IMPACT OF OPERATIONAL AND CREDIT RISK ON THE PERFORMANCE OF SMALL AND MEDIUM ENTERPRISES IN NIGERIA

CHAPTER ONE

 INTRODUCTION

1.1 Background to the Study

Due to the increasing rate at which technological development and globalization is affecting the marketplace, the business environment has become more and more risky and challenging for companies to operate within. It has therefore become necessary to identify, analyze and respond to the different types of risks in today’s market to ensure the survival of a firm. Small and Medium-Enterprises (SMEs), due to their limited resources and structural features, are more influenced by the effect of risks than larger organizations. Risk is defined as the possibility of something undesirable taking place. It is the likelihood of something happening that may affect a business’s objectives either negatively or positively. The term risk, especially in business, can interchangeably be used with uncertainty with respect to the variability of returns associated with a given investment. Although risk is generally considered the possibility of outcomes deviating from what was expected, firms are primarily concerned with negative outcomes since they negatively affect the business operation and thus require proper management.

According to the European commission SBA fact sheets, more than 99.9% of overall registered enterprises across nations fall within the SMEs classification [1]. Due to their significance in contributing to human capital and value-added creation, SMEs require the adoption of an effective risk management (RM) system. Furthermore, in small and medium enterprises (SMEs) and micro companies, where the capital is mostly not sufficient or strong, an unplanned misfortune could likely lead to interruptions in operational activities, financial loss, and bankruptcy (Lap, 2009).

 In the course of their operations, enterprises encounter many risks such as political, natural disaster, credit and operation risks, especially during the start-up and expansion stage. Political risk can be defined as the effects caused by the intersection of political decisions, socio-economic events and market evolutions that may impact specific business interests and situations. The political situation of a country can influence the economy, bring about changes in regulation or affect mitigation of risk. Also any political instability in a country or area will adversely affect business performance. Credit risk denotes to the risk that a borrower will default on any type of debt by failing to make required payments. According to Norlida et al (2015) credit risk depends on the ability of borrower to generate adequate cash flows through operation, earnings, or asset sales to meet their future interest and principle payment of the outstanding debt. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs (Alshatti 2015). Operational risks refer to the financial loss to business as a consequence of conducting it in an improper or inadequate manner and may result from external factors. Operational Risk may tangibly manifest itself in the likes of business disruption, control failures, errors, misdeeds or external events.

Therefore, risk management is deemed a core factor for business competitiveness. It facilitates a firm to develop a unique strategy to minimize the potential losses and open a door for the exploitation of new opportunities (Radner and Shepp 1996). For this reason, Smith and Watkins (2012) argue that risk management should be a major concern for SMEs particularly because they are more sensitive to business risk and competition.

They opine that risk management will assist in the development of contingency plan that can help to stop the erosion of organizational income and consequently improve performance. In this regard, SMEs thus require accessible and standardized tools to help in identification of risks and match them with appropriate techniques.

1.2 Statement of the Problem

SMEs play a crucial role in the development of a country's economy (Ariyo, 2005). They are of significant importance to the economy of developing countries such as Nigeria, where challenges such as poverty eradication and unemployment are considered major issues facing citizens. According to Economic Survey (2009), in Nigeria, SMEs account for 60% of the Nigerian G.D.P and employ more than 80% of the total Nigerian work force. The Nigeria government and other stakeholders in recognition of the importance of this sector to the economy have directed their efforts towards creating sustainable SMEs. These efforts however have not had the desired effect, as most small firms are short-lived and that’s a result of poor risk management. Research conducted on SMEs in Africa suggests that there are more SMEs closures than establishments, with approximately only 1% of SMEs growing from having five or less employees to ten or more (Mead &Liedholin, 1998; cited in Smith & Watkins, 2012). Risk is inherently present in all business actions and in every economic activity, every business decision or any entrepreneurial act.

Operational risk events stem from varied causes, including transaction and execution errors, fraud, improper business practices, product flaws, technology failures, employment discrimination, natural disasters (or ‘acts of god’) and terrorism (Cruz, 2002).

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