RATIO ANALYSIS AS A BANK LENDING TOOL(A CASE STUDY OF UNION BANK OF NIGERIA, OGUI ROAD, ENUGU)
The Oxford Advanced Learner’s English Dictionary defines lending as “giving temporary of something” lending involves giving something for a period of time on the understanding it or its equivalent will be returned.Lending is an essential function of commercial banking. It has to do with an extension of loans borrowers. Through lending, bank management strives to satisfy the legitimate credit needs of the community or credit markets that the bank services or intends to serve.
Bank loans contribute materially to bank profitability by providing a higher return than most other bank assets and by being a key element in the creation and maintenance of depositor relationships. Bank lending tends to be influenced by more subtle and subjective factors such as an evaluation of the borrower’s character, the history of the borrower’s relationships with the bank and his possible influence on prospective new business. These differences emphasize the need to understand the basic concepts and types of lending and to have well-formulated loan policies and practices.
Well conceived lending polices and careful lending practices are essential if a bank is to perform its credit-creating function effectively and minimize the risk inherent in any extension of credit. A bank needs policies and practices specifying how much or what kinds of loans will be made to whom and under what circumstances. Therefore, a bank’s lending policies are in effect, screening devices by the directors and bank managers seek to limit the bank’s loans to the type and character that they think appropriate particularly when loan demand is pressing hard against a bank’s available funds (Howards 1980).
Bank credits are the essential means of creating and maintaining depositor relationships, particularly with business firms. Most banks lend only to firms that keep deposit balances at the bank and most firms maintain deposits primarily at banks that they believe are willing to fulfill their borrowing needs. Therefore, in order to service the credit needs of customers profitably, banks must be willing to assume a somewhat higher average risk on credits than on other bank assets.
Sound lending is an art and not a science, therefore, a credit that is clearly unsafe should not be made. However, absolute safety is neither the only, nor even the best measure of soundness in lending. A sound bank credit should be collectable from planned self-liquidation of the borrower’s assets or from the anticipated income or profits of the borrow rather than from the forced liquidation of any collateral that may be pledged. Therefore, one of the basic criteria for evaluating bank credit should be that the money loaned should normally flow back to the bank as the transaction being financed or consummated or liquidated.
Nevertheless, it should be clear that a bank’s lending policies and practices will be sound if its directors and top management lay own firm guidelines that specify appropriate purposes for which the bank’s credit may be used, relate the bank’s repayment requirement to those purposes and make certain that the bank obtains sufficient protection against unforeseen risks. (Schale and Haley 1977).
The rate of repayment and the final payment schedule so established will be an automatic signal that something has gone wrong with the original estimates and that loan may be in need of immediate attention. Furthermore, it is very essential for the bank to achieve ascertain the credit worthiness of the borrower before extending credit advance. To achieve this, the bank should insist on financial statements and earnings records from all important borrowers no matter how sterling their character may appear or how often the principals in the business play golf with one of the bank’s managers or directors. Moreover, the statements should be complete and sufficiently detached to permit effective analysis.
A discussion of bank lending would be incomplete without some comment on the spirit which banks approach lending. In loan negotiations, many banks still appear to be on the defensive, protecting themselves against the onslaughts of potential borrowers behind barricades of minimum ratios and standardized lending procedures. Other banks seem to regard lending as a challenging opportunity and go out seeking loans, some perhaps, a little too aggressive.
The author’s viewpoint concerning bank policy has been that lending is the primary function of a commercial bank and that a bank should make all the sound loans it can. If this viewpoint is valid, no well-run bank can take a passive attitude toward lending.
- OBJECTIVES OF BANK LENDING:
Banks extend advances to different business organizations or groups for them to meet up their expected financial goals and at the same time yield profit to the bank. Sound loan creates growth to the borrower’s business if well-used and at the bank’s time given profit. Some of the business groups that seek for bank credit (loan) and their objectives are mentioned and analysed below:
Traders require bank loan to enable them hold large stock of inventories to meet the demands of Christmas, Easter and Moslem festivals. This is because such festive occasions are periods of peak sales, and businesses want to hold sufficiently large inventories to enable them take advantage of huge sales. Since their resources may be inadequate to hold sufficiently large inventories, they have to seek for bank loan. These bank loans will help them to meet up their desired goals or targets.
