papers and except for one the reference data only covers the last year before bankruptcy. Therefore a time trend cannot be detected and their relevance cannot be approved. The figure available for the two years prior bankruptcy is the one checking whether total liabilities exceed total assets. Following the balance sheet equation, this is the case when there is negative equity in the balance sheet, which means that the company is under heavy financial distress. The meaning of the figure is therefore obvious. Including the variable could not serve as an early warning as in case the liabilities exceed the assets, the risks have already caused bankruptcy. Summarized, from the ratios covering the financial structure of a company, the most fitting one for the purpose of risk management is the total debt/total assets ratio. Cost of debt The costs of debt are another aspect of the financing risk. The interest rate, which needs to be paid for the debt, is a financial obligation and can become a risk in times of low income. Porporato & Sandin use the variable interest payments/ebit for measuring the debt costs. The variable shows how much of the income before tax and interest is spend to finance the debt. This variable also shows a clear trend when firms approach bankruptcy. Nevertheless, the additional information of this ratio is limited because high debt ratios implicitly include higher interest obligations. Probably the high amount of debt increases the interest payments in two ways. First the total amount of debt is higher for which interest has to be paid. Second, higher amounts of debts also increase the risk premium of the interest rate and therefore the relative interest rate a firm has to pay. Nevertheless the ratio shows, whether the company earns enough to be able to cover its interest expenses and by that has a lower default risk. This is important to account for highly profitable companies with high debt levels. Otherwise those would have debt/assets ratios similar to the companies close to bankruptcy although they are not close to financial distress. However, even though the ratio can be of interest, a problem occurs when including it in the overview and risk management. The problematic aspect is that the comparison 41

values are of limited use for an analysis because Porporato & Sandin use data from Argentina from 1991 to 1998 to calculate them. The interest rates depend on the state of the Argentinean economy in that period and are not comparable to another time period or place without in-depth analysis of the interest rate structures. Even though the ratio itself provides useful information, the values from Sandin s and Porporato s paper cannot be used for the analysis. Liquidity The ratio used in all five papers to measure liquidity is the current ratio, showing the relation between current liabilities and current assets (with slight differences in the definition). Despite of its frequent use in the regressions, the ratio, when observed independently, does not provide reliable information about the risk situation. The ratios of both groups are close to each other. Although the ratio in most cases is lower for the bankrupt group it is not significantly decreasing the closer the firms get to bankruptcy. On the contrary in some datasets it is increasing (Altman and Porporato & Sandin) and even higher than those of the solvent group (Porporato & Sandin). As no clear statement about this ratio can be made, it cannot be reliably distinguished between healthy companies and those close to bankruptcy. Thus the current ratio should not be included in an overview, which is observing the single ratio independently from each other. Instead of the current ratio, a liquidity ratio setting the difference between current assets and current liabilities, also defined as working capital, into relation with total assets could be used. This ratio, which is presented in figure 5, shows a clear development when approaching financial distress. Figure 5: Development of working capital / total assets ratio Data source: Altman (1968) and Ohlson (1980); author s illustration 42

Basically the ratio says whether the firm would be able to pay back all its current liabilities by using its current assets. In case it is not able to, which is when the liabilities exceed the assets, there is an insolvency risk. The total assets in the denominator account for size difference between companies and make the ratio comparable. Furthermore high amounts of total assets decrease the insolvency risk as in case the company cannot pay back its current liabilities with help of the current assets, the other assets could be used for it. Although this step is more inconvenient and difficult, it though would avoid bankruptcy. This decreased risk is also shown in the ratio due to the inclusion of total assets. Therefore this ratio is a good measure for evaluating a firm s liquidity. Furthermore as well Altman (1968) as also Ohlson provide comparison values for both groups of companies, which could be used in the risk management. Profitability For measuring the firms profitability or productivity a wide range of ratios is used in the different papers. In general those ratios can be clustered into three groups. The first group s focus is on sales or a profit margin as a measure for the productivity of the firm. The second group focuses on income of the last period by using the EBIT, net or operative income and the third one uses the cumulated profit of former periods. The ratio sales /total assets is used as well by Altman (1968) as also Porporato & Sandin (they use total assets / sales, which can easily be transformed to be comparable) and therefore available as a time series. Nevertheless the usability of the data is limited as also visible in figure 6. Figure 6: Development of sales / total assets ratio Data source: Altman (1968) and Porporato & Sandin (2007), author s illustration 43

