Strategic risk and SME s performance: an analysis of alternative risk measures Case study PROVISION Ltd

Transcription

1 Strategic risk and SME s performance: an analysis of alternative risk measures Case study PROVISION Ltd Author: Neacşa Iuliana In today s world, managing risk is no more an option but a necessity Why SME? The important role that small and medium enterprises have in most countries of the world economy, primarily in the developed countries, has generated in recent decades, the great interest of specialists for this business. SME contribute to a significant number of jobs, absorbing part of the available workforce due to restructuring of the economy. In addition, SME can influence through their mobility and flexibility, the process of adapting production to market requirements. In Romania, a successful SME acting in the direction of diminishing the role of large monopolistic enterprises, increase employment of active labor, increased competitiveness, thus creating a dynamic and their profitability through a strong impact throughout the economy. The crisis initially affected developed countries, but spread rapidly and the emerging areas, including Central and Eastern Europe, the latter being placed in high-risk category (Romania being considered among the most risky). The global economic crisis has manifested itself by reducing the rate of development of SMEs and increasing the number of bankruptcies, affecting the economy of all states. The period showed that the SME sector is one of the most affected by economic and financial crisis, while representing the sector can contribute substantially to the recovery of the economy as a whole. For SMEs in Romania is a difficult period with reference to economic and social problems they face. Their survival raises problems in periods of economic recession when the number of customers, segments and market share are deficient. In

2 this stage a series of measures are necessary to align the conditions of small and medium European Union. Point out that the main disadvantages of an SME: reduced capital, making them vulnerable to economic shocks, the lack of functional distribution systems and access to efficient and affordable marketing services, low access to new technologies, lack of sufficient managerial and economic skills. Problems faced by SME in this stage are: the depreciation against major foreign currencies, high interest loan capital, inflation, high taxes relative to the volume of activity of firms, lack of own resources, compressing the internal market, competition of foreign products, the difficulties resulting from legislative and institutional and corruption. These problems lead to adverse social and economic consequences. Economic consequences is to decrease investments in the private sector, reducing domestic demand for products and services, reducing turnover and even bankrupt companies, the reduction in revenue from the state budget. The main social consequences are increasing the number of unemployed, tense social climate, decreasing the purchasing power of the population and depriving consumers of products "Made in Romania" more accessible and often better. Company survival depends: the evolution of industry economics, firm age, its size, the existence of competing firms, strategic choices of entrepreneurs, the growth rate of the firm. At present, most governments have adopted anti-crisis measures, grouped into two broad categories: stimulating demand (packages to stimulate consumption, infrastructure programs, tax policies on the system) and loan recovery measures, including measures to recapitalize banks and concentrated on facilitating access to financing for SME. Providing loans covered by state guarantees, is the measure most commonly encountered in the measures adopted by governments in the current period. These important aspects of current economic reality, that one of the basic needs of an SME financing is the need for capital due to reduced financial resources and how beneficial it is for an SME it s optimal performance versus debt, stood at the option that I made the choice to work as a dissertation topic: Strategic risk and SME s performance- an analysis of alternative risk measures.

3 The main objective of the present working paper is to verify what correlations can be found between the main profitability and risk ratios for SME s from different sector of activity, in comparison with the previous theoretical and empirical results. Overall, the paper is an attempt to provide a view on existing correlation between risk levels and rates of profitability, and research conducted during the preparation of the dissertation work, were directed towards the following objectives: approach the theoretical and practical aspects of risk and return rates; presentation of representative indicators and their interpretation in the case study on the Provision Company Ltd; measuring the representativeness and intensity of the link between these indicators of risk and profitability in a sample of 39 SMEs. First chapter begins with the legislative classification of SMEs in our country and continue with their presentation in the context of the current economic situation, their importance and financing needs of SME s and the reason that I choose this theme of the dissertation. In the second and third chapters I presented some important theories and empirical results concerning correlations between Profitability and Risk Rates. Considering many working papers and ideas from the specialty literature, the most relevant profitability ratios are as follows: ROS (Return on sales), ROA (return on assets) and ROE (return on equity). The profitability of a company can be influenced by many types of risk. This can be measured by the following ratios: leverage (measured as debt-to-equity) and coverage (current result/ interest charges), liquidity (current assets to current liabilities). Other factors that have also an impact on the profitability ratios are: the size of the company, the previous profitability and the percentage of the fixed assets in total assets. The performance of the company can be influenced by its financial risk. It is determined by the company s finance policy with equity and borrowings. The companies use equity and borrowing for financing their current activity. The leveraging has two fundamental features for the company: on one hand, the obligation to pay regular interests, which means financial

