Barriers and Risks Affecting SMEs

Barriers and Risks Affecting SMEs in Today’s Market

 

2.1 Introduction

Small and Medium Enterprises form an important part of the economy and it plays an important role in the growth of both the developed and developing economies. The contribution of SME towards national income and creation of employment is enormous. In recent years SMEs have also played a significant role in making their presence felt in international markets. Many SMEs are now involved across the value chain from production to export of goods across the globe. Despite these advantages which SMEs offer and the potential which SMEs have there are many barriers and risks which SMEs face in today’s market.

2.2 Risk Management

According to Webb (1994) and Chapman and Ward (1997) ‘risk is an exposure of loss in a given project’. Jaafari (2001) states ‘risk as the probability of losses which a project incurs’

The importance of enterprise risk management can be understood with the below statement given by ‘The Conference Board’.

“There is clearly a heightened awareness of the need to manage risks more strategically in order to achieve expected shareholder value” (The Conference Board, 2005).

Any plan, activity, project, investment or an action by company may result in two outcomes i.e. positive or negative. Positive outcomes are the representation of the benefits received by the company and negative outcomes are the representation of loss. The focus of risk is to avoid any uncertain unexpected events which lead to making loss for the organization (Williams, 1995).

Risk Management is the framework set up by a company which aims to develop objectives that are measurable enough to identify risks and to identify controls which helps to mitigate those risks (Francis and Richards, 2007). Risk is nothing but anything which prevails the company from achieving its objectives. Every organization faces some or the other form of risk and is very inevitable. In simple words, risk is the uncertainty of the plan (McNamee and Selim, 1998). The level of risk for an organization is basically the anxiety with which the future events are unknown and outcomes turn to be negative for the organization (Irwin, 2007). Within the gamut of risk management is the development of the term called ‘enterprise risk management’. Enterprise risk management is the identification and analysis of the risks which surrounds and surfaces the development of the organization, critical success factors for which efficient and strategic tools are used to influence decision making and organizational plans (Irwin, 2007). An organization who wishes to manage risk in a structured manner necessarily has a risk management team which comprises of internal auditors, risk managers, consultants and external auditors.

The process of risk management is a framework which intends to analyze the weak and uncovered areas which hinder the organization success by taking timely action so as to avoid risk, transfer risk, reduce risk and its impact on the entire organization (Risk Management Standard, 1999). The Australian Standard for Risk Management has recommended a seven step risk management model which aims to identify risk, analyze risk, communicate and consult all the relevant stakeholders of risk and lastly to monitor and control the risk.

Risk management is an important part of all small and medium enterprises companies. Risk and the uncertainty associated with it can have damaging consequences for the entire company which can affect productivity, performance, financial shock which may further lead to sickness. However it is important to note that no organization can completely be safeguarded against risk or eliminate risk but however it can transfer or reduce the impact of risk (Burchett, 1999). Risk management approach is done systematically can improve the chances of the organization to better handle the entire risk management process and eliminate and reduce the exposure towards risk. Godfrey (1996) has highlighted that systematic rick management helps an organization to identify, assess and rank the level of risks faced by the organization, helps to focus on higher risk areas, prepares the team to be better informed about bailing in risky situations, in the event of any adversity coming out of it with least damages and defines roles and responsibilities of each and every person associated with the project.

The impact of risk can be measured with respect to the likelihood of a specified unwanted event and its related unwanted outcomes or loss wherein:

RI stands for ‘Risk Impact’

L stands for ‘Likelihood’ and

C stands for ‘Consequence’.

The likelihood of any uncertain event occurring should be measured in terms of number of occurrences which takes place in a year (Godfrey, 1996). The outcome or risk is most of the times classified into a damage which is financial in nature (Godfrey, 1996). Not always can risk be measured and the exact cost of risk at all times cannot be determined. Most of the component of risk is indirect without any relation and is uninsured.

2.3 Application of Risk Management

To control, reduce, eliminate or transfer risk it is very important to first identify the risks and rank it. At the beginning of the risk management process, risk identification is very important as an appropriate action can only follow the identification step (Bajaj, 1997). Organizations need to take risk management as an ongoing activity for the entire organization rather than for a single point in time (Bajaj, 1997). According to Jaafari and Anderson (1995) risk management has three stages for every organization to follow:

Risk Identification

Risk Analysis

Risk Response

2.3.1 Risk Identification

The most difficult and important amongst all steps is to precisely and clearly define and identify the risks which are faced by the organization. The main question which an organization needs to ask itself is ‘What are the factors which will lead to failure for the organization and create instability and losses’? Risk identification will help the organization to develop contingency plans in advance for any occurrence of a specific type of risk (Godfrey, 1996). Identification of risk further helps the organization to design, plan and develop strategies (Godfrey, 1996).