Although a difference between the two groups of companies can be observed in Sandin s and Porporato s data, there is no significant change in the height of the values when the firms get closer to bankruptcy. As well the data of the solvent as also later insolvent companies increase slightly over time and their spread remains relatively stable. In contrast to that, Altman (1968) provides values, which show a decrease in the ratio of the bankrupt group. However this group starts with higher values than the solvent group, for which only the average value over the 5 years is available, and is decreasing when approaching bankruptcy. Nevertheless the development of the ratio is not significant enough to draw a relevant conclusion from it. Furthermore Altman (1968) comments the use of the sales / total assets ratio in his paper. He states that this ratio is not of use when analysing it separately. It is only adding value when it is part of regression and the ratios are analyzed parallel - as in the MDA. This aspect could explain why Ohlson, who in contrast to the others is evaluating the ratios independently, is not including sales as a parameter in his analysis. Concluding, this ratio should not be included in a company s risk management sheet. The same most probably accounts for the other ratios, which include sales in relation to a balance sheet figure and are only used as part of a regression. Furthermore there is not enough data for the ratios available to evaluate whether there are relevant differences between the groups and to be used as comparison values for a company. When using an income measure and sales, the ratio shows the profit margin of the company, as this is the percentage of revenues, which is left after deducting all costs. (Or when using the operative income all costs related to sales.) The advantage of this ratio is that it shows whether there is a buffer for cost or quantity changes. A low margin is an indicator that a change in cost or quantity can lead to a loss. Either the fixed costs cannot be covered with a lower quantity. Or the increase in the variable costs leads to production costs, which are no longer covered by the price. From the papers only Porporato & Sandin are using both ratios in his model. Their data shows that from four years prior bankruptcy on, no significant development can be identified. The ratios of both groups remain constant and only net income/sales is changing for the bankrupt group. However the change does not show a significant development either. First the ratio drops for the bankrupt group, but very close to 44

bankruptcy it is even higher than that of the non-bankrupt group. Therefore these ratios should not be included in the overview. The remaining ratios measuring the last period s profitability are net income / equity, EBIT / debt and net income or EBIT / total assets. They show the return of the last year on a balance sheet figure. The first two returns depend on the equity/ debt ratio of the firm, as the amount of debt or equity influences the relative return, while the use of total assets is independent of the financial structure of the firm. Furthermore the difference is in the covered expenses. While net income is the income after deducting all expenses, EBIT shows the before tax and interest expense income. Therefore a positive EBIT does not imply a positive return for the year as this still depends on the interest expenses and therefore the financing of the company. An important aspect for every company is that the return exceeds its interest cost in order to cover those with the given financial means. As there does not exist an obligation to pay dividends on equity, the positive return on equity, as used in net income / equity, is from a risk perspective not in the focus of the management. Especially in times of crisis the focus is on the return on debt as this should be higher then the average interest rate the firm has to pay. Therefore the EBIT/debt ratio is important for a company - but only in relation to the interest rate on debt and not independently. In case the ratio is higher, the firm is not under financial distress. The disadvantage of this ratio is that Cerovac & Ivicic (2009) are the only ones using it and due to that the comparison values are available for a single year only and not in a time line. More data is available for the return on total assets, which can deliver valuable information, too. Here, independent of the equity/debt ratio the profitability of firms can be compared to each other. As shown in figure 7, the ratios for companies close to distress are much lower than those of the second group. Furthermore the data available from the paper of Porporato & Sandin shows that the profitability remains nearly constant over time for the healthy companies. For the other group, Altman (1968) highlights a constant worsening of the profitability ratios. Concluding, the return on total assets is a strong indicator for the risk of the company and delivers useful information for the risk management. However, as specified before, additional 45

