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Theoretical Background

Small and medium sized enterprises (SME) play a major role in countries at all levels of

economic development (Caniels, et.al, 2005). Many acknowledge that developed economies

have a high proportion of small businesses, and it is predicted that the number of such entities

will continue to grow, due to declines in manufacturing and growth in the service sector (Burns,

1996; Carson, 1993). As markets are becoming more global, many business opportunities are

opening for small and medium-sized businesses, but competitive pressure is increasing at the

same time (Caniels, et.al, 2005). They need to adjust their actions to the environmental

challenges through active market development, a continuous search for market opportunities andexpansion of their customer base. There are many interesting aspects to marketing and small

firms, and numerous authors deal with this in careful and expertly-written ways with numerous

references to original literature. Many researchers and practitioners are looking to find the

answer to the fundamental question as to why some organizations are profitable with good

perspectives for growth (why they are successful), while others cannot achieve this state

(Beverland, et.al, 2005), all as cited by Kobylanski et. al. 2011.

Organization for Economic Co-operation and Development (OECD), in its report

regarding Small and Medium Enterprises presented some of their characteristics: Small and

Medium Enterprises represent a large part of the economic sector and will continue to represent a

large part and will generate most of the profit. Even so the sector of Small and Medium

Enterprises is characterized by highly dynamism and a powerful entrepreneurial activity; it must

be kept in mind that many of them are small mature enterprises that serve the local market, many

of them struggling to remain competitive (Iuliana et.al.).


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This research is supported by Thomas, et.al, 1990 as claimed by E-Leader, Slovakia,

2006 that in small and midsized enterprises, the key resources are financial resources, the

ent repreneurs time and people who work for the firm. Financial resources are essential. Many

unsuccessful entrepreneurs blame their failures on the lack of adequate financial resources. Yet,

failure attributed to a lack of financial resources indicates either an actual lack of money or the

failure to adequately use the resources available. Non-financial resources are also crucial to the

success of the new business. Well-planned management of time and employees allows the new

small firm to counteract the advantages of large firms. The entrepreneur can realize efficiencies

by using a network composed of suppliers and customers.With regard to critical resources, the entrepreneur must demonstrate sensitivity, control,

delegation and creativity. The successful entrepreneur is sufficiently sensitive to the needs of the

business to identify the proper allocation of resources, has the good sense to control the use of

those resources, delegates work to others, and uses creativity to expand the resource base. The

entrepreneur then plans developmental benchmarks for the new business.

Szilagyi Andrew D., Jr affirms that small business managers experiences with strategic

approach and strategic management point to the need for possible modifications in this process.

First, the process need not be as detailed or lengthy as practiced by large organizations. It could

involve simply responding to the questions: (1) Where are we? (2) Where do we want to go? (3)

Can we get there? (4) How can we get there? (5) What decisions must be made to get there? (6)

How do we monitor performance? Second, b ecause of an organizations small size, most if not

all key employees can make inputs into the process. This allows the company to use important

expertise and contribute to the development of employee commitment and communication. In

essence, it becomes a valuable learning experience for all involved. Finally, top management, or


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the top manager must be willing to give strategic management a chance. The manager must

recognize that his or her company has become a growing enterprise. There is a need for taking

the planning out of the mind of a single person and spreading the responsibility around. The

benefit of this is that the process of transforming a company into a formal organization is

enhanced. Strategic approach in small firms offers some unique advantages and disadvantages.

On the positive side, an organizations small size may not present the complexity and detail

faced by strategic planners in larger firms. In fact, the small business may be considered simply a

strategic business unit. Other advantages include limited products, services, and markets served

the relatively small resource base, and a limited number of options. On the disadvantage side,some equally significant issues exist. First and foremost, the executive team is usually small,

sometimes only one person. This executive, or entrepreneur, may have always operated the firm

from his or her own instincts and sees little use in formalized procedure. Second, information

and data to prepare an external and internal analysis may be limited, if they exist. Third, key

employees usually have gained their skills through experience rather than with the use of

systematic procedures, and resistance to change may develop. Other problems may include the

constraint of limited resources and the issue of company ownership (E-Leader, Slovakia, 2006).