2.3.2 Risk Analysis

According to Williams (1995) the analysis of risk involves the quantification, magnitude and occurrence of the specific type (s) of risks. A risk or an event many be a single one time event or a series of multiple events occurring during a given period of time. There are different technical and statistical tools and techniques used to analyze risks i.e. sensitivity analysis, Monte Carlo simulation, probability analysis and tree based analysis (Mendenhall et al, 1986 and Songer, 1997). Risk analysis helps in quantifying the impact of different types of risk which has been identified (Hayes et al, 1986).

2.3.3 Risk Response

The response to any risk will highly depend on the uncertainty and gravity of the risk. Every risk is different and unique from each other and thus a different strategy needs to be in place to respond to such a risk. At times organizations does not have any plan or response to any particular risk and in such a case the organization plans to absorb the risk, however in other cases the organization will try to reduce, eliminate or reduce the level of risk (Godfrey, 1996).

2.4 Enterprise Risk Management

Enterprises now operate in a market which is not characterized in a monopolistic environment and hence faces pressure from both internal and external variables. Both internal and external variables create pressure on the working of the business. There are lot of risks which are generated out of these internal and external variables and business needs to manage these risks adequately in order to ensure smooth functioning of the business. Enterprise Risk Management is more importantly a strategy for businesses which helps to identify, manage and mitigate risks faced. In order to manage risks, it is important for the firm to define the gravity of the risks and which risks are important which should be accepted and mitigated and the ones which does not require attention (Nocco and Stulz, 2006).

Firms are now focusing and increasing their interest in enterprise risk management because of the change in various policies (Beasley, Clune and Hermanson, 2005). In the year 2003, NYSE changed its corporate governance rules which required that audit committees of the companies need to address risk assessment and discuss policies towards it. The rule further stated that the audit committee is not only required to assess and manage the risks, but also make policies and frameworks and discuss guidelines which helps to monitor the risk assessment and practices which have been undertaken (NYSE, 2003).

COSO defined Enterprise Risk Management as

“Enterprise risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.” (COSO, 2004).

2.5 Micro, Small and Medium Enterprises – Defined in Indian and Global Context

European Union defines Small and Medium Enterprises based on both the number of employees and turnover. An enterprise is constituted as an medium in EU if it has not more than 250 employees and not more than 50 million euro turnover and if not more than 25% of the shares of such an enterprise are in the ownership of another enterprise (OECD, 2005). Similarly a small enterprise is defined in EU if it has not more than 50 employees and not more than 10 million euro turnover. Finally micro enterprises are defined in EU, with not more than 10 employees and not more than 2 million euro as its turnover.

The definitions of small and medium enterprises vary differently in different countries and are not uniform in their size and shape. The definition defers in the context of the economic development which takes place in these countries. The definition given by EU focuses mainly on the number of people employed (OECD, 2005).

The US definition on SME is inclined more towards number of people and turnover. The Chinese definition on SME is also based on the number of employees and turnover. However the Indian definition in based primarily on the investment made in plant and machinery and does not take into consideration the number of people employed.

In the Indian context Micro, Small and Medium Enterprises (MSMEs) play a very crucial role in terms of employment for the country, contribution of GDP and generating export revenues. It is interesting to note that micro, small and medium enterprises have better facts to prove its stand in the Indian economy than large sized companies. The third census related to MSME in the Indian market, the employment to investment ratio of MSMEs is about seven times higher in comparison to large sized companies. Similarly MSMEs are doing better than large sized companies in terms of investment to output ratio (SSI, 2009).

Figure: Comparison between Micro, Small and Medium Enterprises and Large Sized Enterprises

Source: http://ssrn.com/abstract=1284892, working paper series

In the Indian context it is important to understand the definitions which hold true for Micro, Small and Medium Enterprises. A comparison is made between the older definitions provided by the Ministry in 2001-02 and the new definitions provided in the year 2006-07.