information about the interest rate obligations should be included in the risk management. Figure 7: Development of EBIT / total assets and net income / total assets Data source: Porporato & Sandin (2007) and Altman (1968), author s illustration The last group of profitability ratios, which can be found in the literature, are those focusing on retained earnings of the firms. These measures show the cumulated profitability of the firm over time. Retained earnings ratios measure the buffer of funds the company was able to earn over time and which can be used in times of crisis to balance losses. The higher the buffer, the lower the risk of insolvency as first the buffer can be used before equity is consumed by losses. Therefore such a solvency ratio delivers useful and important information in the context of risk management. Altman (1968) sets them into relation with total assets, while Porporato & Sandin are using equity instead. Both datasets show a significant and large difference between solvent firms and those approaching insolvency, which is also presented in figure 8. Figure 8: Development of net income / sales and operative income / sales Data source: Porporato & Sandin (2007) and Altman (1968), author s illustration 46

While the first group of companies on average has a positive ratio, the value for the latter group quickly turns negative and decreases the closer they get to insolvency. Although the difference between the use of equity and total assets in the denominator is only scaling, it though makes a difference when comparing different companies. When using total assets the ratio is independent of the chosen financing mix of the company and therefore better comparable. Due to that retained earnings / total assets and the available comparison data can be included in a risk management for measuring the cumulated profitability of the firm and by that its solvency. 4.1.3. Choice of ratios for identifying and monitoring financial risks In each of the categories one or two ratios are most suitable for the purpose of SME financial risk management. For analysing the financial structure of the company the debt / total assets ratio can be used. Based on the comparison data it can be identified that the closer a company gets to bankruptcy the larger the difference in the ratio compared to financially healthy companies gets. However it must not be forgotten that high debt levels as such increase the bankruptcy risk but do not imply that the company gets insolvent. For this also other factors have to point to high risk and insolvency. Therefore also liquidity in form of working capital/total assets should be monitored and analysed. This ratio also shows a clear development for firms when approaching financial distress - even years in advance. The best ratio for the category profitability is EBIT / total assets, as here next to the available comparison data, also a time trend and significant difference between the two groups are present. Furthermore, retained earnings / total assets can be used to measure the buffer of funds the company has to cope with losses. Overall those ratios are characterized by significant differences between the groups of solvent companies and those at risk. Furthermore appropriate comparison data exists for them, which can be compared with the data of a company in order to evaluate its risk. In addition to those 4 ratios further information can be used to improve the financial risk overview. As discussed in section 4.1.2 also the cost of debt can be of high interest to a company. Although the existing comparison data from the papers for the ratio interest payments / EBIT cannot be applied, a company could keep track of its interest payments. Of main importance is not the relative amount of interest, but whether the EBIT exceeds the cost of debt. Then the interest payments do not lead to a loss. 47

However not a special ratio is needed for this purpose and when the interest payments are relatively stable over time the information can be included in the EBIT / total assets monitoring. This will be specified further in section 4.2.2. Another aspect, which is not used in the papers, but significant with regard to financing risk - and especially follow-up financing - is the duration of assets and debt. This should be matching in order to have constantly the right amount of debt for financing the business. For this fact no comparison data is needed, either. It can be compared whether the duration of the different debt positions is in accordance with the assets. For this a ratio showing the relation between long-term assets and the sum of long term debt and equity can be used. This ratio is equal to or lower than one in case there is a duration match and long lasting assets are not financed with short-term capital. Then there is a low risk of follow up financing. This aspect of duration matching is even more important than matching short-term assets and liabilities. In worst case the company pays too much interest. However when monitoring interest payments separately, the focus here can be on the long-term match. So in total the following 6 ratios or key figures, as presented in figure 9, are a good basis for an overview for SME financial risk management: Figure 9: Ratios for financial risk management overview Source: author s illustration Important is that a single ratio with values close to those of the insolvent companies does not imply that the company itself is close to bankruptcy. It just shows a higher total risk. But for an overall picture also the other ratios and categories have to be considered. 48