In addition, pursuit of an effective entrepreneurial strategy is mainly through information.

Identifying the competitive advantages has to be mapped through the collection and analysis of

information from existing and potential customers. Developing needed information base is, in

practice, a process of selection and concentration on pertinent issues.

According to Beal, Reginald M., 2000, the extent to which information should be

maintained depends on circumstances. Sources of published information are under-utilized

because firms, especially small firms, are reluctant to involve themselves in what at first sights


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appears to be an information jungle which it might be felt is more properly the field of specialist

marketing researchers. But published research on existing and potential technology, on markets

and on individual competitors and customers is easily identified and accessed through an

increasing number of indexing and abstracting services. In addition to published information

strategic management also requires new information about the perceptions of existing and

potential customers. This includes very specific and limited items relating to how customers

perceive the products available to them and why they buy what they buy. This information too is

available to even the smallest firms and the techniques involved in its collection are not unduly

sophisticated. Sustaining customer focus and innovation is clearly a real challenge for small andmidsized enterprises (E-Leader, Slovakia, 2006).

The change the competitive environment determined the small and medium enterprises to

identify new ways to satisfy their clients and to offer them constantly value in a way much more

efficient than their competitors. In order to gain competitive advantage, the firms must choose

the type of competitive advantage that she is trying to obtain and the field in which she will

obtain it. The choice for the competitive field or for the activities of the firm can play an

important role in determining the competitive advantage because the firm aims to establish a

profitable and sustainable position against the forces that determine the competition in its field of

activity. The survival of small and medium enterprises in a highly globalized and competitive

environment suggests that these firms have different competences and they use them efficiently

(Iuliana, et al.).

On the theory espoused by Henry Mintzberg from Robbins, et al. as testify by E-Leader,

Slovakia, 2006, business strategy could follow one of these three modes: planning,

entrepreneurial, and adaptive. He argues that the right choice depends on contingency variables


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such as the size and age of the organization and the power of key decision makers. The planning

mode is a strategy approach that includes a clear statement of objectives, a systematic analysis of

the organization and the environment, and a plan of action to reach those objectives. Managers

should follow the planning mode when the organization is mature and well established, resources

are adequate to engage in opportunity analysis, senior management is in agreement as to the

organizations objectives, and environmental uncertainty is at a low level. Different conditions

may favor one of the other modes. The adaptive mode is a strategy approach characterized by

both the organizations objectives and the means to achieve these are continually adjusted. The

organization moves ahead timidly in a series of small disjointed steps. The adaptive mode of strategy making will be most effective when environmental uncertainty is at a very high level,

thus focusing managements attention on the short term, and when internal power struggles make

it impossible for senior management to agree on where the organization should be going. The

entrepreneurial mode presents a strategy approach in which, a strong leader, usually the

organizations founder draws on personal judgment and experience to form an intuitive image of

the organizations direction. This strategy is characterized by bold dec ision making in which

periods of pause are followed by periods of sprinting. The entrepreneurial mode is more likely to

be effective when the organization is young and small, when a single, powerful leader has an

intimate knowledge of the business, or when crises occur. Small businesses produce relatively

few products or services. Their resources and capabilities are limited. Their strategic options are

comparatively simple and narrowly focused. These conditions do not require the sophistication

inherent in the planning mode. Strategic planning practices in small firms have been found to be

unstructured, irregular, and incomprehensive. They are best described as informal; they are

almost never written down and are rarely communicated beyond the chief executi ves closest


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associates. Moreover, the strategic focus in small businesses takes on a more limited time

horizon than in large organizations, usually covering periods of two years or less. Based on

Mintzbergs analysis, we might expect the strategic planning process in small business firms to

resemble the entrepreneurial mode more than the planning mode. This is what surveys indicate.

Pearson, as affirmed by E-Leader Slovakia 2006 states that business strategy is concerned

with how to make an individual business survive and grow and be profitable in the long term.

The main considerations are as follows: the creation of customers, the identification of

appropriate market niches where no competition exists, the identification of customer needs and

how best they can be satisfied, the application of technology and its future development orsubstitution, the understanding of competitors and how direct competition may be avoided, and

the motivation of people to put their efforts and enthusiasm behind the strategic aims of the

business.

