Empirical Study on Building Financial Early-warning System

for SMEs
LIN Juan FANG Hui
China University of Geosciences ,P.R.China, 100083
linj1998@126.com

（ ）
Abstract: The thesis is based on how Small and Medium-sized Enterprises SME build their financial
Early-warning indicators system. So the thesis had studied the foreign and domestic financial
Early-warning theories, then it designed out innovative SMEs’ Early-warning indicators system that was
based on the actions of financial management, and then designed the model of Early-warning that
combined the way of Efficiency Coefficient. At last the thesis had empirical study of specific company.
Key words: SME, Financial Risk, Financial Early-warning Indicators

1. The Theory of Financial Risk Early-warning of SME

Financial Risk Early-warning of Small and Medium-sized Enterprises (SME) is defined as the risk
controlling system of analyzing and forecasting management and financial information to find out
potential danger, which is based the financial statements, management plans and some relative
accounting data.

1.1 The foreign research status of financial risk Early-warning

The foreign theories of financial risk Early-warning have experienced many courses, such as a
single variable, the multiple variables, financial Early -warning integrated variable model.
（） 1 One single variable Model: The research on the financial early -warning systems started in the
1920's. Fitzpatrick used one single indicator to analyze financial risk early-warning in 1932. William
Beaver, an American, resorted to precise Statistical Methods and raised the univariate model in early
1966.
（） 2 Multiple Linear Discriminant: In 1968, Edward Altman comprehensively analyzed a group of
data, and he first built Z-Score Model in virtue of Multiple Discriminant Analysis. In 1972, Edmister
built financial crisis early warning system for small enterprises. In 1977, Martin first used of Logit to
build financial crisis Early-warning system.
（） 3 Multiple Logistic Regression Model: With the developing of the advanced statistical methods,
the researchers began to estimate the probability of the enterprises in trouble by Multiple Logistic
Regression Model entering the 1980s.
（ ） 4 Recursive Segmentation Method: In 1985, Frydman and others researched a new
method——Recursive segmentation method. Multiple-Variable Model contains large amounts of
information, and Single-variable model is simple. The advantages of this method have both
Multiple-Variable Model and Single-variable model.
（） 5 Neural Network Model: In 1991, Coat and Fant discoursed upon the viewpoint that Neural
Network Model could correctly predict the company's financial crisis. They surveyed 47companies in
financial crisis and 47 healthy companies. The goodness- of- fit of model result was up to 100%.
（） 6 Non-statistical Financial Warning Method:,Messier and Hansen introduced Expert System into
financial warning In 1988; Gregory-Allen and henderson.Jr pointed out that Disaster Theory could
describe company's bankruptcy, and did some empirical tests In 1991;Lindsay and Campbell used
Chaotic Systems to analyze some matching Samples of 46 bankrupt and non-bankrupt companies In
1994. They found that the healthy companies appeared more chaos phenomenon than non-healthy
companies; In 1999, Kim and Meleod built linear models, and nonlinear models of expert decision
making in bankruptcy prediction. The result has shown that the nonlinear models had better effect; In

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2000, Charitou and Trigeorgis applied Option Pricing Model to financial risk early-warning.

1.2 The domestic research status of financial risk Early-warning

The domestic research on financial early-warning was a late start. Overall, there are two major
categories, which is single-model and multi-model comparison study.
（） 1 Single-model Study: in 1996, Xiaohua Zhou proposed F-Score Model; in 2000, Ling Zhang used
more accurate breakdown data sample and Linear discriminant analysis method to forecast. As a result,
this model had better effect than 4-year ago; in 2000, Aimin Zhang utilized the Altman Z-score model
and statistical methods of Principal Components Analysis (PCA). He built PCA-Prediction Model; in
2001, Baoan Yang and others developed an model to forecast the likelihood of a financial crisis based on
BP-Neural network analysis method. The correct rate was acceptably high at 95%.
（） 2 Multi-model Comparison Study: Jing Chen researched 27 companies which got special
treatment in 1998 with Univariate Analysis and Multiple Linear Analysis Method, and Compared of the
two methods; This study is the first domestic research on financial woes in empirical method; in 2001,
Shinong Wu and Xianyi Lu researched 70 companies in financial crisis and 70 companies in normal
conditions, which were Chinese companies listed. They chose six indicators with Single-variable model,
and then built three financial crisis early warning models, respectively using Fisher Linear Discriminant
Method, Multiple Linear Regression Method, and Logistic Regression Method. The research found that
the three model all could do a more accurate judgment before financial crisis.