4.1.4. Comparison data for the risk overview For the risk overview different data is available for a comparison with the company s data. One source of data can be the papers of Altman (1968), Porporato & Sandin, Ohlson and Cerovac & Ivicic (2009). They provide the ratios for the groups of insolvent and financially healthy companies. In the following table 3 the average values of the groups are presented. Table 3: Average risk ratios of non-bankrupt group and bankrupt group Data source: Altman (1968), Cerovac & Ivicic (2009), Ohlson (1980) and Porporato & Sandin (2007) To improve the analysis, further data can be used. As data from struggling companies and average values of healthy companies are available, next to this also some best in class data could be included. The question is where data from successful companies can be obtained. First of all the data needs to be available, which is the case with companies, that are listed on a stock exchange. Those companies listed in a big index as for example the German stock index DAX are over-average successful compared to those not included in the index. It can be assumed that their risk is on average lower than of other companies. However as SME are hardly comparable with the 30 largest companies in Germany, the same accounts most probably for data from the MDAX, where the next 50 companies are listed. The most suitable index, where successful but in comparison to the other two indexes smaller companies are listed is the SDAX - the small cap DAX. Here the next 50 companies of prime standard are organised. Those companies are still large enterprises, nevertheless they can be used as best in class comparison for the overview. In order to use values, which are comparable, it is aimed to compare the case company with companies from the same sector. In case of the comparison values from the papers this is not possible as they are not further specified, however for the best in class values 49

this aspect can be considered. The choice of sector will be the industrial sector, as in this sector the financing and liquidity risk can be regarded as urgent. This is the case because higher amounts of equipment than in other sectors need to be financed and sometimes the projects are long lasting and involve payments in advance, which requires sufficient liquidity. From the SDAX, 15 companies are belonging to the industrial sector. 3 Based on their annual reports, the four financial ratios, which have been chosen for the risk overview, have been calculated. Table 4 shows the average ratios of those fifteen companies and also the average of the 11 companies, which had a positive EBIT in 2006, the full table can be found in appendix II. Table 4: Average risk ratios of best in class group Source: Data from SADX industry annual reports 2006 From the ratios only the EBIT / total assets ratio changes significantly when excluding those companies, which had a loss in 2006. Their other ratios show in general a stable and successful business situation. Especially their retained earnings are even higher than those of the companies with a positive EBIT. Therefore it can be assumed that in general the fifteen companies are successful and with a low bankruptcy risk. In comparison to the data from the papers some differences are present. As the best in class data is from the industrial sector and the data from the papers includes different sectors, this can be an explanation for the differences. Another reason can be the different countries of origin of the companies and therefore different accounting standards. Those standards can also change the balance sheet and by that influence the value of the ratios, especially with regard to reserves. Furthermore most data from the papers is much older than the SDAX data, which also can influence the ratios. Nevertheless as the direction of the ratios still is very similar, the different data can be used for the risk analysis. 3 From the comparison of all SDAX values (Deutsche Börse, 2011b) and those, which are classified by Deutsche Börse in the industrial sector (Deutsche Börse, 2011a) 50