The sources of the strategic competitive advantages can be found in three categories: the

first category contain the competitive advantages seen from the point of view of the industry

structure. The second category is based on the resources and the third category is based on

relationships being enounced by Michael Porter as attested by Iuliana, et al.

One of the basic areas of concern in industrial economics is the interaction between firm

and the characteristics of the market forces. Economists, belonging to this school of thought,

perceive the significance of the link between environment and strategies employed by the firm.

They use the structure conduct-performance diagram. Such a paradigm assumes basic conditions

of supply (input, technology, etc.) and demand (growth of demand, price elasticity, etc...).

Market structure is then put into perspective in terms of number of market players (buyers and

sellers), barriers to entry, cost structure and product differentiation in relation to conduct that is


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illustrated in the pricing, product strategy, research and innovation (Porter 1985). The interaction

would follow through and lead to the enterprises performance represented by its production

efficiency, employment of resources and degree of progress. In this respect, the market structure

comprises the environment within which the firm operates. Within such a paradigm, market

structure, strategy and performance would comprise the variables that influence the firms

competitiveness (Kazem 2004). Porter (1980) attempts to explain the existence of the above-

normal profits, as an expression of the firms market power, and his starting point was the

Structure -Conduct- Performance (SCP) paradigm (Van Gils 2000). In this paradigm, the

industry-structure determines the firm conduct (e.g. pricing, advertising), which in turndetermines the economic performance. Porter (1980) interpreted this line of thought by

substituting conduct with strategy, and arguing that the firm performance is dependent on

industry structure. Therefore, the level of analysis is the industry rather than the individual firm.

Industry attractiveness depends on the level of the opportunity and the threat in an Industry. The

average performance of firms in the economically very attracted industries will be greater than

the average performance of firms in the economically unattractive industries as explained by

Barney (2002). Chaffey (2002) supports Porters classic mode l of the five main competitive

forces and he says that it still provides a valid framework for reviewing threats arising in the

ebusiness era. The value of Porter's model enables managers to think about the current situation

of their industry in a structured, easy-to-understand way as a starting point for further analysis.

In the vision of Michael Porter, the five competitive forces which influence the firms

activity and which put pressure on it are: the threat coming from the new firms entered on the

market; the intensity of the current competition; the pressure from the replacement products; the

negotiation power of the buyers; the negotiation power of the suppliers. According to Porter in


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the study conducted by Sultan (2007) explains that the industry structure is relatively stable, but

can change over the time as an industry evolves and the strength of the five competitive forces

varies from one industry to another. The five forces determine the industry profitability because

they influence the price, cost, and the required investment of the firms in an industry.

The second perspective, resource based perspective is based on exploring strong and

weak points of the competition in order to identify the causes for a potential strategic competitive

advantage. Barney, alleged by Iuliana, et.al defines the firms resources as it follow: the firms

resources gather all the goods, abilities, organizational process, firms attributes, information,

knowledge etc. controlled by a firm which allow it to conceive and implement strategies that areimproving its effective po wer and efficiency . Whereas Porter (1980) intended to see the

competitiveness of the firm as a result of its market position, resource-based theorists do claim

that if firms within an industry are doing well, the reason for this is their core competencies.

Core competencies are the collective learning in the organization, especially how to coordinate

diverse production skills and integrate multiple streams of technologies as explained by Prahalad

and Hamel (1990). Prahalad and Hamel (1990) focus on the resources, capabilities and

competences of the organization as the source of competitive advantage rather than the

environment, as in the traditional approach. Edith Penrose, in her work The Theory of the

Growth of the Firm (1959) is often credited with the idea of the resource-based view. Also the

work of Philip Selznick (1957) stressed the role of distinctive competences and Alfred Chandler

(1962) demonstrated the importance of organizational structure in the utilization of a firms

resources. Wernerfelt (1984), and Rumelt (1997) adopt the resource-based view. Senge (1990)

and Argyris (1994) stress the acquisition of competences through internal mechanisms of

individual and collective learning, while Hamel and Prahalad emphasize strategic tools like