4 expenses that reduce the results, on the other hand taking credits could lead to a profitability surplus. If the cost of borrowed capital is below the cost of equity, appears the possibility of fiscal deducting of the leverage expenses. So, this justifies that credit taking is a possibility of increasing profitability. But, increasing the leverage it means an increase of financial risk that modifies the shareholders attitude, regarding the expected level of profitability. The financial risk appears when the contracted credits don t generate financial efficiency; in other words, when the return on assets obtained using the credit is below the interest of the credit. By maintaining an optimal ratio between the equity and the borrowings, the leverage can be used for increasing the performance. The necessary condition for obtaining a profitability superior to the return on equity is that by a good management of the assets to provide efficiency above the cost of the borrowed resources. Otherwise the financial risk will be imminent. The capital structure of a firm describes the way in which a firm raised capital needed to establish and expand its business activities. It is a mixture of various types of equity and debt capital a firm maintained resulting from the firm s financing decisions. More than four decades ago the modern theory of capital structure established after the publication of the celebrated paper of Modigliani and Miller (1958). The Modigliani Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does no matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. But the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure. According to the static trade-off theory, the agent costs, taxation and the bankruptcy cost encourage the companies to take credits. The bankruptcy risk reduces when the company is profitable. If the company s incomes are sufficient to cover all debts, including interest charges, then the company could benefit of fiscal economy associated with the leverage. A conclusion of

5 the static arbitrage theory could be that the profitable companies can be more indebt because the reduce probability of bankruptcy. A big turnover is a signal that the company is profitable, it has a lower probability of bankruptcy and the cash flows are stable, so it can obtain funds, and it can get credits in better conditions than a smaller company. In a static trade-off framework, the firm is viewed as setting a target debt-equity ratio and gradually moving towards it. Debt financing has one important advantage over equity: the interests that firm pays are tax-deductible while equity income is subject to corporate tax. But debt also increases financial risk that makes debtfinancing choice not cheaper than equity. So, in a static trade-off consideration, managers regard the firm s debt-equity decision as a trade-off between interest tax shields of debt and the costs of financial distress. Under trade-off theory, the firms with high growth opportunities should borrow less because it is more likely to lose value in financial distress. On the other hand, we have the pecking order theory attributed to Myers (1984), that sustain the idea that companies prefer to indebt, avoiding the issue of shares when their sources are insufficient to finance profitable investment opportunities. In these circumstances, a company that borrow forward, on the one hand, a signal of insufficient equity, but also one of the existence of profitable investment projects that it wishes to exploit. Theory based on agency costs illustrates that firm s capital structure is determined by agency costs, which includes the costs for both debt and equity issue. Agency costs arise due to the conflicts of interest between firm s owners and managers. Jensen and Meckling (1976) introduce two types of conflicts: a) conflicts between shareholders and managers and b) conflicts between shareholders and bondholders Conflicts between shareholders and managers stems from the separation of ownership and control. Harris and Raviv (1990) observe that managers will typically wish to continue operating the firm even if liquidation is preferred by shareholders; Stulz (1991) observes that managers prefer to invest all available funds even if shareholders want to be paid dividends. A special case of the conflicts between shareholders and managers is the overinvestment problem. Jensen (1986) argues that, instead of working under shareholders interests to maximize firm s value, managers prefer to increase firm s size to enjoy the benefit of control.

6 Conflicts between shareholders and are that the shareholders or their representatives make decisions transferring wealth from bondholders to shareholders. Other Empirical Evidence on Capital Structure Determinants have shown that a number of factors affect firm s capital structure choice, such as tangibility, tax, size, profitability, growth opportunities and volatility etc. In their distinguished works, Harris and Raviv (1991) summarize that leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size and decreases with volatility of earnings, advertising expenditure, the probability of bankruptcy, profitability and uniqueness of the product. However, the relationship between the factors and capital structure is not consistent. The empirical results vary, and sometimes contradict in many studies. Moreover, comparisons of capital structure across countries reveal that institutional differences may affect the cross-sectional relation between leverage and factors. Among the notable exceptions Rajan and Zingales (1995), in one of the most important empirical studies for corporate capital structure determinants, which were taking as reference in many other empirical studies after that, found out that leverage increased with asset structure and size, but decreased with growth opportunities and profitability. Booth, Aivazian, Demirguc Kunt and Maksimovic, studying the same subject determinant of the capital structure for 10 countries - had reached the opposite conclusion: so, the long-term debts ratios decreased with higher taxes rates, size and profitability, but increased with tangibility of assets. Using asymmetry information on Romanian capital market, in a regresion model realized by M.Dragota in her doctoral dissertation Main factors analysis for capital structure of the companies listed on capital market, on a sample which contained companies listed on Bucharest Stock Exchange for the period , where the dependent variable was the leverage and the independent variables were: tangible assets, size, profitability and market-tobook ratio, following conclusions were drawn: 1. The profitability: excepting a year, for which a positive correlation with the total and commercial leverage can be noticed, but statistically insignificant, in all the other cases, the correlation is negative, for accounting values, but also for the market ones. This sustains the conclusions of the pecking order theory.