Farmers need bank loan or credit facility to enable them purchase farm inputs and to cultivate the land in the hope of repaying the loan after harvesting and selling their crops.
Similarly, manufacturers demand bank loan to enable them purchase raw materials, hold work in progress, finished goods and receivables. Firms operating as dealers in stock require funds to enable them hold stock of securities. Such firm can therefore require loan to enable them hold it extend margin facilities to its client. In the Open Market Operation (OMO) of this country, security dealers or discount houses may have to borrow from banks in order to purchase the amount of government stocks which they wish to purchase.
On the side of the bank, some of the objectives of lending are:
- Profitability: Today, one can see that bank’s profitability depends to a remarkable degree on the cost of its funds. Profit is as a reward of lending money and owning securities. The more loans and investments a bank makes, the higher its profits are likely to be. Banks lend where profit rate is high and risk of repayment and cost of administering loans are low. According to Osayameh (1986), “as profit is necessary for the long term survival of firms and since profitability is used as an index for assessing managerial performance, it is natural that most company managements would consider return on investment as a prime objectives.” He further says that “in lending activity, the bank is concerned with the safety of the loan since it represents a chunk of depositors’ money and a source of income to the bank. No lending is attractive if the expected income is less than the average cost of borrowed funds.
- Growth: One of the major objectives of bank lending is to maximize profits, therefore, for any lending decision and activity to be worth the effort, there must be enough assurance that it will lead to the bank’s business growth in terms of additional variety of services yielding good income to the bank. It should also increase the available quality of bank’s loan resources. If from the beginning, the lending carries far greater risks than are considered reasonable, it is likely that it could turn bad at a future date and therefore fail to contribute to the bank’s loan resources quality wise.
- BASIC PRINCIPLES OF LENDING:
While lending cannot be regarded as a science that is, it cannot be broken down into a fool-proof mathematical formulae to meet all situations, it is possible to be regarded essentially as statements of bank lending. But they are to be regarded to draw from experience certain basic principles of bank lending as statements of general tendencies only and not irrefutable laws inelastic and incapable of wider interpretation to meet given situations. They are neither independent nor umbreakable. These principles and their requirements are all closely interwoven and cannot be isolated.
These are three basic principles behind all bank lending. They are:
- Safety: The safety of any loan is of paramount importance to the bank. The safety of the loan depends upon both the willingness and ability of the borrower to met loan obligations as they fall due. Bearing this in mind, the personal characteristics of a customer deserve thorough evaluation. At the time of repayment, a customer might have money in his possession and still not pay.
Bank will therefore try great emphasis on the character, integrity and reliability of borrowers. There must be a reasonable certainty that the amount granted can be repaid fro profits and cash flow generated from the operations of the borrower. In support of the safety requirement, the borrower must be able to provide acceptable security which will serve as something to fall back on if the expected source of repayment should fail.
- Suitability: The requirement of many borrowers may be completely free from all risks, but fails to comply with this principle which stems from the banker’s wish to concentrate his lending on purposes which are desirable from the standpoint of the economic health of the nation. It is absolutely necessary for a bank to ensure that the purpose of the loan is not in conflict with the economic and monetary policies of the government.
- Profitability: It is a well known fact that banks are businesses oriented mainly to make profits and not a charitable organization. Therefore, it follows that any loan granted is expected to yield some profits for the bank. The purpose of a loan and its implications on the firm’s (borrower) are therefore given due consideration before it is undertaken.
These three basic principles of bank lending can be further broken down into other factors which must be considered when granting a loan and which can be considered as the canons of lending. In spite of all the myriad of controls, guidelines and regulations in respect of bank lending, banks have to exercise care and prudence in their lending activities.
When a bank is approached for a loan, it should obtain satisfactory answers to some basic questions which include:
- How much the customer wants to borrow.
- Why the customer wants bank finance
- How long he wants it
- How he intends to repay
- How financially strong the borrower’s business is to ensure continuity if his plans suffer a setback.
- What security he can offer.
