The Use of Ratios as Bank Lending Tools in Cameroon
Department: Accounting
No of Pages: 50
Project Code: ACC8
References: No
Cost: 5,000XAF Cameroonian
: $15 for International students
Abstract
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 on 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 key words 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 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. The
following ratios were used in the study; Profitability Ratios, Leverage Ratios,
Liquidity Ratios, Activity Ratios, Asset Management Ratios and Cash Flow
Ratios.(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 analysing 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 of loans in Commercial banks.
The null
hypothesis which states that “Ratio Analysis does not have a significant impact
on 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.
CHAPTER ONE
INTRODUCTION
1.1 Background to the
Study
Bank
lending is concerned with provision of funds for needy customers as loans from
the savings of the fund surplus units paid into the bank. Due to the
established fact that the saved fund is at the disposal of the bank for
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 profit are by far one of the most profitable services
provided by banks. It is the corner stone of a bank. Great care thus has to be
exercised in this activity.
Commercial
banks are special institutions in 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 bank 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 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 any one borrower or the loss of exposure the bank can
accommodate.
In
the current world banks are moving away from the traditional approach of
demanding for collateral when lending to customers, instead they require more
information on the lenders this has brought to for 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 business for finance. 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:
- 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 on a monthly basis. Gross income is simply a monthly pay-check before
one pays off the costs, such as taxes and interest expense.
- 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.
- 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.
- Working Capital Ratio
The
working capital ratio, also known as 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
- Debt-to-Equity Ratio
The
debt-to-equity ratio highlights a company’s capital structure.
1.2 Statement of the
problem
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 decision.
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 in 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 loan. Cash generation ratio
measure 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 decision 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 in to 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 dead weight 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 make two major.
These
effects are the limitation of bank’s financial performance and lending.Many
researchers have not looked deep on 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 lending decision and how does these ratios explain the lending habit of banks in Cameroon?
1.3.2 Specific research
questions
- What are the different ratios that guide bank-lending decisions?
- Which of these ratios is most important in making 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 lending decision and how these ratios explain the lending habit of
banks in Cameroon?
The
Specific 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 bank to make lending decisions.
- To evaluate the impact of ratio analysis in granting of loans in commercial banks.
- To establish the extent to which commercial banks apply ratios in making lending decisions.
- To make recommendations.
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