Project Topic - EFFECT OF FINANCIAL RATIOS ON THE PERFORMANCE OF DEPOSIT MONEY BANKS - AZ Research Consult (MBA MSc Dissertation/thesis Project Writer) Nigeria

Project Topic – EFFECT OF FINANCIAL RATIOS ON THE PERFORMANCE OF DEPOSIT MONEY BANKS

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CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Many nations’ business reports’ readers rely on financial data to help them make more informed judgments. Investors and debtors are two of the most significant groups of users. Because they think that financial indicators have predictive potential, these individuals scrutinize the substance of financial statements and compute a wide range of financial indicators before making credit or investment choices (Al-Ajmi 2008).

Financial ratios provide useful quantitative information to investors and analyst who want to evaluate the operations of a firm and analyze its position within its industry over time (Al-Ajmi, 2008). Financial ratios are used for a number of reasons, to value firms (Fama and French, 1998), to differentiate creditworthy companies from others (Altman, 1968), to identify acquisition targets and to indicate the process of organizational turnaround.

Firms such as commercial banks require the use of Financial ratios to assess their performance especially liquidity position (Solomon, 2009) commercial banking is and always have been, the art of borrowing short and lending long. Although the number of services a modern commercial banks offer has increased immensely, risk taking which is a fundamental nature of banking, remains unchanged. It is inherent in maturity transformation which is another fundamental feature of banking. In this process of mobilizing short deposits for loan creation and investment which are usually long term, liquidity risk is incurred. This arises from the obvious inevitable mismatch, therefore adequate liquidity is required to manage the risk in banking, this simply means being able to meet every financial commitment when due, whether it is withdrawing from a current account, maturing euro or interbank deposit of a maturing issue of commercial paper (Solomon, 2009).

It is difficult to assess inter organizational performance from one or two simple numbers. Nevertheless, in practice a number of different ratios are calculated in strategic planning endeavours and, taken as a whole and with some caution, these financial ratios do provide some information about some the relative performance of an organization, a careful analysis of a combination of an organization. In particular, a careful analysis of a combination of these financial ratios help to distinguish between firms especially banks that will eventually fall and those that will continue to survive. Evidence suggests that, as a early as five years before a bank fails, it is possible to detect trouble from the value before a bank fails, it is possible to detect trouble from the value of this financial ratios (Wikipedia, 2010).

Therefore, the usefulness of financial indicators depends large on the integrity of financial statements made available by the bank. A sound and healthy banking industry is relevant for the growth of any economy because banks occupy a strategic position in the financial system of the country. Thus, the importance of financial ratio in evaluating the financial position and performance of the banks cannot be overemphasis.

The Capital Adequacy Ratio (CAR) is one of the financial soundness ratios commonly used by the financial regulators to assess sound banking practices and financial performance of banks. It is a financial regulatory ratio introduced to improve banking sector‟s ability to absorb unanticipated adverse shocks and to ensure that banks cover a sufficient percentage of total assets with their own funds. It is used to restrict procyclicality by limiting the build-up of leverage in banks. The CAR is fully loss absorbent on a going-concern basis and serves as part of a bank‟s regulatory capital. It shows the extent the bank equity holder can absorb losses without being forced into liquidation and enables banking industry to take full advantage of its profitable growth opportunities. From the Central Bank‟s point of view, the CAR is the core measure of a bank‟s financial strength and it enables the Central Bank of Nigeria (CBN) to categorize banks into well-capitalized banks, under-capitalized banks, significantly under-capitalized banks, critically under-capitalized banks and insolvent banks in Nigeria. As a regulatory ratio, the CAR is measured as the addition of the Tier 1 and Tier 2 capital divided by the total (risk-weighted) assets of the banks. Under the Basel II framework, the CAR has a regulatory benchmark of 8%. However, the effect of CAR and financial performance of banks from the extant literature has so far produced diverging results. While the studies of Swamy (2011) and Dietrich & Wanzenried (2009) have found a positive relationship between the CAR and profitability of banks, those of Saona (2011) and Elsayed (2013) have shown a negative relationship. This situation necessitates the reexamination of the CAR as a financial soundness ratio in this study.