Classification of Micro, Small and Medium Enterprises into Different Categories (Old Definition)

Classification

Investment Ceiling (Excludes land and building)

Manufacturing

Services

Micro

Upto INR 25 lacs

Upto INR 10 lacs

Small

Between INR 25 lacs and 100 lacs

Utp INR 10 lacs

Medium

Not Defined

Not Defined

Table: Old Definition of SME in India

Source: DC (MSME)

Classification of Micro, Small and Medium Enterprises into Different Categories (Old Definition)

Classification

Investment Ceiling (Excludes land and building)

Manufacturing

Services

Micro

Upto INR 25 lacs

Upto INR 10 lacs

Small

Between INR 25 lacs and 500 lacs

Between INR 10 lacs and INR 200 lacs

Medium

Between INR 500 lacs and 1000 lacs

Between INR 200 lacs and INR 500 lacs

Table: New Definition of SME in India

Source: DC (MSME)

The Indian Micro, Small and Medium Enterprises segment offers employment to over 30 million people who helps to generate nearly 40% of India’s total exports and the sector is enlarged to nearly 13 million units. The Micro, Small and Medium enterprises contribution to GDP is a staggering 8% to 9%. This segment on an annual basis received cash flow of over USD 12 billion. Study conducted by Ayyagari, Beck and Demirguc-Kunt (2007) in 76 countries including both developed and developing, and found that Small and Medium Enterprises account for nearly 60% of the total manufacturing employment.

2.6 SMEs in India – Present

After independence India has given high priority and attention to its small and medium enterprises (SMEs) which made it possible to define various policies and guidelines towards this segment. However despite several policies and measures taken in the last five decades, SMEs have remained a very small and uncompetitive sector. Further in the year 1991, when the Indian economy opened its doors for liberalization, the problems of SMEs further increased which made it very difficult to survive owing to both increasing domestic and foreign participation. At present the sector is facing intense pressure with high number of units closing every year. However despite these facts, notably SMEs are a driver of growth for a developing economy like India where SMEs account for nearly 40% of the gross industrial value addition and 50% of the total manufacturing exports to the outside market. SMEs in India are spread with over 3.2 million units which produces more than 8000 items which ranges from the basic daily use items to highly sophisticated items and machines. Over 30 million people are employed in this sector which is only next to agriculture in terms of providing employment in India. However in the context of risk management, SMEs face a lot of risks owing to increased foreign competition, change in technology and variable market environment (SSI, 2009).

The present market situation has been comparatively better for SMEs than in the past. Between the year 2001 and 2006, Small and Medium enterprises with net turnover between INR 1 crore and INR 50 crore grew at a rapid rate of 701% compared to 170% growth witnessed by larger companies having turnover over INR 1000 crores (Business World, 2007). The total Small scale industries production was at its peak in the year 1989-90 with INR 1,90,000 crores which fell drastically in the next ten years i.e. post liberalization in 1991. Only after 2000, the production level was surpassed and is now rising dramatically. There are has been a rise not only in terms of production but also in terms of employment and exports (Business World, 2007). The average growth in the number of units has been around 4.1%. The below table gives the performance of micro and small enterprises in India.

Performance of Micro and Small Enterprises

Year

No of Units (in Lacs)

Production (Rs Crores)

Employment

(In Lacs)

Exports (INR Crore)

Registered

Unregistered

Total

At Current Prices

At Constant Prices

2002-2003

15.9

93.5

109.4

(4.1 %)

3,11,990

(10.5 %)

2,10,630

(7.7 %)

260.2

(4.4 %)

86,010

(20.5 %)

2003-2004

16.9

96.9

113.9

(4.1 %)

3,57,734

(14.7 %)

2,28,730

(8.6 %)

271.3

(4.3 %)

97,643

(13.6 %)

2004-2005

17.5

101.0

118.5

(4.1 %)

4,18,262

(16.9 %)

2,51,510

(10.0 %)

280.4

(4.1 %)

1,24,415

(27.3 %)

2005-2006

18.7

104.7

123.4

(4.1 %)

4,76,200

(13.9 %)

2,77,665

(10.4 %)

293.9

(4.3 %)

N.A

Note: Figures in brackets indicates the percentage growth in current year compared to that in the earlier year

Source: Development Commissioner of Small Scale Industries

In present market situation, small and medium enterprises have ventured abroad and some have also entered into the acquisition mode. Lot of small and medium enterprises have started exporting their produce in western world. The small and medium enterprises sector has slowly and steadily transformed itself from a locally concentrated business to a more globally recognized manufacturer and supplier. Small and medium enterprises have also started investing into research and development activities in order to compete abroad. Many clusters and sectors within the small and enterprises gamut have shown tremendous growth in the past few years.