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alliances, licensing, mergers and acquisitions. The resource-based theory becomes more and

more subject of critique under the pressure of globalization. Some of these critiques are: (1) the

most important problem to the resource-based view is the lack of a clear and coherent treatment

of dynamics; it does not theorize the mechanisms underlying the creation of new resources

(Barney 2002),(2) the theory may be criticized for being tautological. This approach is one-sided

and thus in danger of neglecting the environment which is still critical to the organizations

survival (Van Gils 2000), (3) the application of the resource-based approach to the strategic

management of the small firms has been limited. Rangone (1999) argues that the application of

the resource-based approach to small firms has to take account of small-firm characteristics.Using the value chain as the conceptual framework, Bretherton and Chaston (2005) show how

small and medium-sized wineries use their resources and how they access other resources by

using strategic alliances. The wineries have engaged in strategic alliances, rather than structural

ties, at various stages of the value chain, to gain access to scarce resources and capabilities.

There is clear evidence that the over-performers have had access to adequate resources, which

has led to sustainable competitive advantage and superior performance.

The third perspective, the relationship one includes the relations between the firms as a

rare, valuable and hard to imitate resource which can be a source of competitive advantage.

Firms are participating to various business relationships, over their life cycle, together with the

customers, clients, partners and competitors. Unavoidable the firms performance will be

influenced positively or negatively by the business and by the entire network of relations

established.

Competitiveness and learning on how to compete resourcefully continuous to be the

major issue in the 21 st century landscape. Irrelevant to markets the firm seeks to compete the


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future appears to be unstable and challenging. Regardless, if a company aspires to obtain success

on leadership beyond in their current and prospective markets, their directors must understand

that the world economy is changing at an ever more accelerating pace. New and faster product

introduction and designs are brought into the market, more emphasis on cost and lower price

offers is seen, and personnel cutbacks is widespread. These measures are instilling firms to

become leaner with its corresponding negative effect in consumer consumption patterns.

Ultimately, though, savings incoming from these proceedings are expected to pass on to

consumer and arouse expenditures (Coplin, 2002).

Competitiveness is the mean by which entrepreneurs can improve their firmsperformance, and which can be measured according to a number of dimensions including market

share, profit, growth, and duration. At the same time Man and Chan (2002) stress the importance

of links between competitiveness and performance as having a long term rather than a short-term

orientation (Sultan, 2007).

Iuliana, mentioned the sources of obtaining strategic competitive advantages can be

divided in: (1) Characteristic capabilities. The strategic competitive advantage is obtained by

constant development of new capabilities and resources as a response to rapid changes of the

market. Among these resources and capabilities, the knowledge represents the most valuable

asset. (2) Human resources. In the modern economy, the competition is a matter of goods and

services. Factors that can differentiate an organization by its competitors, producers of goods or

services from public or private sector, is represented by its employees that are the way the firm

administrates and use its human resources. (3) Radical innov ation. The firms long term success

is related to its capacity of innovation. The firms investments in products and processes

improvement are leading to profit, but the radical innovation is one that will lead the firm on new


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markets. (4) The externalization of the competitive advantage sources. Recently, the attention of

the researches moved from analyzing the firm alone toward analyzing its supply chain as a whole

unit for gaining competitive advantage. The success key for Toyota seems to be the effective

integration of the supply process which leads to improvement of the strategic management of the

firm as well as the timing of the production process of the firm with the suppliers, creating the

system just-in-time. (5) Organizational culture. The power of the organizational culture is

another competitive advantage. A firm positioned to success can built and maintain a culture

oriented toward innovation, in which employees are following the cause and the mission of the

organization. (6) Firms management. The manager is the one shaping a group of people into ateam, transforming them in a force that allows for a firm to obtain strategic competitive

advantages. (7) Knowledge management. The growth and globalization, combined with the

rapidly development of the information technology had enabled firms to create sophisticate

systems of knowledge management in order to create strategic competitive advantages. (8) Scale

economies represent an important quantitative factor being obtained according with the

production volume, enabling to the firm to significantly reduce costs, especially the fixed ones.