2. The Design of Financial Risk Early-warning System of MSE

2.1 The Basic Structure of Financial Early-warning System of MSE

Financial Early-warning System

Financing Early- Investing Early- Operating Early- Distribution Early-

warning indicators warning indicators warning indicators warning indicators

Capital structure Investment income Profitability Distribution

structure

Capacity to pay Investment Operating Capacity for

structure capacity to capital growth
assets

Financial risk Efficiency of assets Capacity to cash

flow

Earnings quality

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 Chart 1: Financial Early-warning System of SME
Table 1: Financial Early-warning Indicators and Weights of SME
（ ）
Financing Early-warning Indicators 30%
Capital
Sstructure
（ ）
Debt Ratio 10% Total Liabilities/Total Assets

Operating Cash Flow Current Liabilities Net cash flows from operating activities / Current
Capacity to
Ratio(7%) Liabilities
pay
Times surplus cash (7%) Net cash flows from operating activities / Net profits
Financial
Times interest earned (6%) Earnings before interest and tax /Interest
risk
Investing Early-warning Indicators (20%)
Investment
Investment yield (8%) Investment income / investment costs
income
Long Term Equity investment Ratio(4%) long-term equity investment /Latest Audited Net Asset
Investment
structure External Investment and Equity
External Investment/ Owner's equity
Ratio(4%)
Efficiency
Net assets yield (4%) Net profit / Owner's equity
of assets
Operating Early-Warning Indicators (40%)
Net profit margin (7.5%) Net profit / Sales
Profitability
Return on assets (7.5%) Net profit /Average total assets
Operating Inventory turnover (5%) Costs of goods/Average inventory
capacity to
assets Accounts receivable turnover (5%) Sales/Average accounts receivable
Capacity to Main Business Income Cash Recovery
Net cash flows from operating activities /sales
cash flow Rates (7.5%)
Earnings Cash flows from operating activities / Cash outflows
Operating cash in-out flow ratio (7.5%)
quality from operating activities
Distribution Early-warning Indicators (10%)
Distribution
structure
Dividend payment ratio (4%) Dividends ／Net profit
（Owner's equity －
at the end of year Owner's equity at
Capacity Capital accumulation ratio (3%) the beginning of year ）／ Owner's equity at the beginning
for capital of year
growth （ －
Reserve fund at the end of year Reserve fund at the
Reserve fund growth ratio (3%) beginning of year ）／
Reserve fund at the beginning of the
year

3. The Empirical Analysis of SMEs’ Financial Early-warning Indicators

3.1 The satisfaction and impermissibility of early-warning indicators (maximum or minimum).

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 Table 2: Industry Standards of Financial risk Early-warning Indicators

Main Operating
Business Reserve Cash
Return Net Capital Net
Income Fund Flow
Maximum Variables on Profit Accumulation Assets
Cash Growth Current
Assets Margin Ratio (3%) Yield
Recovery Ratio ( Liabilities
Rates Ratio

Satisfaction 0.0432 0.0667 0.0925 0.0292 0.0765 0.0703 0.1133

Impermissibility 0 0 0 0 0 0 0
Cash
Times Times Accounts
In-out Investment Inventory
Maximum Variables Interest Surplus Receivable
Flow Yield Turnover
Earned Cash Turnover
Ratio
maximum Variables 1.0898 0.0879 8.53 2.6146 11.64 7.82
impermissibility 0 0 1 1 5.82 3.91
Debt Long Term Equity External Investment and Net assets
Interval Variables
ratio investment Ratio Equity Ratio yield
Satisfaction (max) 0.5431 0.3887 0.4564 0.3389