2.7 Barriers encountered by SMEs in International Business

Numerous studies have highlighted that small and medium enterprises have many problems and obstacles than large sized companies. A study was conducted in 2006 for over 10,000 units in small, medium and large sized enterprises across 80 countries found that getting access to finance is one of the major challenges faced by SMEs. The study found that 39% of the small firms, 38% of medium firms and 29% of the large sized firms are facing pressure because of lack of availability of required finance (Beck and Maksimovic, 2006). The wisdom of SMEs having less access to finance is owing to the supply related features. Financial institutions and banks often hesitate in lending to small and medium enterprises because of the inconsistent business model, no stability in cash flows and the capacity to repay and service the obligation (Berger and Udell, 2006; Watanable, 2006).

Globalization has opened the doors for lot of small and medium businesses around the world and has created business opportunities. Small and medium enterprises can exploit the international opportunities by gaining both economies of scope and economies of scale, by spreading risks across the markets and product line and taking benefits of low cost resources in different geographies around the world (Wilkinson and Brouthers, 2006). However despite all these advantages which small and medium enterprises can reap from international markets there are a lot of complexities and barriers which these businesses have to face. Small and medium enterprises lack expertise in handling international operations, there are a lot of trade and legal regulations and lastly there are various risks which these companies face in international markets (Leonidou, 2004).

Sonia (2003) in her study found that there are four main barriers which affect the functioning of SMEs in international markets: knowledge related to export, lack of easy access to key resources, high procedural regulations and external market.

Further a study was conducted by Fillis (2002) which found that SMEs normally face problem in starting with the international business. SMEs are not able to choose a reliable foreign partner with whom they can trade, they are further not in a position to match competitor pricing, lack of knowledge about the local markets, difficulty in communicating with the foreign customers and lack of knowledge about the trade practices in international markets.

Leonidou (2000) also conducted a study on SMEs and found that the main problems which SMEs face in international markets are related to the intense competition faced in international market, inability of the company to offer competitive prices, disturbing macroeconomic situation in international markets and lastly lack of support and assistance given by foreign governments and foreign bodies.

2.8 Present Issues faced with SMEs in India

In the past banks were very sceptical of lending to the SME segment; however the banking mindset has changed dramatically owing to the vast potential and business which this segment offers. Different banks have different norms with respect to what constitutes an SME. However the New Act and amendment which has come have clearly defined the gamut under which SME has been defined. However Indian definition is very different from the foreign version of SME which constitutes turnover between INR 10 crores and INR 700 crores. The lending made to this segment has increased at a faster pace between 2000-2001 and 2005-2006 with 79% growth in lending. However it is important to note that lending to medium enterprises has been growing faster compared to lending to small enterprises. By 2006 the lending made to small scale enterprises grew only by 6.3% (SSI, 2009).

In the past lending were made small scale industries on a very conventional method, however banks and financial institutions now have a very expertise department handling lending to small and medium enterprises. Banks and financial institutions have now started adopting new practices and methodologies which entails studying the company to the last dot before any lending is made.

Some of the key problems which Small and Medium Enterprises face are given below.

Higher Rate of Interest i.e. above Bank PLR

Lack of clear and Adequate Collateral

Conditional use of Working Capital Facilities

Time consuming procedures and lot of documentation

Higher Processing Fees charged

Heavy penal interest/fees

Restricted use of the funds

2.8.1 Marketing

Another key area which requires attention for Small and Medium Enterprises is marketing. Small and medium enterprises exist to sell their products which in turn depend on better and skilled marketing techniques. Small and Medium enterprises do not hold a better bargaining power and hence they have to sell their goods on credit which makes their cash flows delayed causing problems in the working capital cycle. Because of lack of funds, small and medium enterprises do not have access to highly paid professionals and they lack marketing and selling skills (Sonia, 2003).

2.8.2 Technological Upgradation

For small and medium enterprises, it becomes very important to have new technology in place so as to compete in the outside market. However acquisition to technologically advanced machinery is a onetime investment for these companies and it becomes very difficult for them to manage it due to paucity of funds. Secondly small and medium enterprises are not completely aware about the new technology and tools which are available in the market for speedy and low cost production (Stuti, 2005).

2.8.3 Sickness in Small Scale and Medium Enterprises

Small and medium enterprises operate in an environment which has high level of competition both from large sized domestic companies and foreign companies. Because of the inability of these companies to match the competition of large companies, small scale enterprises are not able to have access to higher level of funds and are not able to service regular interest rate and pay their debt leading to becoming a non performing asset for the bank (Stuti, 2005).