First of all the debt ratio in the SDAX companies is significantly higher than that of the non-bankrupt group from the papers. It is in the range of the average of the bankrupt group up to 3 years prior bankruptcy. Nevertheless from this point on the debt ratio increases significantly and exceeds the ratio of the SDAX companies. Therefore a ratio up to 60% does not show a high risk, when starting to exceed 70% however, the risk increases heavily. The situation wit regard to WC / total assets is very similar. Here the SDAX companies have ratios around 20% and when passing the 10% margin the risk is high. When analysing the EBIT / total assets ratio there is no difference between the profitable companies from the papers and the SDAX. Their ratios are around 11% and below 5% the bankruptcy risk increases. However, this ratio shows much earlier than the other ones that a risk of bankruptcy is present. This is also the case with the retained earnings ratio. While the successful companies in the SDAX have an average of 12% and those from the papers of even 36%, the bankrupt group companies on average have a negative value here. As soon as the retained earnings get close to 0, the risk increases. As the difference between the groups is large, the values can be used to mark different areas in the graphic overview and to categorize the case company. For debt/total assets and WC / total assets the bankrupt group ratios from two years prior bankruptcy on can be used to mark the critical area. The values from year 3 and 4 are not useful, as they are too close to the SDAX values, which mark the successful area. For the other two ratios next to the ratios from the SDAX companies, the values from four years prior bankruptcy of the bankrupt group companies can be used. For EBIT / total assets and retained earnings / total assets, the negative development is already visible four years prior bankruptcy. The values from the non-bankrupt group from the papers will not be used explicitly as they have even better ratios than the SDAX companies and can be considered even more successful. However for categorizing the case company, as positive benchmark the values from the SDAX companies should be enough. So, in the graphics the critical and positive areas are marked by the values of the bankrupt group and SDAX group values. Within those values the ratios from the case company will be presented. Based on the position in the graphics, the risk situation of the case company can be analysed. 51

4.2. Example for the use of the financial risk overview: case study In the following part, the chosen ratios for the risk overview will be applied to a case company. Its values will be compared to the group of insolvent, those of healthy and also best in class companies, to analyze the overall risk situation of the case company. 4.2.1. Case company The Case Company has to be a German SME from the industrial sector, for which sufficient financial information are available. Therefore the aim is to choose a company, which is listed in the entry standard, which has the lowest regulations and requirements at the German stock exchange. The advantage of a company, that is listed there is that sufficient data from the IPO presenting the financial situation of the company before going public, is available. This data can be used for the analysis. Furthermore the entry standard with its low requirements in comparison to the prime standard is mainly used by smaller companies. Therefore the chance of finding a SME is higher there than in the SDAX. The sector of the company should be industrial to be comparable with the 15 companies of the best in class group. From the industrial companies in the entry standard, which can be obtained by comparing the list of entry standard companies and those belonging to the all industrial cluster of the German stock exchange a company is chosen (Deutsche Börse, 2011a; Deutsche Börse, 2011b). TWINTEC, in the following called Case Company, is fulfilling the requirements. The data, which will be used in the example is from 2006, the year prior its IPO. In 2006, 65 people were employed at Case Company, which is less than the maximum headcount of 250 for medium sized enterprises (Twintec, 2006). Furthermore, according to the European Commission definition, the balance sheet total and also the turnover belong with " 24,7 million and " 45 million to the group of medium sized enterprises, which ends with " 43 million and " 50 million respectively (Twintec, 2006; European Commission, 2011). Therefore the company belongs to the enterprise category medium sized and it can be assumed that it can be used as an example of a typical medium sized enterprise. Its data will be analysed in the following. In addition to the 2006 data also the data from 2007 to 2010 will be included in the analysis. The data is from the annual reports of TWINTEC, however, the assumption for the case company is, that the data is the plan data for the following 4 years after IPO. 52

