REVIEW adverse impact on the capital and earnings.

REVIEW OF
LITERATURE

Risk can be broadly defined as any
issue that can impact the objectives of a business entity and the potentiality
that both expected and unexpected events may have an adverse impact on the
capital and earnings. Similarly, risk characterized situations where the actual
outcomes for a particular event or activity are likely to deviate from the
estimate or forecast value. Risk also can traces in two directions; the outcome
may be better or worse than originally expected. Traditionally, risks have been
identified with two categories, static risk and dynamic risks. Static risks are
the ones that cause only damages without the opportunity of earning from their
occurrence. They are always negative and have the characteristics of being
unexpected because they are determined by accidental events. These risks fall
perfectly under the insurance policy. Dynamic risks are those that can cause
either damages or earning opportunities. These are the typical entrepreneurial
risks and consequences (Mowbray and Blanchard, 1979). Alternatively, risks
occur within the firms and their business environment can be divided as
internal and external risk. Operational risks, financial risks and
organizational and management risk are internal risks as they have their
sources within the firm (Henschel, 2008). External risks occur in the business
environment of the firm and can be economical, technological, political, legal
or cultural changes (Scheve, 2006). Henschel (2008) states that the most
relevant risk categories for SMEs are internal and strategic and business
process risk.  

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Defining SME

There is no standard, universal
definition of Micro, Small and Medium Enterprises. Different agencies have
defined on different parameters like sale, number of employees working,
investment in Plant & Machinery etc. The Group SME Department of the World
Bank considers “Number of Employees” as the criterion for identification of SME.
It states “SMEs are usually defined as companies with up to 250 employees”. In
June 2004, the BASEL Committee (International Settlements of Central Banks of
member countries) stated in the BASEL ACCORD: “SME Borrowers are defined as
those with annual sales of less than 50 million. Euros” (i.e., around 250
crores) Thus annual sales are internationally identified as the sole criterion
for SME status as per BASEL committee. The working group constituted by RBI
under the Chairmanship of Ganguly recommended turnover as a measure of defining
SME. The outer limit of annual sales for the recognition of SME status is at
Rs. 50 crore (10). When the turnover is up to Rs. 2 crore it is classified as
tiny, and from Rs. 2/- crore to Rs.10/- crore as small and from Rs.10/- to
Rs.50/- crore as Medium. Micro, Small & Medium Enterprises Development Act
2006 clearly defines Micro & Small Enterprises. With the inclusion of
service sector in MSE, the definition makes a clear demarcation of
manufacturing and service enterprises separately both for micro and small
enterprises. For manufacturing enterprises the investment in Plant &
Machinery up to Rs.25/- lakh for micro and over Rs25/- lakh up to Rs.500/- lakh
for Small manufacturing enterprise. For service enterprises, investment in equipments
is the yardstick. When investment in equipments is up to Rs./-10 lakh it is
classified as Micro service enterprise and when the investment in equipment is
over Rs.10/- lakh up to Rs. 200/- lakh, it is classified as Small Service
Enterprise2 . Internationally, SME is a composite category with no subtypes,
whereas both Ganguly committee and MSMED Act have sub-divisions. (S.K.Bagchi,
2008).

Risk
Management

One
of the first definitions of risk is attributed to Bernoulli, who in 1738
proposed measuring risk with the geometric mean and minimizing risk by
spreading it across a set of independent events (Bernoulli, 1954). Accordingly,
the traditional definition of risk is measured by two combined variables: a)
frequency of occurrence (probability) of the “risky” event, i.e., the
number of times the risky event is repeated in a predetermined period and b)
extent of the consequences (magnitude) that the event generates, i.e., all the
results of its occurrence.

Following
Chapman and Cooper (1983), risk is the possibility of suffering economic and
financial losses or physical-material damages, as a result of an inherent uncertainty
associated with the action taken.

In
a later definition developed by management literature, the concept of risk
comprises positive and negative consequences of an event, which may affect the
achievement of strategic, operational and financial objectives of a
company (BBA, et al., 1999).

Given
the complexity and magnitude of the risks that companies face, scholars
recognize a macro classification of risks into two main categories (Mowbray, et
al., 1979). First, pure or static risk is the risk that only causes damage
without the opportunity of earning from its occurrence. Always negative, it is
characteristically unexpected because it is determined by accidental events.
This risk falls perfectly under the insurance policy. Second, speculative or
dynamic risk is the risk that can cause either damages or earning
opportunities. These are the typical entrepreneurial risks, consequences, for
example, of an investment that has not generated a profit. They are normally
related to planning and managing the different businesses and functions of the
enterprise, such as production, product, marketing and sales.

Risky
events can be caused by external factors (economic, environmental, social,
political and technological aspects) or internal factors (infrastructure, human
resources, process and technology used by a company) (COSO, 2004).