(9) The superior value offered to international clients. The competitive advantages result from

the firms ability to achieve the activities either to lower costs th an their competitors either in

other ways that create value for the client and allow firms to ask for a higher price.

As quoted by E-Leader, Slovakia 2006, small organizations which understand their

customers can create competitive advantage and so benefit from higher prices and loyalty of

customers. Higher capacity utilization can then help to reduce costs. While it is important to use

all resources efficiently and properly; it is also critical to ensure that the potential value of the

outputs is maximized by ensuring they fully meet the needs of the customers for whom they are


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intended. An organization achieves this when it sees its customers objectives as its own

objectives and enables its customers to easily add more value or, in the case of final consumers,

feel they are gaining true value for money.

According to Economist Intelligence Unit, 2005 as pronounced by E-Leader, Slovakia,

2006, economic restructuring in Slovakia increases still more the role of small and medium

businesses in this economy. Small and midsized enterprises are very important elements of

Slovak market economy. They fill many gaps in the economic structure and so they are the

source of new work places and employment with positive social and psychological impact on the

development of society. They inspire business spirit and creating new visions and therefore theycan stimulate competitiveness and employment.

This study is also supported by William King in his study on the Advantages Small

Businesses Have Over Large Companies, that some advantages of a small business over a large

company are: (1)Quick response time: A small business is very quick to respond to problems and

solve them due to a smaller chain of command. Top management is usually available at once and

so are the relevant people to be able to handle the situation in a short period of time. On the

contrary, larger businesses are notoriously slow to respond to problems and have a long complex

chain of command. Additionally, they have a number of policies to be adhered to and practices

that must be followed at many steps along the way. This makes them slow to solve problems and

snags that come up in the course of even routine work; (2)Flexibility in making decisions: A

small business has the flexibility to bend, manipulate and change the rules depending on the need

of the hour, whereas a large company is stuck in a quagmire of policies and legalities. There are

no exceptions to the rule for a large company whereas there may not be that many rules for a

small business. This allows employees, managers and owners the flexibility to make decisions on


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the spot, instead of waiting for a long chain of command to get to the person who is able to make

a decision. The decision can be made faster, at times instantly, in a small business and work can

carry on. This increases the productivity of the employees as well; (3)Personal Attention: The

small business is able to give time and attention to its customers and this is the foundation of a

successful business. Why do people love their favorite little coffee place as opposed to a huge

chain like Starbucks? Because the waitress is not in a rush and the guy at the counter knows your

name and because of those lovely little quiches they make at 6 o'clock every evening. Customer

service has the ability to make decisions and change the rules depending on who they are

serving, which is simply not possible in a large company that has to standardize its approach; (4)Specialized: A lot of small businesses are small because they are specialists. Some are boutiques.

This gives them a major competitive edge over the large companies that form the competition.

They can do well at tasks that are ignored or under-serviced by big busy companies; (5) Flat

structure means easy communication: There is often a single point of contact offered by a small

business to its customers and this person is able to service the client better for it. The person is

more likely to know the customer's history with the company, better able to make a judgment

call and well versed with each section within the small business. This is mainly due to the flatter

organization structure of the small business; (6) Change with times: The small business is more

geared towards change due to its smaller size. Less training is required and the change has better

reach throughout the organization. A large company requires a lot of time, money and effort to

make even the smallest change due to its sheer size and complex organization structure. The

small business therefore, has more future-readiness.

It is often argued that large companies, by definition, are able to be more efficient

because they can achieve economies of scale that others are not able to reach. Large companies


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usually offer more products in each product line, and their products may help to satisfy many

different needs. If a consumer is not sure of the exact product he needs, he can go to the larger

producer and be confident that the larger producer has something to offer. The consumer might

believe that the smaller producer may be too specialized. Larger companies can cater to a larger

population because of sheer size, while smaller companies have fewer resources and must

specialize or fall victim to larger, more efficient companies.

