Ratio Analysis As A Bank Lending Tool

1.0 INTRODUCTION:
1.1 BACKGROUND OF 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 by far one of the most services provided by banks. It is the corner stone of a bank. Great care thus has to be exercised in this activity.
In the lending by banks, some lending policies should be adhered to, some questions should be addressed regarding:
(a) Who is the bank lending to?
(b) How honest is this customer?
(c) What is the reputation of this customer at a time?
(d) How much can the bank lend to a customer at a time?
Judgment in lending is the real test of a bank’s skill and as such the health of the business and not just the customer should be of a great interest to the bank. Banks suffer great losses following the non-payment of loans. Banks should develop carefully into an analysis and use of the financial statements before lending. This analysis involves the assessment of a company’s or borrower’s past; present and anticipated future financial condition that could lead to future problems and to determine any strength that the company/ borrower might capitalize on.
The tools for the financial statement analysis are the financial ratios which can be used to answer some important questions regarding a company’s/ customer’s well-being.
Such very important questions regarding are:
(a) How liquid is the company?
(b) Is management generating sufficient profits from the company’s assets?
(c) How does the company’s management finance its investments?
The answer to these questions in two words are RATIO ANALYSIS.
According to UBAKA (1996), ratio is defined as a useful tool with which to analyse a set of financial statements. It is the only such tool available to accountants to analyse a set of financial statements. Ratio is the arithmetic relationship between two figures in a set of financial statement. It can be presented in a number of forms. The particular form of presentation chosen for any relationship examined is the one which the analyst can best interpret, for instance, some people prefer to look at the periods, while others prefer percentage presentation.
The three basic financial statements which form the bedrock from which the financial ratios are usually computed for analysis are:
(a) Balance sheet which represents a statement of financial position of a firm at a given period of time, including asset-holding, liabilities and owner’s equity.
(b) Profit and loss statement (which is sometimes referred to as income statement) presents a measure of the net profit results of the firm’s operations over a specified interval. It is computed on an accrual rather than on a cash basis.
(c) Statement of charges in financial position (which is also known as sources and use of adds statement provides an accounting for the sources provided during a specified period and the uses which they are put).
Analysis of the above financial statements employing financial ratios requires low arithmetical skill. Ratios are of use principally to the higher levels of management, who are responsible for maximizing profits and planning for the future. One must understand the inner workings of the financial ratios and the significance of various financial relationship to interpret he data bearing in financial analysis as to provide information about an establishment and such information do not be limited to accounting data. Ratios based on past performance may be helpful in predicting future earnings capacity and financial projections of an establishment. We must beware of the different limitations of such data. Financial statement is merely a summary records of the past and we have go beyond the financial statement and look into the nature of the organization, its position within economy, its activities, its research expenditures and above all, the quality of its engagement before granting loan (MATHER 1979). Financial ratios are of four types and are used to analyse the financial position of a firm. They are:
1. Liquidity Ratios: These ratios indicate the firm’s capacity to meet short-run obligations. Liquidity ratios measure the firm’s ability to fulfill short-term commitments out of its liquid assets. These ratios particularly interest the firm’s short-term creditors liquid assets include accounts receivable and other debts owed to the firm which will generate cash when those debts are paid in the near future. Also included are cash and other assets as marketable securities and inventories either of which can be sold to generate funds for meeting maturing short-run obligations.
Two types of liquidity ratios are the current and quick ratio.
(a) Current Ratio: The simplest measure of the firm’s ability to raise funds to meet short-run obligations is the current ratio. It is the ratio of Current Assets to current liabilities. Current assets are viewed as relatively liquid which means they can generate cash in a relatively short time period. If current ratio is too low, the firm may have difficulty in meeting short-run commitments as they mature. If it is too high, the firm may have an excessive investment in current asset.
To reduce a high current ratio, the component(s) of current asset that is too large should be reduced and the funds invested in more productive long-term assets used to reduce debt or paid out as dividends to the owners of the firm.
Current Ratio = Current Asset
Current Liability
(b) Quick or acid test ratio: Measures the firm’s ability to meet short-term obligations from its most liquidity assets. In this case, inventory is not included with other current assets because it is generally far less liquid than the other current assets excluding inventory dividend by current liabilities. Thus:
Quick Ratio = Current Assets Less Inventory or Stock
Current Liability
2. Leverage Ratios: Measure the extent of the firm’s total debt burden. They reflect the firm’s ability to meet its short and long term debt obligations. These ratios are computed either by comparing fixed charges and earning from the income statement or by relating the debt and equity items from the balance sheet. These leverage ratios are important to creditors since they reflect the capacity of the firm’s revenue to support interest and other fixed charges and whether there are sufficient assets to pay off debt in the event of liquidation. Shareholders too, are concerned with these ratios, since interest payments are an expense to the firm that increases with greater debt. If borrowing and interest are excessive, the firm can even experience bankruptcy.
Leverage ratio is of three types which include:
Debt-to-total assets ratio: This ratio equals total debt divided by total assets. Thus: Debt to total asset ratio = Total debt (liabilities)
Total Assets
Thus ratio is also referred simply as a debt ratio generally, creditors prefer a low debt ratio since it implies a greater protection of their position. A higher debt ratio generally means that the firm must yield a higher interest rate on its borrowing, beyond some point the firm will not be able to borrow at all.
Times Interest Earned Ratio
divided by interest
Thus, equals Earnings Before Interest and Taxes.
(EBIT) Thus EBIT
Interest charges
This ratio reflects the firm’s ability to pay annual interest on its debt out of its earnings. Here creditors feel highly confident that the debt interest will be paid since interest is amply covered by Earnings Before Interest and Taxes (EBIT).
3. Fixed charges coverage Ratio: This equals income available to meet fixed charges divided by fixed charges. Fixed charges include all fixed naira outlays, including debt interest, sinking fund contribution and lease payments. A fixed charges is a cash outflow that the firm cannot avoid without violating its contractual agreements. The firm periodically deposits money in a sinking fund which is eventually used to pay off the principal of the long term debt for which the fund was set up fixed charges coverage
= Income available for meeting fixed charges
Fixed charges
That is, Operating income + lease payment + other incomes
Interest + lease payment + before tax as sinking fund contribution
Fixed charges coverage ratio indicates how much income there is to pay for all fixed charges.
4. Activity Ratios: Indicate how effectively the firm uses its total assets in generating sales. These ratios indicate whether the firm’s investments in current and long term assets are too small or too large. If the investment in assets is too large, it could be that the funds tied up in that asset should be used for more immediate productive purposes. And if the investment is too small, the firm may be providing poor service to customers or inefficiently producing its product. Under the umbrella of activity ratio, we have:
(a) Inventory Turnover which equals cost of goods sold divided by average inventory turnover implies a large stockouts. A low inventory turnover implies a large investment in inventories relative to the amount needed to service sales. Excess inventory ties up resources unproductively. On the other hand, if the inventory turnover is too high, inventories are too small and it may be that the firm is constantly running short of inventory (out of stock) thereby losing customers. The objective of this ratio is to maintain a level of inventory relative to sales that is not excessive but at the same thing or time, is sufficient to meet customer needs.
(b) Average collection period: This is a measure of how long it takes from the time the sale is made to the time the cash is collected from the customer. This ratio indicates the firm’s efficiency in collecting in its sales. It may also reflect the firm’s credit policy. The sooner the firm receives the cash due to sales, the sooner it can put that money to work earning interest.
(c) Fixed Assets Turnover: This reflects how well the firm’s assets are being used to generate sales. This indicates how intensively the fixed assets of the firm are being used in adequately low ratio implies excessive investment in plan and equipment relative to the value of output being produced.
(d) Total Assets Turnover: This reflects how well the firm’s assets are being used to generate sales. If it low, it indicates the excessive investment in fixed assets (James and Horne 1989).
(e) Profitability Ratios: These ratios measure the success of the firm in ensuring a net return on sales or investment. Since profit is the ultimate objective of a firm, poor performance indicates a basic failure which if not corrected over too long a time would probably result in the firm’s going out of business under the umbrella of profitability ratios we have:
Return on Equity (ROE): This is the best single measure of the measure of the firm’s success in fulfilling its goal. Management objective is to generate the maximum return on shareholders investment in the firm. At the end of this work, the problems of bank lending would have been revealed and a way of achieving effective and efficient bank lending through careful analysis and use of financial statements in appraisal if borrower’s loan application before lending.

