The Use of Ratios as Lending Tools for Banks
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This project seeks to study ratios and how they influence lending functions in commercial banks, investigating the extent to which ratio and the ratio analysis process assists bank managers in their decisions. Over the years, ratios have become important tools used in this study because one of the most important tasks of ratio analysis is assisting the financial managers to achieve efficiency through the provision of suitable financial information. Some of the keywords used in this study included ratios, ratio analysis, credit analysis process, commercial banks, financial statements, and lending. In carrying out the above-mentioned functions, research questions were formulated and used in the analysis of the study. The following objectives were also formulated and used;(1)To assess the different ratios used by banks to make lending decisions following ratios were used in the study; Profitability Ratios, Leverage Ratios, Liquidity Ratios, Activity Ratios, Asset Management Ratios and Cash FloRatios.(2)To examine the most important ratios used by banks to make lending decisions. Relevant tables were built on the data collected from Ecobank and percentages were used in analyzing the data. It was discovered that Profitability Ratios with a 1st ranking are the most used type of ratios when granting loans as all respondents mentioned in their responses with a percentage of 100, followed by Leverage and Cash Flow Ratios both ranked 2nd with a percentage of 26.67% each, with Activity Ratios ranking as 3rdwith 20% and lastly Liquidity Ratios ranking 4th and a percentage of 13.33%. (3)To evaluate the impact of ratio analysis in granting loans in Commercial banks. The null hypothesis which states that “Ratio Analysis does not have a significant impact on the grating of loans in commercial banks” was tested and from the responses was found to be wrong. Hence, it was rejected. Based on the findings, some recommendations were put forward which, if adopted will go a long way in enhancing the effectiveness and reliability of using ratio analysis in evaluating the financial performance of a given institution in a given period before lending.
Bank lending is concerned with the provision of funds for needy customers as loans from the savings of the fund surplus units paid into the bank. Since the saved fund is at the disposal of the bank for a specified period, the bank can thus provide these funds to their customers who may have greater use for these funds at the time. The reason behind bank lending is the need to attain some economic growth through lending to already existing businesses for expansion and to individuals with entrepreneurial prospects to set up businesses and for making a profit are by far one of the most profitable services provided by banks. It is the cornerstone of a bank. Great care thus has to be exercised in this activity.
Commercial banks are special institutions in the modern economy because of their ability to efficiently transform financial claims of savers into claims (advances) issued to businesses, individuals, and governments (Mishkin and Eakins, 2007). A commercial bank’s ability to evaluate information and to control and monitor borrowers allows it to lend to the borrowers at the lowest possible cost. This implies that commercial banks accept the credit risk on these loans in exchange for a fair return sufficient to cover the cost of funding to household savers and the credit risk involved in lending. The commercial bank needs information useful in evaluating the credit risk of borrowers. Credit risk arises from the possibility that the borrower will default. In no way would a bank extend credit to a potential defaulter (Mishkin and Eakins, 2007). Determining the credit risk on individual loans or bonds is vital before a bank manager can price a loan or value a bond correctly and set appropriate limits on the amount of credit extended to anyone borrower or the loss of exposure the bank can accommodate. In the current world, banks are moving away from the traditional approach of demanding collateral when lending to customers, instead they require more information on the lenders this has brought to the Credit Reference Bureau. To improve on the credit information the banks should use ratio analysis which can easily be computed from the financial statements.
When it comes to lending, the first thing any bank will do is work out the suitability of your finance business. They’ll want to determine if you’ll be able to repay the amount you borrow (the principal) with the interest they charge within a reasonable length of time.
A potential lender will use a wide variety of factors to assess your creditworthiness. The bank will also use a more specific set of factors. There are factors they are required to think about because of law and regulation, while other factors are used as part of their own policies. A bank’s decision to give you funding will depend on some of the following areas: your profits and cash flow, what security is available, what will the loan be used for, your personal credit assets, collateral or collaterals available, ratios, and Enterprise Finance Guarantee(EFG). Examples of ratios that guide lending decisions in other parts of the world include:
1. Debt-to-Income Ratio
The debt-to-income ratio (DTI) is a lending ratio that represents a personal finance measure, comparing an individual’s debt repayments to his or her gross income every month. Gross income is simply a monthly pay-check before one pays off the costs, such as taxes and interest expense.
2. Housing Expense Ratio
The housing expense ratio is a lending ratio that compares housing expenses to a pre-tax income. The ratio is often used in conjunction with the debt-to-income ratio when assessing the credit profile of a potential borrower. It is also used in determining the maximum level of credit to be issued to a borrower.
3. Loan-to-Value Ratio
The Loan-to-Value ratio (LTV) is a lending ratio used by financial institutions in assessing the lending risk before approving a mortgage for property purchase.
4. Working Capital Ratio
The working capital ratio, also known as the current ratio, indicates how much current assets a company owns relative to its current liabilities. The ratio shows how easily the business can meet its short-term obligations that are due within a year. So, the working capital ratio is equal to current assets divided by current liabilities
5. Debt-to-Equity Ratio
The debt-to-equity ratio highlights a company’s capital structure.
Banks use different ratios to guide the decision to either grant a loan to a customer or reject the loan application. Different ratios such as Profitability, Efficiency, Liquidity, Solvency, and Cash Generation ratios have been used over time to guide bank lending decisions. Profitability ratios measure or used to assess a business’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders’ equity over time, using data from a specific point in time.This is useful because it usually means the business is performing well by generating revenues, profits, and cash flow.
Efficiency ratios measure a company’s ability to use its assets and manage its liabilities effectively in the current period or the short-term. For a bank, an efficiency ratio is an easy way to measure the ability to turn assets into revenue which would influence the payment of a loan. Liquidity ratios measure a debtor’s ability to pay off current debt obligations without raising external capital. Hence influencing how to pay off especially short term loans. The solvency ratio measures whether a company can meet its short and long-term liabilities which banks look at when granting loans. The cash generation ratio measures the company’s ability to generate cash purely from operations, compared to the total cash inflow which shows banks a business ability to generate cash
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, 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. Research studies have shown that dead weight debt makes two major. These effects are the limitation of bank’s financial performance and lending. 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.
To accomplish this objective, the following research questions will be asked;
1.3 Research Questions
1.3.1 Main research question
- What are the different ratios used by banks to make the lending decision and how do these ratios explain the lending habit of banks in Cameroon?
1.3.2 Specific research questions include
- What are the different ratios that guide bank lending decisions?
- Which of these ratios is most important in making a lending decision?
- What is the relationship between ratio analysis and lending decisions in commercial banks?
1.4 Objectives of the study
The main objective of this study is to examine the different ratios used by banks to make the lending decisions and how these ratios explain the lending habit of banks in Cameroon? The objectives of the study include:
- To assess the different ratios used by banks in making lending decisions.
- To examine the most important ratio used by banks to make lending decisions.
- To evaluate the impact of ratio analysis in granting loans in commercial banks.
- To establish the extent to which commercial banks apply ratios in making lending decisions.
- To make recommendations.