ABSTRACT

This research focused on how ratio analysis impacts loan issuance by commercial banks. The objectives included identifying various ratios and their influence on the loan portfolio in commercial banks’ loan granting process and examining the correlation between ratio analysis and loan issuance in these institutions. The data collection methods involved primary data, specifically information collected from the field through questionnaires. The data was gathered using a sample size of 30 questionnaires. Descriptive and regression analyses were the primary analytical methods used. The results revealed a significant positive correlation between ratio analysis and lending decisions (r=0.689**, p>0.01), suggesting that effective use of financial ratios by commercial banks can improve lending decisions by 68.9%. Consequently, there is a 31.1% gap that commercial banks need to address, mainly due to the limitations of ratio analysis. This study is vital as it helps commercial banks understand the impact of ratio analysis on loan granting in microfinance, which is crucial for decision-making by the microfinance sector and the government. It is recommended that microfinance institutions adjust their lending strategies considering the impact of ratio analysis on loan issuance. This adjustment will help ensure a stable banking sector, which is integral to the economy.

CHAPTER ONE INTRODUCTION

1.1 Background of the Study

Commercial banks play a crucial role in modern economies and are fundamental to financial systems, primarily due to their efficiency in transforming savers’ financial claims into advances for businesses, individuals, and governments. This transformation process involves commercial banks evaluating information, managing, and monitoring borrowers, thereby accepting credit risk in return for a fair return that covers funding costs. Credit risk emerges from the possibility of borrower default, as outlined by Mishkin and Eakins (2007).

UBAKA (1996) defines ratio as a valuable tool for analyzing a set of financial statements. It is a method used by accountants to scrutinize financial statements.

The three essential financial statements serving as the foundation for computing financial ratios are: (a) Balance Sheet (b) Income Statement (c) Statement of Changes in Financial Position Analysis of these statements necessitates ratio analysis, primarily conducted by upper management, focusing on profit maximization and future planning.

Financial ratios measure a company’s financial performance (Sujarweni, V.W. (2017)). They help in determining how a business is financed. The primary financial ratios include:

1. Liquidity Ratio: Assesses a firm’s capacity to meet short-term obligations with its liquid assets, which are particularly of interest to short-term creditors. Liquid assets include accounts receivable and other debts owed to the firm, expected to generate cash when paid. Types of liquidity ratios: (a) Current Ratio (b) Quick or Acid-test Ratio (c) Cash Ratio

2. Solvency Ratios: Gauge the extent of a firm’s total debt. These ratios reflect the firm’s ability to meet both short and long-term debt obligations. They are calculated by comparing fixed charges and earnings from the income statement or relating debt and equity items from the balance sheet. Under solvency ratios, we have: (i) Debt-to-Equity Ratio (DER) (ii) Debt-to-Asset Ratio (DAR)

3. Profitability Ratio: Measures a firm’s success in generating a net return on sales or investments. Since profit is a crucial goal, underperformance indicates a fundamental failure that, if not corrected, could lead to business failure. Types of profitability ratios: (i) Return on Equity (ROE) (ii) Net Profit Margin (NPM) (iii) Return on Investment (ROI)

4. Turnover Ratio: Indicates how effectively resources are utilized, including men, machines, materials, money, and methods. A higher turnover ratio signifies better resource utilization. Types of turnover ratios: (i) Debtors Turnover Ratio (ii) Creditors Turnover Ratio (iii) Assets Turnover Ratio (iv) Inventory Turnover Ratio

5. Market Ratio: Reflects a company’s performance in the secondary market and is beneficial for stock market investors for fundamental analysis. Types of market ratios: (i) Dividend per Share (ii) Earnings per Share (iii) Dividend Payout Ratio

1.2 Problem Statement

Banks often hesitate to extend loans due to associated risks. Lending, while essential, is risky, with the issue of unpaid loans being a critical criticism of banks’ judgment. Therefore, banks must analyze a borrower’s financial statement before lending. Commonly, banks have inadequate appraisal methods for assessing borrowers’ financial status, focusing merely on profitability without a thorough assessment. In lending, it’s crucial to ensure repayment availability at the due time. The main problem is banks’ inability to recuperate loans from potential borrowers.

Research indicates that asset quality is a significant predictor of insolvency, with failing banks typically having high levels of non-performing loans before failure (Dermirgue-Kunt, 1997). Non-performing loans are a major cause of economic stagnation, as they lock resources in unprofitable sectors, hampering economic growth and efficiency.

Waweru and Kalani (2009) found in Kenya that customers’ failure to disclose essential information during loan application is a primary customer-specific factor contributing to non-performing loans. This calls for a review of credit managers’ capabilities and the decision models they use. Since banks rely on financial statements and ratios for financial analysis, determining which ratios to use for accurate and clear information is crucial. This research aims to address this issue by identifying ratios deemed useful by commercial banks in making lending decisions. Discriminating to identify a limited set of financial ratios is necessary for deciding on a client’s creditworthiness.

1.2.1 Main Research Question

i. What is the impact of ratio analysis on commercial banks’ loan granting?

1.2.2 Specific Research Questions

i. How does the solvency ratio affect commercial banks’ loan granting? ii. How does the liquidity ratio influence commercial banks’ loan granting? iii. What is the effect of the profitability ratio on commercial banks’ loan granting?

1.3 Objectives of the Study

A ratio is a technique facilitating the comparison of significant figures, expressing relationships in percentage form, and interpreting borrowers’ accounts by highlighting important features (Spice and Pegler, 1971). This study’s focus is on the analysis service provided for lenders (financial institutions).

The main research objective is:

• To explore the impact of ratio analysis on commercial banks’ loan granting.

Specific objectives include: i. Evaluating the influence of the solvency ratio on commercial banks’ loan granting. ii. Assessing the impact of the liquidity ratio on commercial banks’ loan granting. iii. Analyzing the effect of the profitability ratio on commercial banks’ loan granting.

1.4 Hypotheses of the Study

• Null Hypothesis (Ho1): Solvency ratio has no significant effect on commercial banks’ loan granting.
• Alternative Hypothesis (H1): Solvency ratio significantly affects commercial banks’ loan granting.
• Null Hypothesis (Ho2): Liquidity ratio has no significant impact on commercial banks’ loan granting.
• Alternative Hypothesis (H2): Liquidity ratio significantly impacts commercial banks’ loan granting.
• Null Hypothesis (H03): Profitability ratio has no significant effect on commercial banks’ loan granting.
• Alternative Hypothesis (H3): Profitability ratio significantly affects commercial banks’ loan granting.

1.5 Significance of the Study

This research highlights the issues related to the analysis of a borrower’s financial position by lenders. As a system designed to foster economic and individual growth through loans, this study examines the problems where managerial and other deficiencies have led to increasing defaults in loan repayments.

Bank and financial institution managers must make informed decisions to enhance efficiency and reduce nonperforming loans. This study’s findings will benefit investors for investment evaluation, academia and researchers for further study, bank management for credit decisions, borrowers for enhancing project evaluation methods, and financial analysts. The study will reveal banks’ methods in assessing customers before extending credit and suggest efficient lending methods using financial statement analysis and interpretation. It will prompt lenders to reevaluate their assessment approaches, as poor assessment leads to ineffective lending.