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March, 2014

Author: Ali Al Aali

Academic Supervisor:

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

Table of contents
1. Introduction ................................................................................................. 1
1.1. Context and research question ............................................................... 1
1.2. Methodology and structure of thesis......................................................
1.3. Delimitations and validity......................................................................
2. Theoretical overview ................................................................................... 3
2.1. Definition of main terms ........................................................................
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 ...................................................................
2.2.1. Process of risk management ............................................................ 7
2.2.2. Risk categories .............................................................................. 13
2.3. Financial risk management ..................................................................
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 .............

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 .....

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.

Context and research question

Risk and economic activity are inseparable. (Liekweg & Weber, 2000,
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 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 fulfills the requirements and can
be applied to SME?

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: authors 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
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 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.

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
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.

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.

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,

As a first step for the definition, similar terms, which are often used
exchangeable in every days 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 decisionmaking 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).

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.

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 the theory, gains and losses due
to volatility might even out. However this might be different in a shortterm 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 (Schnborn, 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
companys 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.
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
Small sized
Medium sized

< 50
< 250

< 10 million
< 50 million

Balance sheet total

< 10 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).

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 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: authors 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 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,

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
(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
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, 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 companys 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 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
manage 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).
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 firms
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.

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
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).

External financial risks are based on the risk factors of exchange and
interest rates as well as commodity prices (Schnborn, 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 & Blu, 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,
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 companys
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 prediction of this
sensitivity is also difficult and hardly measurable. It is therefore in
practice ignored for most products and companies (Schnborn, 2010, p.4).
Commodity price risk




procurement market is



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 (Brner, 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. Long- term 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).
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 (Brner, 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 companys 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),
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 assets 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 (Brnger, 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, 2010, p.1) Futures, forwards,
options and swaps are the first generation of derivatives (e.g. Armeanu &
Blu, 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 & Blu, 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 contracts 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; Brnger, 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, Brnger, 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).
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 managements time involved in the process (Brnger,
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 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 (Brner, 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
Gttler (2007) find that SME on average have equity ratios lower than

20% (Behr & Gttler, 2007, p.194). For German SME, Brner (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% (Brner, 2006, p.302). These low ratios make bank loans the most
important source of funding for SME (Behr & Gttler, 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 & Gttler, 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.
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 managements 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 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 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 (Milos Sprsic, 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).
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 SMEs 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)
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
2 Garca-Teruel & Martnez-Solano (2007); van Caneghem & van
Campenhout (2010); Levenson & Willard (2000); Everett & Watson

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 latters 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
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 firms ability to
pay its current and future

bills. Additionally the success of the company in form of a return is

important as losses lead to a decrease in the companys 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 & Brggemann, 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

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).

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
companys 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 companys insolvency risk (Baetge & Brggemann, 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 firms 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

financial situation of the company of interest is assessed (Baetge &

Brggemann, 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,
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).

Based on a logit regression, Baetge (2002), together with the rating agency
Moodys, developed a rating tool for evaluating a companys 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 & Brggemann,
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 Moodys - 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
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.)

Informatio x% of all
Category of Ratio (used in x out of 11
38 % of all
cash, quick or current assets / current
liabilities (8)
5 use 1 or working capital (6)
or current
to total
on assets,
(8) assets
profitabilit 29 %2of all
sales to assets (5)
2 dont use
retained earnings (4)
18 % of all
equity to debt or total assets (8)
debt to assets (6)
9 use 1 or
debt cost & 5 % of all
cost of debt (3)
debt structure (1)
7 do not use
5 % of all
growth in profit or value (4)
7 do not use
6 % of all
sector, size, staff cost (4)
7 do not use
*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, authors
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
owners 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

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
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








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

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 companys 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 & Brggemann, 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).

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 &
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.

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
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.

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 firms 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: authors illustration

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 companys 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 SMEs 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.

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), authors 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

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
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.
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

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 Sandins and Porporatos paper cannot be
used for the analysis.
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); authors illustration

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 firms 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.
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 groups 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), authors

Although a difference between the two groups of companies can be

observed in Sandins and Porporatos 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 companys 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

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 periods 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
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,

information about the interest rate obligations should be included in the risk

Figure 7: Development of EBIT / total assets and net income / total

Data source: Porporato & Sandin (2007) and Altman (1968), authors
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 /

Data source: Porporato & Sandin (2007) and Altman (1968), authors

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


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

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 shortterm 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: authors 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.

4.1.4. Comparison data for the risk

For the risk overview different data is available for a comparison with the
companys 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

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



3 From the comparison of all SDAX values (Deutsche Brse, 2011b) and
those, which are classified by
Deutsche Brse in the industrial sector (Deutsche Brse, 2011a)

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 nonbankrupt 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.

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
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 Brse, 2011a; Deutsche Brse, 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.

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 / (longterm 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 longterm 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.

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

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

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

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

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 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
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.

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,
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 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.