- The bank’s assessment of the customer (Mather 1979) summarized the canons of lending as:
- “How much is required?”
- “Purpose(s) of the loan?”
- “For how long are the funds required?”
- “What is the source of repayment?”
Amount: There is a tendency for customers to ask for the amount they think the bank will lend rather than the amount they consider realistically needed to see a project through. The amount required has to be considered not only in relation to the capital resources of the borrower but also in relation to the purpose for which the loan is needed. It is important or the bank to assess whether the amount being sought will be adequate to satisfactorily carry out the very project. There is no point for the bank to grant a maximum amount which is inadequate to finance the project if the borrower cannot contribute the balance from his own resources. The borrower’s contribution to the project is very important.
When the question of amount is being considered, it is necessary to relate the amount that the bank is being asked for to the amount which the borrower is contributing to the project (Mather 1979). The borrower’s contribution to the project must be reasonable as it is one of the ways the bank can determine the borrower’s commitment.
Purpose of the loan: It must be emphasized that knowledge of the purpose for which credit advance is to be used is very important. A bank would not wish to advance money to finance an illegal or fraudulent project. Some projects or ventures are completely banned by the government and are not expected to be carried out by any bank. A bank for instance, will not lend to financial gambling, betting and speculation since the government frowns at it.
Sources of Repayment: It is a standard rule of banking that if the bank cannot see how the borrower can repay advance, he must not lend even if adequate security is available. The sources of repayment is very vital. The money to be lent is not for the bank but belongs to depositors. Repayment will therefore be at the heart of any proposition before a bank. The bank will be more inclined to lend if the customer can demonstrate how and when repayment will be made. A prudent banker will wish to know how long the advance is likely to outstand and from what source it is to be reduced and eventually repaid. Advances made to a sound borrower to support normal trading requirement will be repaid in the ordinary course of business as the trade cycle of the borrower revolves. For instance, where the retailer or the wholesaler borrows to increase his stock, the bank will be repaid from the proceeds of the sale of goods.
Business of the Borrower: The bank needs to ascertain this by carefully analyzing the financial statements of the borrower. After the analysis, the bank should be in a better position of determining the inherent strengths and weaknesses of the firm and whether the firm is strong enough to keep going if the plan suffers a setback.
In other words, the nature optimism of every potential borrower has to be discounted and the real prospects of the nature coldly assessed in the light of known conditions. With the experience of the borrower, is the project likely to succeed? If it fails, the bank will have to fall back on its security to recover its advances and the lending will be fundamentally unsound. If it succeeds, sufficient will be available from profits after taxation, gradually to liquidate the bank debt. Again, there is no trainlines in demanding a prescribed course. It is a question of considering the business and its prospects in conjunction with all other factors and recording as it were a vote for or against the proposal.
Security: This should not be seen as the source of repayment but only as something to fall back on if the expected source of repayment fails. The ability of a borrower to produce tangible security is not the most important criterion for granting loans as the offer of security does not weaken the need for a thorough examination of the proposal. This, however, does not go to mean that security is unimportant. Security as a kind of insurance serves as a buffer against unforeseen adverse developments.
It should normally be obtained as an additional leverage to for its advance because borrower’s position do sometimes change quickly – (Osayemeh 1986). It follows that the prudent bank lender will always endeavour to obtain the maximum security available from the borrower. The advantages and disadvantages of the various types of banking security and the distinctions between the direct and collateral cover are beyond the scope of this project but it is prudent here to emphasize that the best security is of little value if it cannot be realized without difficulty when an emergency arises. Therefore, the real security for any advance must clearly be granted to a borrower in whom the lender may have every confidence, and it is a sine qua non of good lending never to afford any facility to a borrower upon whom the banker should know his customer and be able to judge not only his integrity to use the bank money to advantage and repay it within an acceptable period.
Who is the borrower and what does the banker know of his business experience and integrity? What are the nature and prospects of his business in relation to economic conditions and needs? In short, without confidence in the borrower, it is dangerous to make any advance. So many opportunities arise in banker/customer relationships to enable the borrower to take unfair advantage of the bank and other trade creditors. For example, looses can easily be hidden in trading account by over-valuation of stock, while assets covered by a floating charge may legally be sold and the proceeds used to meet pressing creditors or director’s salaries regardless of the bank position.