4.2.2. Overall financial risk situation of the case company The overall financial risk situation of the case company will be assessed by comparing its values of the chosen risk ratios to the critical and positive limits. The first information is the debt / total assets ratio, which is presented in figure 10 and provides information about the financing structure of the firm. Figure 10: Case company analysis of debt / total assets Source: data from TWINTEC annual reports 2006-2010 Already in 2006, before the IPO, the ratio of case company is with 66% better than the average German SME ratio (see section 3.1.1) and implies one third of equity financing and with that higher financial stability than on average. The ratio will even improve due to the IPO and from 2007 it is planned to be in the positive area and better than the average of SDAX group of 56%. This development shows a positive and from 2007 a very positive and stable situation, which decreases the overall bankruptcy risk. Further analysis of the financing structure with the long-term assets / (long-term debt + equity) ratio, presented in Figure 11, confirms the stable situation of the case company. The ratio is below 50% from 2006 on over the whole plan horizon. This means that all long-term assets are also long-term financed and there is no risk of problems with follow-up financing. However, this also implies that around half of the long-term financing is used for short-term assets. So the case company might pay relatively too high interest rates as it cannot adjust the funds according to its needs and is stuck in long-term contracts. Nevertheless this aspect with regard to duration match is not that problematic as financing long-term assets with short-term debt. Furthermore the interest payments are relatively low due to the high equity levels. In total also the duration match points to a stable financing situation and low bankruptcy risk. 53

Figure 11: Case company analysis of long-term assets / (long-term debt + equity) Source: data from TWINTEC annual reports 2006-2010 The liquidity of case company is monitored by the working capital / total assets ratio. As shown in figure 12, in the beginning this ratio shows a strong situation of the company with regard to liquidity. With values between 52% and 73% the case company has much more liquidity than the bankrupt group and also than the SDAX group on average. From 2008 the liquidity starts to decrease and in 2009 and 2010 it is around 1/3 of the 2006 value. Nevertheless it is still close to the level of the SDAX companies although compared to the starting point the decrease is large, meaning a huge fall in liquidity and by that increased liquidity risk and also bankruptcy risk. Figure 12: Case company analysis of working capital / total assets Source: data from TWINTEC annual reports 2006-2010 The next focus lies on profitability and also cost of debt. Next to the EBIT also the interest payments of the company are important information in a risk management context. The interest payments are subtracted from the EBIT and only if they are smaller, the company does not face a loss for that year. Therefore this information 54

should be considered next to the aim of a positive EBIT. The interest payments depend on the interest rate and the loan level. When both stay relatively constant, this information can be included in the EBIT evaluation. The case company pays an average slightly more than T" 300, which is an interest rate of 8% and relative to the total assets 1%. The EBIT at minimum needs to cover these expenses and therefore the EBIT / total assets ratio has to exceed 1%. This is even below the aim of reaching 5% in the ratio based on the bankrupt group data. Explanations for this are the low debt level and therefore lower interest payments of the case company. As visible in figure 13, in the first two years the earnings situation is deep in the positive area and with more than 20% return on total assets much higher than among the SDAX companies. Here the EBIT exceeds by far the required minimum and the interest payments. Figure 13: Case company analysis of EBIT / total assets Source: data from TWINTEC annual reports 2006-2010 The situation, however, changes significantly in 2008. In this year already the EBIT is negative, meaning that after interest expenses the case company faces a loss. This loss is around 40% of the value of all assets and therefore dramatic for the company. Although the situation betters in the proceeding years, the former levels are not reached by far and the case company is outside of the positive area. In 2009 the EBIT is close to SDAX level but in 2010 it is zero, implying a loss after deducting the interest expenses. Although due to the low debt levels, the loss is also low. So, the EBIT / total assets ratio shows a dramatic worsening of the business and risk situation of the company. Starting very successful, losses quickly lead to a high solvency and by that bankruptcy risk. The situation, visible in the development of the EBIT / total assets ratio, is also present in the retained earnings / total assets ratio, which is presented in figure 14. The profits 55