The strongest competitive advantage is a strategy that that cannot be imitated by other

companies. Competitive advantage can be also viewed as any activity that creates superior value

above its rivals. A company wants the gap between perceived value and cost of the product to begreater than the competition. Some of its advantages are (1) Product differentiation is achieved

by offering a valued variation of the physical product. The ability to differentiate a product varies

greatly along a continuum depending on the specific product. There are some products that do

not lend themselves too much differentiation, such as beef, lumber, and notebook paper. Some

products, on the other hand, can be highly differentiated. Appliances, restaurants, automobiles,

and even batteries can all be customized and highly differentiated to meet various consumer

needs. In Principles of Marketing (1999), authors Gary Armstrong and Philip Kotler note that

differentiation can occur by manipulating many characteristics, including features, performance,

style, design, consistency, durability, reliability, or reparability. Differentiation allows a

company to target specific populations; (2) Service Differentiation. Companies can also

differentiate the services that accompany the physical product. Two companies can offer a

similar physical product, but the company that offers additional services can charge a premium

for the product. Mary Kay cosmetics offers skin-care and glamour cosmetics that are very similar

to those offered by many other cosmetic companies; but these products are usually accompanied


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with an informational, instructional training session provided by the consultant. This additional

service allows Mary Kay to charge more for their product than if they sold the product through

more traditional channels; (3) People Differentiation.. Hiring and training better people than the

competitor can become an immeasurable competitive advantage for a company. A company's

employees are often overlooked, but should be given careful consideration. This human

resource-based advantage is difficult for a competitor to imitate because the source of the

advantage may not be very apparent to an outsider. As a Money magazine article reported, Herb

Kelleher, CEO of Southwest Airlines, explains that the culture, attitudes, beliefs, and actions of

his employees constitute his strongest competitive advantage: "The intangibles are moreimportant than the tangibles because you can always imitate the tangibles; you can buy the

airplane, you can rent the ticket counter space. But the hardest thing for someone to emulate is

the spirit of your people." This competitive advantage can encompass many areas. Employers

who pay attention to employees, monitoring their performance and commitment, may find

themselves with a very strong competitive advantage. A well-trained production staff will

generate a better quality product. Yet, a competitor may not be able to distinguish if the

advantage is due to superior materials, equipment or employees; (4) Image Differentiation.

Armstrong and Kotler pointed out in Principles of Marketing that when competing products or

services are similar, buyers may perceive a difference based on company or brand image. Thus

companies should work to establish images that differentiate them from competitors. A favorable

brand image takes a significant amount of time to build. Unfortunately, one negative impression

can kill the image practically overnight. Everything that a company does must support their

image. Ford Motor Co.'s former "Quality is Job 1" slogan needed to be supported in every

aspect, including advertisements, production, sales floor presentation, and customer service.


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Often, a company will try giving a product a personality. It can be done through a story, symbol,

or other identifying means; (5) Quality Differentiation.. Quality is the idea that something is

reliable in the sense that it does the job it is designed to do. When considering competitive

advantage, one cannot just view quality as it relates to the product. The quality of the material

going into the product and the quality of production operations should also be scrutinized.

Materials quality is very important. The manufacturer that can get the best material at a given

price will widen the gap between perceived quality and cost. Greater quality materials decrease

the number of returns, reworks, and repairs necessary. Quality labor also reduces the costs

associated with these three expenses; (6) Innovation Differentiation. When people think of innovation, they usually have a narrow view that encompasses only product innovation. Product

innovation is very important to remain competitive, but just as important is process innovation.

Process innovation is anything new or novel about the way a company operates. Process

innovations are important because they often reduce costs, and it may take competitors a

significant amount of time to discover and imitate them. Some process innovations can

completely revolutionize the way a product is produced. When the assembly line was first

gaining popularity in the early twentieth century, it was an innovation that significantly reduced

costs. The first companies to use this innovation had a competitive advantage over the companies

that were slow or reluctant to change, all as attested by Reference for Business, 2011.