In particular, unsecured lending and advances made against the pledge of product call for unquestionable confidence in the integrity and cooperative dealing of the borrower.
What is known of the experience of the borrower? If a private trader or partner in a firm, has not made a success of the business to date? How long has he been engaged in this particular trade and what profit has he earned? Does he spend all the profits he makes or does he live prudently, leaving adequate margin for possible losses? It would be unwise today to share with an unexperienced borrower the obvious risk entailed in tapping or exploring a new market or business.
Therefore, it is important for a bank to know a borrower very well and be able to judge his ability, intelligence and his business experience. The financial statements of the borrower can also throw some light on the borrower’s performance.
Borrower Capital Resources: Some customers expect their bank to provide most of the capital required in a business. The liquid position of any potential borrower demands close assessment and the greater the bank debt, actual or prospective, in relation to the capital resources of the business, the weaker inherently must be the financial position of the borrower who employs a position of the short-term funds to buy fixed assets.
Meanwhile, lack of capital in the business may be overcome from the banking standpoint by the deposit of adequate personal security by the proprietors. Instead of investing directly in their business, they support the bank debt with their own private assets.
2.4 PROBLEMS/CONSTRAINTS OF BANK LENDING:
Some of the constraints that militate against bank lending in Nigeria act as a redeemer to the general economic situation in the sort-run and equally frustrate banking activities in the case of credits and this will pose its own drastic problems on the economy in the long-run. These constraints should be picked and analysed one after the other. These constraints are:
- Default in Repayment: When a banker lends to a borrower, he has at the bank of his mind that the borrower will comply with the terms stated at the onset of the contract. It is because of the dynamic nature of our economy that commercial and other financial lenders ask for an adequate security from the borrower before extending credit advance. The bank’s ability to lend is sometimes marred by default in repayment of previous loans. If, for instance, a customer borrowed short-term promising to repay the advance after twelve(12) months and at the end of the twelfth (12th) month, he cannot liquid date of the debt, in case of subsequent request for further facilities, the bank (lender) will definitely reflect or delay the proposal. That may even affect other borrowers in the sense that the lender will carry out thorough survey of the proposer’s credibility before granting the request. This will not only take time but will also affect the project for which the advance is sought.
However, certain things can make borrower not to meet up his financial obligations. Example for a corporate customer, poor financial planning or assessment of his business is a sign of bad operations and a signal of default. A customer who runs into more costs than his forecasted profit is bound to fail. It is therefore, the duty of the lender (banker) as a business adviser to let his customer know this in advance. Lack of cash to meet other financial obligations is another cause of business failures. There are many other causes of business failure which might frustrate the borrower’s effort to replace, but we are not dwelling much on such factors as they are not the point in mind.
For personal customers, extravagant spending may affect their loan repayment. Example, if a loan is for raising a building and the borrower diverts it for chieftaincy matters, this means that the purpose of the loan has been defeated and to repay such advance will be difficult for the borrower. This is why the banker (lender) should monitor the project to make sure that the advance is directed to the purpose for which it was granted. It must be stated that a prudent banker always look into the memorandum and articles of association (if borrow is a limited company) to know the company’s powers to borrow since borrowing outside its powers ultra vires the company and the lender cannot claim.
The lender (banker) must acquaint himself with these factors because they are facts pointing towards default in repayment. If a customer borrows N10m for a period of two years and at the end of the two years he could not repay fully, then the bank will not be able to expand credits and this will eventually affect prospective borrowers (Osayemeh 1986).
- Attitude of Bank Staff: Owing to poor staff/public relationship, some customers find it extremely hard to request for information especially where it relates to their private affairs. Some people hate hearing that some other people knew that they operate on credit basis. Most managers in our banks started from scratch, may be as clerks or supervisors and have never desired to further their education. These set of managers have a different way of perceiving things, some do fear giving out loans as they are only keepers of other people’s funds.