Satisfaction (min) 0.3431 0.1887 0.2564 0.1389

Impermissibility(max) 0.8862 0.5774 0.7128 0.4778

Impermissibility(min) 0.22155 0.14435 0.1782 0.11945

3.2 The Average of Company Financial Ratios from 2002 to 2006 in China

Table 3: The financial ratios from 2002 to 2006

Financing Early-warning Indicators Operating Early-warning Indicators
X1:Debt ratio 0.1881 X9:Net profit margin 0.0438
X2:Operating cash flow current liabilities ratio 0.2547 X10:Return on assets 0.0700
X3:Times surplus cash 7.9140 X11:Inventory turnover 3.0943
X4:Times interest earned 155.0856 X12:Accounts receivable turnover 1.7598
X13:Main Business Income Cash
Investing Early Warning Indicators 0.0722
Recovery Rates
X5:Investment yield 0.0221 X14:Operating cash flow in-out ratio 1.0918
X6:Long Term Equity investment Ratio 0.0900 Distribution Early-warning Indicators
X7:External Investment and Equity Ratio 0.0840 X15:Dividend payment ratio 0.0931
X16:Capital accumulation ratio 0.0102
X8:Net assets yield 0.0512
X17:Reserve fund growth ratio 0.0507

3.3 Effectiveness Coefficient Indicators

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 Table 4: The Financial Ratios’ Effectiveness Coefficients
Financing Early-warning Indicators Operating Early-warning Indicators
X1:Debt ratio 48.9921 X9:Net profit margin 86.2669
X2:Operating Cash Flow Current
100 X10:Return on assets 100
Liabilities Ratio
X3:Times surplus cash 100 X11:Inventory turnover 51.6552
X4:Times interest earned 100 X12:Accounts receivable turnover 32.0948
X13:Main Business Income Cash
Investing Early-warning Indicators 91.2216
Recovery Rates
X5:Investment yield 48.9921 X14:Operating cash in-out flow ratio 100
X6:Long Term Equity investment Ratio 10.9808 Distribution Early-warning Indicators
X7:External Investment and Equity Ratio 11.8159 X15:Dividend payment ratio 5.8098
X16:Capital accumulation ratio 73.9726
X8:Net assets yield 89.1323
X17:Reserve fund growth ratio 86.5098

3.4 This company’s Comprehensive efficiency coefficient near 5 yeans

G = ∑Gi*Wi
G---- Comprehensive efficiency coefficient; Gi ---- Single efficiency coefficient variable
Wi ---- weight
G=0.1X1+0.08X2+0.06X3+0.06X4+0.08X5+0.04X6+0.04X7+0.04X8+0.075X9+0.075X10
+0.05X11+0.05X12+0.075X13+0.075X14+0.04X15+0.03X16+0.03X17=72.5298

3.5 The Company’s Financial Early-warning estimated Degree

Comprehensive Efficiency Coefficient of the company is 72.5298 from 2002 to 2006, this shows
that the company is in the middle stage, high financial risk, general assets situation. Single efficiency
coefficient variable can also get this result. The major reason lies in investment and cash flow risk. So
the manager should pay attention to the two aspects.

Table 5:The Table of Early-warning Judgments

Comprehensive
District Effectiveness Notes
Coefficient
Super risk ≤60 enterprises in the financial crisis, asset deterioration
enterprises heavy financial risk is extremely high, asset
Serious risk 60-70
poor condition
enterprises in the high financial risk, the general situation
Middle risk 70-80
of assets
Light risk 80-90 Enterprise Financial higher risk, asset condition
No risk ≥90 enterprises minimal financial risk, in good assets

4. Conclusion

Through the study on the Small and Medium-sized Enterprises’ financial risk early warning system
of indicators, the innovational conclusion can be obtained. Based on Small and Medium-sized
Enterprises’ four financial management activities to design financial early-warning indicators system,
refer to Comprehensive efficiency coefficient method, and build the financial early warning model for
SME. SME can judge operating and financial risk; At the same time, SME can change or adjust some
indicators under enterprises’ different conditions.

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 References

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Financial and Economic Publishing House, 2004: 121 127 (in Chinese).
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