According to Storey,1994, as set forth by Sultan, 2007discusses the general differences

between large and small firms in terms of centrality of owner-manager, the structure, resources

and number, and variety of products and range of markets served. In smaller firms, owner-

managers are less able to influence competitive environment than larger firms. Besides, smaller

firms' organization structures are likely to be organic and loosely structured rather than


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mechanistic and highly formalized (Jennings and Beaver 1997). In smaller firms, all the roles

will either be performed by one manager or by a very narrow range of managers who may have

been appointed because they are family members or friends rather than on the basis of ability or

education. However, small firms generally have little commitment to research and development

(R&D) and are highly dependent on external knowledge sources (Vossen 1998). The size of the

SMEs in the developed countries is interlinked with the size of the international niche markets

where they compete, while the size of the SMEs in the developing countries is mostly

determined by the domestic markets where they operate. Moreover, the SMEs in developed

countries are more likely to be highly specialized compared to those in the developing countries.Most of the SMEs in the developing countries are one-person businesses, and the largest single

employment category is working proprietors (Fisher and Reuber 2000). This group and its family

represent the majority of the workforce in most developing countries. The informal relationships

of the family dominate formal, explicit relationships when trust, loyalty and family ties are

important to advancing the businesses (Habbershon and Williams 1999).

The information in the four basic financial statements is of major significance to a variety

of interested parties who regularly need to have relative measures of the companys performanc e.

Relative, is the key word here, because the analysis of financial statements is based on the use of

ratios or relative values. Ratio analysis involves methods of calculating and interpreting financial

ratios to analyze and monitor the firms performance. Basis inputs to ratio analysis are the firms

income statement and balance sheets. Ratio analysis is not merely the calculation of a given

ratio. More important is the interpretation of the ratio value. A meaningful basis for comparison

is needed to ans wer such questions as Is too high or too low? and Is it good or bad? (Gitman,

2008).


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Financial ratios can be divided for convenience into five basic categories: liquidity,

activity, debt, profitability, and market ratios. Liquidity and debt ratios primarily measure risk.

Profitability ratios measure return. Market ratios capture both risk and return.

The liquidity of the firm is measured by its ability to satisfy its short term obligations as

they come due. Liquidity refers to solvency of the firms overall financial position- the case with

which it can pay its bills. Because a common precursor to financial distress and bankruptcy is

low for declining liquidity, these ratios can provide early signs of cash flow problems and

impending business failure. The two basic measures of liquidity are the current ratio and quick

(acid- test) ratio. The current ratio measures the firms ability to meet its short -term obligations. Itis express as follows: Current ratio = current / assets current liabilities . Quick (acid-test)

ratio is similar to the current ratio except that it excludes inventory, which is generally the least

liquid current asset. It is calculated as follows: Quick ratio = (current assets inventory) /

current liabilities , sometimes the quick ratio is defined as (cash + marketable securities +

accounts receivables) / current liabilities .

Activity ratios measures the speed with which various account are converted into sales or

cash-inflows or outflows. In a sense, activity ratios measure how efficiently a firm operates along

a variety of dimensions such as inventory management, disbursement and collections. Inventory

turnover commonly measures the activity, or liquidity, of a firms inventory. It is calculated as

follows: Inventory turnover = Cost of goods sold/ Inventory . Another inventory activity ratio

measures how many days of inventory the firm has on hand. Inventory turnover can be easily

converted into an average age on inventory by dividing it into 365.Average collection period, or

average age of accounts receivable, is useful in evaluating credit and collection policies. It is

arrived through this formula: Average collection period = Accounts receivable/ Average sales


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per day . The average payment period, or average age of accounts payable, is calculated in the

same manner as the average collection period: Average payment period = Accounts payable/

Average purchases per day . The total asset turnover indicates the efficiency with which the

firm uses its assets to generate sales. Total asset turnover is calculated as follows: Total asset

turnover = Sales/ Total assets.

The debt position of a firm indicates the amount of other peoples money being used to

generate profits. Debt to asset ratio or simply debt ratio measures the proportion of the total

assets financed by the firms creditors. The higher this ratio, the greater the amount of other

peoples money being used to generate profits. The ratio is calculated as follows: Debt ratio =total liabilities / total assets. Times interest earned ratio sometimes called the interest coverage

ratio, measures the firms ability to make contractual interest payments. The higher its value, the

better able the firm is to fulfill its interest obligations. The times interest earned ratio is

calculated as follows: Times interest earned ratio = earnings before interest and taxes /

interest. Fixed- payment coverage ratio measures the firms ability to meet all fixed payments

obligations, such as loan interest and principal, lease payments, and preferred stock dividends.