They do not realize that for a bank to profit, it has to take more risk or at lease balance the risk with the prospects. The largest proportion of bank profits come from deposits which the banks give out as loans. On this note, the customer must be treated with courtesy and respect. The application must be carefully treated and there must be a depth analysis of the proportion. Where the customer’s proposal is rejected, he should be made to understand the reason for the bank’s inability to grant the request. This is, of course, one of the virtues of a good banker.
- Security: It is not conducive to analyse the problems of bank lending in our economy without highlighting the types and effects of securities which our financial institutions (banks) demand as a safety net. There are many and different types of securities required for bank lending and each is valued according to its marketability.
Security should not be seen as the source of repayment. Therefore, the ability of a borrower to produce tangible security is very important before extending credit. But some banks (lenders) do neglect this and thereby imposing too many problems in the economy to the extent of forcing some banks out of business (distressed).
- Management: One of the major causes of business failures is poor management of its resources especially financial resources. Inability to foresee the future risk of an advance taken or even inability to monitor the loan given and know when the borrower is off the line pose their individual problems on bank lending in our past situation. Some people think that anybody can manage a business. Most of our banks today are manned by managers who started their careers as clerks or supervisors and have never tried to practice management. Some of these managers extend credit advance without a depth survey of the suitability, safety and profitability.
According to the Branch Controller of Union Bank Ogui Road, “The most important reason why indigenous businesses do not receive bank facilities as they should from banks is the failure of many of them to honour pledges given in respect of such facilities in the past”. There are some problems arising directly from the internal management and organization of the indigenous business ventures. Some of these problems which the banks have identified include the usual poor and out of record keeping of financial statements and thereby pose problems to the bank in lending decision.
The banks feel that any management which is able to live with inadequate information about its own performances is bound to make costly mistakes which can adversely affect efficiency and profitability. Lack of adequate staff training inherent in most commercial banks pose the problem of ineffective banking management. Training is a continuous and life-long exercise for every organization wishing to attain its goals and most business embark on training especially because of changes in technological nature of business world, etc. For bank manager who do not undergo this training process is bound to meet problems in management.
- Underbanking: The problem of underbanking hinders the quality of services available from the Nigerian publics. Because a bank’s ability to establish branches is dictated by the Central Bank of Nigeria, it has not been easy for banks to extend their services, of which lending is an important one, to some of the rural areas in the country.
An agriculturist in the bank on one of my research days said that the lack of a bank branch in his town of operation affects his establishment as he finds it difficult to obtain loan when crucially needed to enhance his working capital and because the bank where he keeps account with is in the urban area f the State (Enugu State), the bank manager fears, most of the time, to give him a loan, since he does not come to the bank very often for deposits and withdrawals. “Most of the banks get their licences from the Federal Ministry of Defence rather than the State Ministry which could have given them free hand to expand and control their affairs” (Adekaiye 1986).
- C.B.N. Credit Guideline: This revealed that our banking system controlled by the C.B.N. The commercial bank’s ability to expand or contract credits depends on whether the C.B.N. guidelines instruct for increase or decrease in the prevailing rates of interest. Therefore, the commercial banks hands are automatically tied up by the Central Bank of Nigeria Guideline and moral suasion. Again, high lending rate introduced by C.B.N. affects the banks. For instance, a bank that pays more than it gains as interest will definitely not lend since little will be available for such purpose. This will reduce the bank’s profit as the bank meets its cost through interest charges.
Although the aim of monetary policy is to regulate the volume, direction and price of money supply and credit in the economy whole the discount rate is the rate of interest the C.B.N. charge the commercial bank on loans extended to them. Now, if the aim is to reduce liquidity of the banking system, thereby limiting their ability to lend, the idea is to increase the discount rate and when this is done, the cost of borrowing will increase and there will be negative investments. But, if the discount rate is reduced, borrowing will become attractive and banks will have some resources to lend. Furthermore, reserve requirement (6% of reserve ratio) is used by the C.B.N. to reduce the ability of commercial banks to make loans to their customers by increasing the ratio. Moral suasion is also used by the C.B.N. to influence lending policies of the commercial banks.
