The impact of ratio analysis on the granting of loans in commercial banks

Abstract

The ways banks do their evaluation of loans vary from one lending institution to another. In most cases, the banks tend to rely on the data generated by the credit reference bureau (CRB).

Several studies have also established that financial institutions use ratios when evaluating their customers for purposes of lending. While evaluating their customer’s banks look at different aspects of the financial statements and each bank has its area of emphasis.

The question is which of these ratios are commonly used in Commercial Banks and what level of importance is attached to each of them. The focus of this study is whether the banks in Cameroon also use ratios and if so to what extent do they use them.  

Descriptive research was used in this study which involved just a Bank which was ECOBANK BUEA. The findings were analyzed using primary data of 15 questionnaires which were administered to the employees of ECOBANK BUEA.

The descriptive statistics used included arithmetic mean, mode, median, standard deviation, maximum and minimum values, tables were then generated to help in simplifying the results. The study established that ECOBANK has in place a credit risk management team.

The bank uses ratios in making their evaluation of corporate customers and that the most important ratios in credit evaluation are the liquidity ratios and that profitability ratios also play a key role.

The study recommends that each bank should have its own internal method of credit evaluation, to subsidize credit reference bureau [CRB], this is because CRB has a weakness of delay in the updating of data, and also the data is generated based on information from other banks which may not be very accurate.

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The complex nature of the past business world and the transformation of the entire world into a global village have been of great concern to managers of all forms of business organisations.

According to Ojuigo (2001), the problems of managers are multi-varied because of inefficiency in the management of poor decision outcomes of these organisations. Therefore, the managers are unable to achieve the organisational objectives within a period of time.

As diverse as a business is, its controllable and uncontrollable factors influence all decisions which ultimately lead to the realization of set objectives. To achieve this, management needs reliability, authentic and relevant information from the financial statements of potential debtors to efficiently facilitate loan decision making.

Stakeholders always seek the existing order and understanding about the phenomena governed by laws governing their relationship and need to predict their behaviour. This kind of attitude towards access to integrated data collection was done to make better decisions considering the high volume of raw data to create and develop the growing market the need for investment in human societies use.

The use of financial information has always led to intellectual challenges to provide useful information and good decision-makers (Asghar, 2011)

One of these cases, trying to balance between the discoveries of financial information has been using financial ratios decisions since the nineteenth century, though before the fit theory was developed in the human sciences (Asghar, 2011).

The first causes of financial statement analysis can be traced back to the last stages of America’s drive to industrial maturity in the last half of the nineteenth century.

As the management of enterprises in the various industrial sectors transferred from the enterprising capitalists to the professional manager and as the financial sector became a more predominant force in the economy, the need for financial statements increased accordingly

Both of these were primary causes of financial analysis, but the shift in power to the financial institution was especially important (James, 2013)

The first financial ratio of the financial analysis was more than the current information needs to those awarded credit supplies, then came to be able to view the relations between financial data expressed in the form of a system.

This idea led to the emergence of a triangular system that Thompson was still valid and desirability is necessary. This activity challenges from different angles of a commercial institution, such as lending decisions, operational and financing to continue, and lead to the formation of financial ratios are different schools. \

Experience using financial analysis, financial ratios reflect the different applications in a variety of decisions, but in theory, principles, have not been examined.

In the United States, as in all other countries that now possess a developed financial ratio analysis, the only important financial instruments in existence were until in 1840, money, short term trade credit, long term credit, and urban mortgages.

The only important financial institutions were banks of issue and commercial banks (Lasher, 2005).

 Banks in South Africa have undergone immense regulatory and technological changes since the attainment of constitutional democracy in 1994.

South African banks are faced with increasing competition and rising costs as a result of regulatory requirements, financial and technological innovation, entry of large foreign banks in the retail banking environment, and challenges of the recent financial crisis.

These changes had a dramatic effect on the performance of commercial banks. Most studies on bank performance in South Africa have studied the efficiency of South African banks using Data Envelopment Analysis (hereafter DEA), studying the periods 1997-2007 and 2000-2005 respectively. This study evaluates banks’ performance for the period 2005-2009 using financial ratio analysis, (Ncube, 2009).  

The history of Cameroonian formal banking is less than 50 years old and its origins are traced to the later era of colonialisation i.e. during the post-second war French and English mandate rule in Cameroon. (Nicohalle, 2001).

Cameroonian commercial banks have undergone immense regulatory and technological changes since the attainment of constitutional democracy in 1994.

Their banks were faced with increasing competition and rising costs as a result of regulatory requirements, financial and technological innovation, entry of large foreign banks in the retail banking environment and challenges of the recent financial crisis, so financial ratios analysis enable us to identify unique bank strengths and weaknesses, which in itself inform bank profitability, liquidity and credit quality (Robert, 2010).

However, the success or failure of today’s business depends largely on the quality of decisions made by management, which in turn depends on the reality of accounting on them.  

The collapse of many businesses either private or public is due to poor decisions. The question is whether management has used information provided in the financial statement extensively to enable rational decisions.

1.2 Problem Statement

The importance of valid loan assessment can be understood through the substantial economic crises that the global economy has suffered as well as the severe problems that invalid lending decisions bring for both banks and clients (Tronnberg C.C, 2014).

The principal aim of making loan decisions is to get adequate returns from it. According to Needham and Dransfield (1991), “people, as a rule, will only lend their money to a client if they are satisfied with the returns they get from it”.

Lending decisions is one of the most important decisions that managers are concerned with because it affects both the liquidity and profitability of the bank. There are many assessments that banks take into consideration before granting out loans.

Banks before the nineteenth century relied solely on financial statements but as the world continued to evolve, many people seek for loans from commercial banks and so they needed other techniques to assess the credit potentiality of their customers apart from relying solely on the reports from the financial statements in other to avoid deadweight debt.

As a result of that, ratio analysis of financial reports was introduced to enhance the decisions made by managers in granting out loans to customers.

Many banks in Cameroon have not survived in the banking industry due to deadweight debt creeping most of their activities.

These huge overdue balances in their books with their resulting consequences have resulted in the collapse of banks. Research studies have shown that dead weight debt make two major effects on banks. These effects are the limitation of bank’s financial performance and lending potentials (Karimet, et al.., 2010).

Many researchers have not looked deep at the role of financial statement analysis (ratio analysis) in making lending decisions, which is the gap that this study seeks to fill. That is why the purpose of this study is to determine the extent to which commercial banks in Cameroon rely on ratio analysis of financial reports in granting loans.

To accomplish this objective, the following research questions will be asked;

The main research question in this study is; what is the impact of ratio analysis on the granting of loans in commercial banks. The main research question is further divided into the following specific research questions;

• What is a ratio?

• What are commercial banks?

• What is a loan?

• What is ratio analysis?

• Do banks in Cameroon use financial ratios in making credit evaluations?

• What accounting ratios are used in credit granting decisions?

• What is the degree of usefulness of each of these ratio analysis on granting loans in commercial banks?

• What is the relationship between ratio analysis and lending decisions in commercial banks?

• To what extend do Cameroon commercial banks rely on accounting information in their lending decision?

• How can commercial banks in Cameroon assess the creditworthiness of a firm seeking a loan?

• Should a bank lend based on collateral securities?

1.3 Objectives

The objectives of the study are to:

1. To find out the various types of ratios and their relationships in determining the loan portfolio in granting of loans in commercial banks.

2. To examine the impact of ratio analysis in granting loans in commercial banks.

3. To make recommendations.