7 According to the pecking order theory, a positive correlation between leverage and growing opportunities could be explained. Thus, the debt rose when the internal financing resources were not enough for investment and diminished when these were sufficient. 2. Tangible assets (as a percent of total assets): the financial theory mainly sustains a positive correlation between them and the leverage. In the Romanian case, when the variable is statistically significant, the correlation is negative. The conclusion of a negative correlation with the commercial debt, and, respectively, with the total debt (in which, the former are predominant) is logical, because this is how the companies finance the investments in current assets, while the financial debt is used to finance the fixed assets. 3. Size is positively correlated to the financial debt. The big firms sent a more direct signal to the creditors and could obtain a credit more easily, especially in the context where a bigger turnover is associated to a smaller risk exposure 4. Market-to-book-ratio: the correlation is negative and statistically significant for the market values, no matter the kind of debt we referred to. For the book values, there were positive, but also negative correlations, but in most cases they are not statistically significant. In my study case presented in 5 chapter, on a sample of 39 SME on different sector of activity, interesting conclusions were obtained in point of correlating the economic- financial indicators with the bankruptcy risk, even if the results of the model can not be extended at the level of the general population as the sample is not representative. The method that I used to analyze the relevance of the accountancy information is the linear regression ecuation, where the dependent variable is indicators of financial performance and the independent variables are the financial ratios. The independent variables that have the most high Standard Deviation, meaning the variables that have the largest oscillation related to their mean, are Inventory, Average Payment Period and Average Collection Period. Variation coefficients are bigger than 50% for all analyzed indicators, which questions the significance of the sample average for each indicator separately (as we can see from the fig.10). Also in this case we speak about communities who are not homogeneous after analyse of indicators on the 39 companies included in the sample. Coefficient of variation for total sample (39 companies)- Fig. 10 linear The Coefficient mean average of variation Rates of return deviation

8 Gross profit margin 0,44 0,28 63,96 Assets turnover ratio 1,48 1,13 76,55 Inventory turnover 275, ,53 405,33 Net margin rate 0,12 0,64 518,77 Average collection period 74,52 68,06 91,34 Average payable period 88,29 102,11 115,66 ROA -0,02 0, ,64 Return on equity (ROE) 0,38 1,39 369,99 Earning power -0,03 0,23-913,08 Rate Risk Current liquidity 1,29 1,14 88,40 Quick liquidity 0,96 0,93 96,55 Debt ratio 0,36 0,26 71,19 Leverage -0,38 10, ,76 Using the regression coefficients result as we can see from the graphics below, an existent relation between the dependent variable and the independent one, meaning how much the dependent variable suffer modifications. The determination coefficient R² expresses the percent of the variation of the dependent variable which is explained by the regression equation. Analyzing the correlations, the following observations can be issued: Size is positively correlated to the short term debts. In general, the companies with a big turnover have chances to obtain high profitability, and as a consequence is more easier to obtain credit from the banks. I found a negative correlation between profitability (summarize by asset turnover ratio, Return on assets ROA, Return on equity ROE, earning power) and risk rate expressed by leverage and debt ratio. This means that the profitable companies from our sample will prefer to base on own their resources rather than taking a credit. And on the other hand they prefer a to take a credit on short term for their working capital needs. The size of leverage is not a sign of performance. It was demonstrated even from the graphs that the companies with a high level of leverage do not succeed to cover their debts. The leverage level should be maintained at a low level, less than 1

9 value, which also means that they should better count on their own resources more than on the borrowings. For a more productive activity, the companies should try to keep a lower level of fixed assets in total asset. I found a positive relation between liquidity (current and quick liquidity) and the indicators of performance (economical return ROA, Return on equity ROE, earning power) The companies with a high liquidity as of December 2009 are a company whose short term debts are covered by the short term assets. A part of the debts are covered by their own resources and so we get back to the pecking order theory. Of course a too high liquidity level is not the best case, because that could mean that a company stocks its money instead of investing it in some productive actions. The interest coverage doesn t have an important influence in my study case. But ideally the current result should cover all the interest charges. BIBLIOGRAPHY Anghelache Constantin ( 2004) Statistica teoretica si econometrica Badita M., Goschin Z, Cristache S.E. (2001) Statistica aplicata in economie Dragota M, Stancu I, Obreja L Proiect CNSIS AT nr 86/2007 Faza Finala- Raport de cercetare pentru proiectul cu tema : Este relevanta teoria de agent pentru alegerea structurii de finantare? Modelarea dependentei intre structura financiara si perfomantele intreprinderii Dragota Mihaela, Main factors analysis for capital structure of the companies listed on capital market doctoral dissertation, 2005 Dragota V, Obreja L., Ciobanu A.M, Dragota M., Analiza financiara si gestiune financiara operationala, vol 1, Ed Economica, 2003 Harris M., Raviv A. ( 1991) The theory of Capital Structure Journal of Finance nr 1 Stancu I, Obreja L, Ciobanu A.M (2005) Investitii directe. Evaluare, selectie si finantare Staicu (Stroe) R.S IMM in Romania- Teza de doctorat, Bucuresti 2008

10 Stancu Ion Finante Editia a patra, Editura economica, 2007 Paul Halpern, J Fed Weston, Eugene F. Brighan Finante Manageriale, Ed Economica, 1998 Voineagu V.,Lilea E., Vatui M, Goschin Z., Boldeanu D. Statistica econometrica "The early history of the G7". Britannica Online. Strategia Guvernamentală pentru dezvoltarea sectorului IMM