Finally, mention must be made of selective credit control or what we popularly know as “sectorial allocation”. This is a procedure whereby the CBN tends to favour one sector of the economy than the other. Because of the government’s development programmes to revamp the economy, agricultural and industrial sectors are at a lower ratio while the least favoured sectors pay higher ratio of interest.
In other words, the CBN tends to favour one sector of the economy than other. The CBN in its guideline (credit guidelines) will order the banks to charge lower interest rates for loans granted to those favoured sectors while at the same time force them to grant to these.
In other words, the CBN in its guideline (credit guideline) will order the banks to charge lower interest rates for the loans granted to these favoured sectors while at the same time force them to grant more loans to the same sectors. Non-compliance with these guidelines normally attracts penalty and to avoid this, the banks must adhere to it. All these and many others cause constraints in lending.
The table below shows the allocation by credit by CBN.
|COMMERCIAL BANK % 1995
|A: preferred sectors
(i) Agriculture (Agric. Forestry and
(ii) Manufacturing Enterprises (mining, quarrying and construction)
(iv) Solid Minerals
|B: Less Preferred Sectors:
N.B.: “Banks are to regard allocation targets in “A” as minimum and that of “B” as maximum (Azuzu, C.C.N. 1995).
2.5 PURPOSE OF RATIO ANALYSIS:
The accounts published annually by companies constitute an important source of information for both internal and external users, and their form and content are carefully regulated with the intention of ensuring that they are a helpful and reliable guide to corporate progress.
Ratio analysis has been developed to help translate the information contained in the accounts into a form more helpful and readily understandable to users of financial reports. The ratios do not appear in the accounts, however, and the user must calculate and interpret them or employ some one with the necessary skill to do the job. Due to the banker’s particular relationship with his customer that is, his ability to insist on the regular provision of up to date financial information for the duration of the advance, ratio analysis can be used to following, through the underlying commercial business, establish the reasons for unexpected variations in performance and make a fair assessment of the degree of risk involved at periodic intervals. Ratio analysis provides decision makers with the additional required information to assess the past performance and the financial position of the borrower and also to help form an opinion concerning likely future progress.
Furthermore, ratios are a shortcut method of conveying certain crucial facts about a firm’s (borrower’s) operations and financial situation. According to Osayemeh, the crystallization of any trading activity is to assess the performance result over a trading period normally expressed as a profit or loss, this is very important before extending credit advance. Before extending a loan, banks and other financial institutions generally apply ratio analysis to a prospective borrower’s financial statements. The results of the analysis can be a determining factor in whether or not the loan is made.
Ratio analysis is also among the tools used by Moody’s and standard and poor’s in rating the bonds corporation (Howard and Hampel 1980). When creditors provide funds to a firm, their primary interest is the future capacity of that firm to repay the debt. In fact, creditors are concerned with the firm’s liquidity ratios since the existing or near term current assets are generally used to liquidate short-term debts. Clearly, long-term lenders are interested in the current and future prosperity and financial strength of the firm. These lenders are concerned with any financial ratio which reflects the ability of the firm to meet long-run debt requirement – (leverage ratios both as a measure of the firm’s policy and ability with respect to liquidating short-term debt (Martin Mayer 1974).
The leverage ratios particularly interest lenders because they reflect how much the firm is presently in debt. For most lending purposes, how much the firm profitability ratios offer a sufficiently good measure of the firm’s operating effectiveness.
In evaluating the firm as an investment prospect, security analysis frequently examine the financial ratios. The analyst is interested in the desiring ability of the firm’s operating efficiency and financial strength of the firm’s stock and banks as an investment and in any information reflecting upon the firm. Financial ratios will be of interest to government agencies both for the purpose of appraising the financial health of the purpose of appraising the financial health of the regulated firm and for rate setting (Edward and Mellet 1987).
The management of a firm is also concerned with all aspects of its operations and its relations with creditors, investors and the government. The firm’s ability to fulfill commitments to creditors (liquidity and leverage ratios) and to minimize cost (activity and profitability ratios) determines whether it will meet its ultimate objective of providing shareholders with a maximum return (reflected in the profitability ratios). Financial ratio analysis is therefore not just a device for outsiders, it is also useful as a management tool.