Risk
management is defined as the process intended to safeguard the assets of the
company against losses that may hit it in the exercise of its activities,
through the use of instruments of various kinds (prevention, retention,
insurance, etc.) and in the best cost conditions (Urciuoli and Crenca, 1989).
Another definition is RM refers to the process of planning, organizing,
directing, and controlling resources to achieve given objectives when
unexpectedly good or bad events are possible (Head, 2009).

The
International Organization for Standardization (ISO 31000, 2009) identifies the
following principles of RM that should: create value; be an integral part of
the organizational processes; be part of decision making that explicitly
addresses uncertainty; be systematic and structured; be based on the best
available information; be tailored; take into account human factors; be
transparent and inclusive; be dynamic, iterative and responsive to change; and
be capable of continual improvement and enhancement.

The
adoption of an RM methodology can lead firms to reduce the uncertainty in
enterprise management, to ensure continuity in production and trading in the
market, to decrease the risk of failure, and to promote the enterprise’s
external and internal image. Therefore, RM creates business value, maximizing
business profits by minimizing costs (Urciuoli and Crenca, 1989).

Risk
management follows a stage-gate process (Henschel, 2009; ISO 31000, 2009;
Urciuoli and Crenca, 1989 ;). A preparatory step requires defining the RM
plan to be consistent with strategic business objectives, and conducting a
context analysis. The first stage aims to identify all the risks to which the
enterprise is exposed. The second stage is the assessment and risk analysis,
which aims to determine the probability and the expected magnitude associated
with the occurrence of the damage. A threshold of acceptability must be
defined to proceed to the next stage, depending on the risk appetite of top
management and on the resources available for RM. The third stage is the
treatment of unacceptable risks, which identifies the most appropriate actions
to reduce the risk; and finally the process is supervised. In the literature, the
first two phases (identification, evaluation and analysis) are often called
risk assessment. The implementation of an RM system is a long-term, dynamic and
interactive process that must be continuously improved and integrated into the
organization’s strategic planning (Di Serio, et al., 2011).

SMES AND RISK MANAGEMENT

SMEs show little separation between the
entrepreneur’s strategic thinking and decision making and firm formal planning
system (Lyles et al. 1993). McKierna and Morris (1994) noted that SMEs are
characterized with the central role of the owners and multiplicity of duties
and close identity with employees. According to Smith (1998), enterprises in
their startup phase often underestimate risks or even ignore them completely.
Startup SMEs usually face a high degree of uncertainties and the necessity to
make quick decisions (Freseet al. 2000). Empirical studies show that the
attitudes of SMEs towards risks and their risk assessment differ significant
from that of large firms. Henchel (2008) states that risk management is a
challenge for SMEs in contrast to larger firm they often lack of the necessary
resources, with regard to human capital, data base and specificity of knowledge
to perform a standard and structured risk management.

Similarly, Matthews and Scott (1995) stated
that most of SMEs do not have the necessary resources to employ specialists at
every position in the firm. They focus on their core business and have
generalists for the administration function. In contrast to larger firms, in SME
one of the owners is often part of the management team. His intuition and
experience are important for managing the firm (Dickinson, 2001). Therefore,
owner manager in SME is often more responsible for many different tasks and
important decisions. In fact Sparrow (1999) find that risk management practices
in SMEs relate to the beliefs and attitudes of founding entrepreneurs. SMEs do
not tend to use special techniques to optimize significant risks.

Literature related to risk management in SMEs
is quite limited and still in an early phase of development and little studies
have been focused to risk and risk management within the sector. Janney and
Dess (2006) noted that SMEs are away from adopting a positive approach towards
risk management due to limitations such as inadequate infrastructure, limited
managerial and technical expertise, lack of financial and intellectual
resources to generate substantial technological developments and change, weak
information networks to locate and recognize information and knowledge that is
especially relevant to them, and low investment in research and development.
Similarly, a study of Turpin (2002) states that most of SMEs have no official
risk strategy which is due to problems of communication with of delegating risk
management competencies to employees. His study further notes that increasing
competition, low of competencies to competitors, changing customer demands,
wrong strategies due to lack of market data and personal absences rate are
frequently and most importantly risk for European SMEs. Matthews and Scott
(1995) find that many SMEs have no explicit picture of business risk and their
risk management is often not well structured nor systematic or standardized.
Henschel (2008) states that lacking of expertise and knowledge in SMEs can make
a huge business risk for SMEs. According to O’Hara et al (2005), SMEs identify
two barriers to risk assessment; time pressure and access to suitable guidance.
He noted that given assess in appropriate guidance and help SMEs can improve
risk assessment efficiently. Sparrow (1999) stated that the belief and
attitudes of founding entrepreneurs are more influence on risk management
practices in SMEs. As a result that makes decisions in terms of their business
as an entity rather than in terms of manager specific risks. Smith stated that
the enterprises in their start up phase often underestimate risks or even
ignore these completely. Startup SMEs usually force high degree of uncertainty
and the necessity to make quick decisions (Islam et al. 2008). Empirical
studies further show that the attitudes of SMEs toward risks and their risk
assessment differs significantly from that of large enterprises since risk
considerations in SMEs take place in a more holistic way.