1.2 STATEMENT OF PROBLEMS:
Banks are scared of extending loans to customers due to the risk involved. Bank lending even, while considered important is regarded as a risk because of the problems it is associated with. The problem of unrepaid loan is a criticism of bank’s judgment thus, every bank has to employ an analysis financial statement of the borrower at a given period. Most banks are characterized by poor lending which may arise in poor appraising of borrower’s financial statement. The banks in most cases, share the common belief of customer that, the fact that he is making profit is an open scheme to the heart of the treasury and thus the bank fails to see that there is no simple way of assessing the borrower’s financial position before lending. In lending activities, it is necessary to see that money for repayment will be available at the appropriate time. The basic problem therefore is the inability of banks to recover their potential borrowers.

1.3 OBJECTIVES OF STUDY:
Ratio has been defined s that technique that is possibly used to facilitate the comparison of significant figures thereby expressing the relationship in form of percentage thus enabling the accounts of the borrower to be interpreted by bringing into focus salient features thereof (Spice and Peglers’ 1971). The analyzing service functions provided for lenders (financial institutions) is what this study is all about. The objectives, therefore included:
i. To find out how ratio analysis helps financial institutions in lending. In other words, to find out how ratio analysis services as a vital tool for lending by commercial banks and institutionalized lenders.
ii. To ascertain if actually ratio analysis is of any use to bank managers in ascertaining financial performance of a borrower.
iii. To explore the ratio analysis and find out their importance and how they can be used by bank managers in lending decision.
iv. To show how a careful study, analysis and use of financial ratio can help a lender to obtain a good knowledge of the financial aspects of a borrower and thus aid lending.

1.4 SIGNIFICANCE OF THE STUDY:
Having identified the problems to which the study logically relates, the significance of the research therefore is to bring into focus these problems and its impact on the analysis of the borrower’s financial position by the lender. As an institutional arrangement designed to promote economic and individual growth through loan advancement, efforts will be made in this study to look into the problem areas where managerial and other deficiencies have contributed to the ever increasing default in the steady loan repayment schedule by the peasant borrowers.
The research work is highly important for it is essentially an empirical enquiry into the deficient lending functions of the banks. The study when completed will expose the methods employed by banks lenders in assessing customers before extending credit advances. The study will also suggest an active and efficient lending means by employment of an analysis, interpretation and use of financial statements to aid the lending process which will be useful to banks and other institutional lenders. It is also significant for its will enable the lenders (Banks) to reconsider their lending assessment, the poor assessment will lead to poor lending.
Furthermore, the research work will seek to expose the malignant problems associated with the peasant defaults in repayment of loans granted to customers. And it will also examine its impact on economic environment in Nigeria. The contention of the author is that if the candid recommendation from the thorough study are religiously adopted, it will help to restore normalcy and sanity in the manner which financial position of the borrower should be assessed by the financial lender before extending credit advances.

1.5 SCOPE AND LIMITATION OF THE STUDY:
The research work is designed to cover the financial ratio which financial lenders and other institutionalized lenders will use to assess the financial position of the borrower before extending credit advances. It is a common knowledge that sound lending by lenders rest on information provided to the lender concerning the borrower’s financial condition and performance before extending credit advances as discussed. The research work is also designed to cover all the basic principles behind sound lending. The constraints of bank lending which lead to default in repayment of the advances extended are not left behind in this research work. Again, the researcher went further to find out the purposes of this Ratio Analysis (if any) and the parts it plays in decision making concerning advances extension by the lenders in order to achieve a sound lending.