As is true of the times interest earned ratio, the higher this value, the better. The formula for

fixed-payment coverage ratio is Fixed-payment coverage ratio = (EBIT + Lease Payments) /

(Interest + Lease payments + {(Principal payments + Preferred stock dividend) x [1/ (1-

T)]}) , where T is the corporate tax rate applicable to the firms income.

There are many measures of profitability. As a group, these measures enables analyst to

evalu ate the firms profits with respect to a given level of sales, a certain level of assets, or the

owners investment. Without profits, a firm could not attract outside capital. Owners, creditors,

and management pay attention to boosting profits because of the great importance the market


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places on earnings. A useful tool for evaluating profitability in relation to sales is the common-

size income statement. Each item on this statement is expressed as a percentage of sales.

Common-size income statements are especially useful in comparing performance across years

because it is easy to see if certain categories of expenses are trending up or down as a percentage

of the total volume of business that the company transacts. Three frequently cited ratios of

profitability that come directly from common-size income statement are (1) the gross profit

margin, (2) the operating profit margin, (3) the net profit margin.

The gross profit margin measures the percentage of each sales dollar remaining after the

firm has paid for its goods. The higher the gross profit margin, the better (that is, the lower therelative cost of merchandise sold). The gross profit margin is calculated as follows: Gross profit

margin = (Sales- Cost of goods sold)/ Sales = Gross profits/ Sales . Operating profit margin

measures the percentage of each sales dollar remaining after all cost and expenses other than

interest, taxes, and preferred stock dividends are deducted. It represents the pure profits earned

on each sales dollar. Operating prof its are pure because they measure only the profits earned

on operations and ignore interest, taxes, and preferred stock dividends. A high operating profit

margin is preferred. The operating profit margin is calculated as follows: Operating profit

margin = Operating profits/ Sales . The net operating profit margin measures the percentage of

each sales dollar remaining after all cost and expenses, including interest, taxes, preferred stock

dividends, have been deducted. The higher the firms net profit margi n, the better. The net profit

margin can be calculated as follows: Net profit margin = Earnings available for common

stockholders/ Sales . The firms earning per share (EPS) is generally of interest to present or

prospective stockholders and management. As we noted earlier, EPS represents the number of

dollars earned during the period on behalf of each outstanding share of common stock. Earnings


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per share is calculated as follows: Earnings per share = Earnings available for common

stockholders/ Number of shares of common stock outstanding . The return on total assets

(ROA), often called the return on investment (ROI), measures the overall effectiveness of

management in generating profits with its available assets. The higher the firms return on total

assets the better. The return on total assets is calculated as follows: ROA = Earnings available

for common stockholders/ Total assets . The return on common equity (ROE) measures the

return earned on the common stockholders investment in the firm. Generally, the owners are

better off the higher is this return. Return on common equity is calculated as follows: ROE =

Earnings available for common stockholders/ Common stock equity .Market ratios relate the firms market value, as measured by its curre nt share price, to

certain accounting values. These ratios give insight into how investors in the marketplace feel the

firm in doing in terms of risk and return. They tend to reflect, on a relative basis, the common

stockholders assessment of all aspects of the firms past and future performance. Here we

consider two widely quoted market ratios, one that focuses on earnings and other that considers

book value. The price/earnings (P/E) ratio is commonly used to assess the owners appraisal of

share value. The P/E ratio measures the amount that investors are willing to pay for each dollar

of a firms earnings. The level of this ratio indicates the degree of confidence that investors have

in the firms future performance. The higher the P/E ratio, the greater the investor confidence.

The P/E ratio is calculated as follows: P/E ratio = Market price per share of common stock/

Earnings per share. The market/book (M/B) ratio provides an assessment of how investors view

the firm s performance. It relates the market value of the firms share to their book -strict

accounting value. To calculate the firms M/B ratio, we first need to find the book value per

share of common stock: Book value per share of common stock = Common stock equity/


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Number of shares of common stock outstanding . The formula for the market/book ratio is

Market/book (M/B) ratio = Market price per share of common stock/ Book value per share

of common stock .

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