of 2006 and 2007 lead to an increase in retained earnings, which exceeds the level of that in the SDAX companies. In those two years the ratio does not point to a high bankruptcy risk. The change is in 2008, where the negative EBIT and high loss lead to a consumption of all retained earnings of the company. Although the next year is more successful, the profit in 2009 only leads to an increase of retained earnings up to the edge of the critical area. Furthermore, the slightly negative income in 2010 already leads to the next decrease. In total, this ratio, although also starting on very positive levels, points from 2008 on to a largely increased solvency and bankruptcy risk. Figure 14: Case company analysis of retained earnings / total assets Source: data from TWINTEC annual reports 2006-2010 For analysing the overall risk situation and bankruptcy risk of the case company, all ratios have to be taken into account. The low debt ratio and therefore high buffer of equity for losses is an argument for a low financing and bankruptcy risk. Especially the situation after the IPO is very stable. The high level of equity leads also to a low financing risk, as all long-term assets are long-term financed and problems with follow up financing are unlikely. Although this might lead to excess capital and unnecessary interest payments, this aspect points also to a low overall risk. This positive picture is however not supported by the other ratios. Although the financing risk is low, the other internal financial risks are not. The liquidity measured by working capital / total assets is high in the first years and significantly above the average of the SDAX group of 21%. After the loss in 2008, however, this ratio shows also a worsening. The business situation in that year decreased the liquidity of the case company. Nevertheless the liquidity remains positive and even after the loss in a distance to the critical area. This means that this ratio does 56

not identify an urgent liquidity risk. But nonetheless the liquidity situation worsened heavily in comparison to 2006 and 2007 and should therefore be monitored. The picture, which the profitability and solvency ratios show, is more dramatic. Especially the earnings situation worsened after 2007, where the ratios of EBIT and retained earnings to total assets are deep in the positive area and above the SDAX average. The plan for 2008 shows a negative EBIT equivalent to around 40% of all assets. This loss decreases the liquidity and also consumes the retained earnings from previous years. The development shows a significant increase in liquidity and solvency risk, which increases the overall bankruptcy risk of the case company. Furthermore the situation in 2009 and 2010 is only slightly better and far away from that in 2006 and 2007. Although the EBIT is positive and the profit in 2009 leads to an increase of retained earnings, the EBIT is at the critical margin and 2010 shows no profit. The overall analysis of the ratios shows a worsening of the risk situation in three steps. In a first step the liquidity decreases, leading to higher liquidity risk. Then, the EBIT turns negative and the loss consumes the retained earnings of the firm. Due to that the equity of the firm decreases, too. This results in a higher solvency risk and could lead to higher debt levels. The advantage of the case company is the low debt level and high buffer from preceding years preventing a bankruptcy, although the risk for this is increased significantly. The important aspect in that case is that further losses and by that worsening of the solvency situation have to be prevented. Possible steps of how this can be achieved are named in the next section. 4.2.3. Possible extensions When facing losses and a worsening of the risk situation it is important to identify the reasons for this. The question, which needs to be examined in detail, is where the decrease in EBIT is coming from. Does a decrease of sales lead to problems of covering the fixed costs? Do the prices for inputs increase significantly and decreased the profit margin? Or can the reason for the predicted loss be found in a different area than the financial risks? By comparing the plan to the preceding years, the management can identify critical deviations and possibly the reasons for the predicted loss. As in such a situation no further decrease in earnings can be managed, it should be aimed to secure the earnings situation. Possible actions for this are an intensified 57

liquidity management, especially with regard to the receivables of the company. It might be useful to think about default insurances for larger positions or factoring - the selling of receivables to a third party. By doing this, the cash in flows of the company are secured, the liquidity risk is lower and defaults of customers will not lead to a significant decrease in earnings. Therefore the solvency risk will also be lower. In case of the case company the financing is not a possible source of risk, as the high equity level leads to low interest payments and a stable financing situation. When the management of internal financial risks is not sufficient next to the management of other risks also the effects of external financial risks should be analysed. If they have a major impact on the earnings situation of the company, the management might consider the use of derivatives to manage these risks. For example the different projects could be analysed. For the most relevant or large ones the company could try to secure the earnings indirectly by using derivatives on the input factors. For the main ones a maximum price could be fixed Therefore, once a worsening of the risk situation or a single risk has been identified, the aim should be to further analyse the source of the risk. Furthermore depending on the risk, different measures or methods to manage it should be used. However, the first and very important step is to monitor critical factors and identify possible risks in order to be able to manage them. 58