LIMITATIONS OF THE STUDY:
The research work is designed to cover a selected sample. Again, for easier collection of data commercial bank out of all the commercial banks in the country was chosen is the Union Bank of Nigeria Plc, Ogui Road Branch, Enugu. The researcher had many constraints in the collection of the data due to the economic condition of the country such as high cost of transportation. This was as a result of the heavy increase on the general level of commodities, including the acute fuel scarcity which hampered my mobility.
Consequently, due to the nature of banking which demands secrecy, it was difficult to elicit a number of information from the staff of the bank. However, the study was narrowed down to a particular financial institution: UNION BANK OF NIGERIA PLC, ENUGU. The researcher has chosen to further limit the study to a particular branch of the institution situated at Ogui Road, Enugu starting from the obvious mentioned problems encountered by the researcher which affected wider average for data collection, there were incessant lock-outs and certain industrial disharmony among the agitating workers of various department of the institution at that particular period.
The ugly scenario gave rise to non-challance and erroneous fear that answering questions and conducting interviews by the bank officials with outsiders could attract punishment from superior authorities. However, inpsite of the foregoing, the researcher had to forego some basic personal needs in order to actualize the purpose of this research work.

1.6 HYPOTHESIS OF THE STUDY:
In order to have a sound basis for this research project, the researcher considers it imperative to build up a hypothesis. This hypothesis will serve as a guideline to the project. The researcher is considering whether Ratio Analysis as a bank lending tool has helped in any way in the extending credit to customers in the mentioned organization.
Based on this, the following hypothesis will guide the study.
1. The Null Hypothesis (Ho): Ratio Analysis is of no value for bank lending.
2. The Alternative Hypothesis (H1): Ratio Analysis serves as bank lending tool.
3. That default in non-repayment of loan is due to improper analysis of the borrower’s financial statement before extending credit.

1.7 BRIEF HISTORY OF UNION BANK OF NIGERIA PLC:
What is now known as Union Bank of Nigeria Plc came to Nigeria in 1917 as Barclays Bank Company (Dominion, Colonial and overseas) which alter changed its name to Barclays Bank International United and presently, Barclays Bank Plc.
All along, it had been a subsidiary of that bank until the Banking Decree of 1969, when it became locally incorporated with the name Barclays Bank of Nigeria Ltd, and having its Head Office at 40 Marina, Lagos.
On 12th March, 1979, this name was further changed by its Board of Directors (BOD) to Union Bank of Nigeria Ltd, and later to Union Bank of Nigeria Plc. This was as a result of the shareholding structure changing to 80% of Nigeria ownership and 20% Barclays Bank Plc, a change that effectively made it the first Nigerian Bank for its counterpart to have 80% Nigerian ownership. However, Barclays Bank Plc recently relinquished its 20% holding making it eleven thousand (11,000) staff with nearly 250 branches spread all over the country. It also has a branch in London and New York. All other dealings with the outside world is through agency arrangement with the parent bank, Barclays Bank Plc. Over the years, Union Bank Nig. Plc, has established itself as a leader in the banking industry.
The net profit achievement for the past five years speaks for itself. This has been possible through the selfless service of its employees who have toiled to bring the bank to its giant status.
In fact, it employs the largest number of employees in the banking industry. It has its slogan as “Big, Strong and Reliable”, in every sense of it including its capital and reserve base.

1.8 DEFINITION OF TERMS:
(a) LENDING: Is concerned with giving money to another for a period of time on the understanding that it will be returned.
(b) BANK LENDING: Is thus concerned with the provision of funds for needy customers as loans from the savings units paid into the bank.
(c) RATIO: Is the technique used to facilitate the comparison of significant figures thereby expressing the relationship in form of percentage thus enabling the accounts of a borrower to be interpreted.
(d) FINANCIAL STATEMENT: This is made up of balance sheet, profit and loss statement and sources and application of funds statement. It gives report on managerial success or failure.
(e) P.M.O.S: Profit Margin On Sales.
(f) R.O.T.A.: Return On Total Assets.
(g) R.O.E.: Return On Equity.
(h) LOAN PORTFOLIO: The amount of money which a borrower needs at a point in time and the purpose of requiring such account is regarded as loan portfolio.