Indian SMEs are facing lot of problems and difficulties in selling their produce both in domestic and international markets because of intense competition. For being able to fight back competition and grow locally and globally, SMEs need access to low cost finance, higher technology upgradation and larger emphasis on innovation. Small and Medium enterprises produce over 8000 different items in India and has been growing at a steady pace of 8 to 9% annually. Despite its importance in the Indian market, small and medium enterprises face lot of obstacles and challenges in running their business. The key problems faced by these enterprises are inability to raise working capital funds from the banks, low level of bargaining power, higher bureaucratic procedures and lack of management skills. Further the entry of foreign players and large sized companies further hinders these companies development (Kacker, 2005).

2.9 Risk Management and SME

Few decades back, risk management was encircling around only few tasks and risks however in the present market, the situation has changed and there has been a stress on companywide risk management framework (Islam et al, 2008; Berry et al, 2007; Alquier and Tignol, 2006, Arnsfeld et al, 2007, Leopoulos et al, 2006). Because of poor risk management systems with SMEs bank are reluctant to lend to SMEs. Lenders and financial institutions including banks now demand for better accountability and transparency in the way risk management is carried out in the company (Merna and Al-Thani, 2008).

All forms of businesses need risk management systems in place, but small and medium enterprises specifically need a robust risk management framework in place. Large sized firms have professionals and highly paid personnel which are specifically appointed to identify and manage risks, however the case is different for small and medium enterprises in place. SMEs are normally closely held companies which are unlisted or partnership firms and HUFs. There is a prime fundamental difference between the way business is carried out by SME and large sized firms i.e. by the character and integrity of the promoter/owner. Following are specific risks which are faced by SMEs:

2.9.1 Constitution of Business

Small and medium enterprises are closely held family businesses where business is mainly run with the help of family members, friends and relatives. The constitution of these enterprises is mostly into proprietorship or partnership basis and private limits companies. Very few companies are public limited company and whose scrip are listed on the stock exchanges. Since all these constitutions are closely held businesses, they lack transparency, accountability and professionalism in the way they operate. The inability of these enterprises to display transparency and accountability makes it vulnerable to raise capital from banks and financial institutions (Sonia, 2003).

2.9.2 Leverage

The nature and business of a small and medium enterprise is such that there is a restriction to mobilize capital and funds from banks. Their inability to raise capital and borrowing capacity impacts the capacity of these enterprises to leverage on the financial structure (Howorth, 2001).

2.9.3 Tough competition and Inadequate Margin

Small and medium enterprises face intense competition from large sized companies and foreign players which makes it difficult for them to run their business. High level of competition makes them incompetent to absorb the rising input prices of raw materials and other key resources. Similarly on the selling side, these enterprises lack bargaining power and invariably have to offer higher period of credit limits which in turn postpones the receivables and at times makes them sticky. This makes it very vulnerable for small and medium enterprises to run their working capital cycle smoothly (Sonia, 2003).

2.9.4 Sticky Account Receivables

The business of small and medium enterprises is characterized in such a way that they have to give a higher lending period to their customers. This is because of the weak bargaining power present with these enterprises. The inability of the enterprises to dictate terms with their customers makes it difficult for them to manage their receivables on time. Postponement of present receivables impacts the current liquidity position of the company which invariably also increases the chances of receivables turning bad and sticky (Stuti, 2005).

2.9.5 High Employee Turnover

Small and medium enterprises do not offer high growth prospects for employees which make it very difficult for the management to retain staff. Most of the employees work on a daily wage basis and hence there is a high level of rotation of new employees coming in the organization. This is very risky and expensive for the management since management has to invest in some form of basic training before the employee goes in for work. This leads to lot of wastage and additional cost in the form of training, knowledge updation which in turn impacts the productivity of the enterprise. Gaining access to semi-skilled and skilled employees is one of the major problems and risks faced by SMEs (Stuti, 2005).

2.9.6 Collateral Security

The presence of collateral implies that banks need not worry about their funds being lent. Wherever the collateral security is present, banks are safeguarded and do not involve themselves into detailed business analysis and viability of the funds being used. Collateral otherwise also reflects the creditworthiness of the borrower. Collateral is normally required by banks when the business is relatively very small, there is no proven track record and no credit rating is available (Sonia, 2003). However small and medium enterprises normally keeps their stock and book debts as their primary collateral and property as their secondary collateral. This is because of the risk faced by SMEs in running their business and chances of incurring losses and turning stick which will lead to loosing the land and building kept and collateral security.

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