5. Critical review and conclusion When doing business, constantly decisions have to be made, whose outcome is not certain and thus connected with risk. In order to successfully cope with this uncertainty, corporate risk management is necessary in a business environment, which is influenced by market frictions. Different approaches and methods can be found for applying such a risk management. However, those mainly focus on large corporations, though they are the minority of all companies. (Rautenstrauch & Wurm, 2008, p.106) Furthermore the approaches often require the use of statistical software and expert knowledge, which is most often not available in SME. They and their requirements for risk management have mainly been neglected. (Vickery, 2006, p.466; Rautenstrauch & Wurm, 2008, p.106) This also includes the internal financial risk management, which was in the focus of this work. Due to the existing risks in SME and their differences to larger corporations as well as the lack of suitable risk management suggestions in theory, there is a need for a suggestion for a financial risk management in SME. The aim was to find a possible mean for the risk identification, analysis and monitoring, which can be applied by SME to manage their internal financial risks. For this purpose the financial analysis, which has been used in research to identify indicators for firm bankruptcy, was chosen. Based on an examination and analysis of different papers, despite of their different models, many similarities in the applied ratios could be identified. In general the papers focus on three categories of risk, namely liquidity, profitability and solvency, which are in accordance to the main internal financial risks of SME. From the ratios the most appropriate ones with regard to their effectiveness in identifying risks and the availability of comparison data have been chosen. Together with comparison data of bankrupt companies from the research papers as well as of successful companies from the German SDAX, those ratios form the overview for internal financial risk management. In this overview data of a SME can be filled in order to evaluate its risk situation with help of this overview. For this evaluation it would have been ideal to use data from bankrupt companies originated in the same country and sector as the SME to improve the comparability. The problematic aspect about the applied data is that the information about the bankrupt 59

companies is older, from different countries and sectors. Furthermore the average value was the only information available in the papers with the result that the dataset could not be corrected of outliers in the values. A possible improvement in further research could be to collect new data, which is matching the characteristics of the SME, which is subject of the risk evaluation. This is likely to improve the evaluation further. Nevertheless the data and the overview can be used in SME risk management. The overview is a risk identification tool, a mean for risk analysis on high level and graphical monitoring at the same time. With the help of the overview a company can easily check whether one of the main risk categories is urgent and needs to be managed. Once a risk is identified on a high level, further internal data can be analysed to figure out where the source of the risk is. Finally appropriate measures can be chosen in accordance with the specific needs of the company. Those last steps are not specified in this thesis and could be subject to further research. The proposed overview is a first step to get an overview of the risk situation. For a detailed assessment of the risk and direct steps to manage it, the available data needs to be analysed in detail. Depending on the company, which uses the overview, next to the chosen ratios additional information about the sector or critical aspects to the company could be included. As a general and comprehensive mean, the overview is suitable for an internal financial risk management in SME. The requirements based on the characteristics of SME are that neither special software nor expert knowledge or large resources are necessary for its application. This is the case here. The overview is based on available company data and the ratios have a direct meaning, which is understandable and connected to the risk categories. Therefore it can easily be applied within a SME. However it must not be ignored that the use of the financial risk overview does not mean that the risks are managed or the risk is decreased. This needs to be done in separate steps. Nevertheless the overview is comprehensible and easy to apply. Due to that it is a first mean, which SME can use to identify, analyse and monitor their risk, which was not available for them in literature before. 60