Similarly, the Liquidity Coverage Ratio (LCR) is another financial soundness ratio that is applied in the assessment of the banking institutions soundness and financial performance. Following the financial innovation and global market developments, which transformed the nature of liquidity risk of banks in recent years, the BCBS (2008) observed that the contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks‟ balance sheets, have led to severe funding liquidity strains for some banks and central bank intervention in some cases. In a bid to address these events and ensure that internationally active banks have up to 30 days of high quality liquid assets to meet short-term institution specific and systemic stresses in the banking sector, the BCBS introduced the LCR. This ratio is aimed at enhancing banks‟ ability to cope with the short-run liquidity risk as well as exposure to a run on a bank‟s wholesale liabilities. As a metric of determining the soundness of the banking sector, the LCR is measured as the ratio of High Quality Liquid Assets (HQLAs) to the Total Assets of banks or the Net Cash Outflows over a 30-day horizon. The Bank for International Settlement (2014) requires this ratio to be at least 60%. Although, Ötker-Robe and Pazarbasioglu (2010), demonstrated in previous study that the LCR has significantimpact on the profitability of the Asian and European banks, the study of Giordana and Schumacher (2012) in contrast showed that this ratio does not have significant impact on the profitability of banks in Luxembourg. Given these diverging results, this study is also encouraged to extend frontier of knowledge on this ratio.

While the financial analysts have argued that the push by the CBN for the DMBs to begin adopting and implementing Basel II requirements in Nigeria could amount to a regulatory action that might affect the DMBs‟ financial performance adversely, the panelists at the CIBN 7th Annual Banking and Finance Conference held on 10 to 11 September 2013 by Nigerian and International experts drawn from banking, finance, legal, academic, government and real sectors have unequivocally resolved that the CBN, the Nigeria Deposit Insurance Corporation (NDIC) and other safety net participants should promote and ensure the implementation of Basel II in Nigeria without delay. This, according to them, will ensure more safety of the depositors‟ funds and engender more confidence in the Nigerian banking system.

1.2 Statement of the Problem

According to Andre (2009) the recent credit crisis, which exposed significant weaknesses in the risk assessment frameworks of banks has raised serious concern at the global level; while in the Nigerian banking sector, the CBN Financial Stability Report (2009) shows that there is a major challenge of inadequate risk management framework for identifying and controlling the risks associated with the activities of the DMBs in Nigeria.

A review of extant literature on financial ratio also indicates that controversy exists among financial scholars and academic researchers on the cyclical nature of the financial ratio and the impact it may have on the financial performance of banks. Likewise, unanimity does not exist among financial experts and policy analysts over whether Basel II can contain systemic banking crisis and be a panacea to the future financial crisis.

Some managers do not employ financial ratios in performance appraisal and in the evaluation of investment decision because of technicalities involved in financial ratio analysis, fear of assessment and in experience. Therefore, they make use of other alternatives instead of using financial ratios.

1.3 Research Questions

To extend frontier of knowledge on effect of financial ratios on the performance of Deposit Money Banks, the following research questions have been raised:

To what extent does Capital Adequacy Ratio affect the financial performance of Deposit Money Banks in Nigeria?
How does Liquidity Coverage Ratio influence the financial performance of Deposit Money Banks in Nigeria?
What is the impact of Asset Quality Ratio on the financial performance of Deposit Money Banks in Nigeria?

1.4 Objectives of the Study

The main objective of this study is to examine the impact of Basel II on financial performance of DMBs in Nigeria. Specifically, the study sought to:

Ascertain the extent to which Capital Adequacy Ratio affect Return on Assets of Deposit Money Banks in Nigeria.
Determine the degree to which Liquidity Coverage Ratio influences Return on Assets of Deposit Money Banks in Nigeria.
Examine the impact of Asset Quality Ratio on Return on Assets of Deposit Money Banks in Nigeria.

1.5 Research Hypotheses

To achieve the objectives of this study, the following hypotheses have been formulated:

Ho₁: Capital Adequacy Ratio has no significant effect on Return on Assets of Deposit Money Banks in Nigeria.
Ho₂: Liquidity Coverage Ratio has no significant influence on Return on Assets of Deposit Money Banks in Nigeria.
Ho₃: Asset Quality Ratio has no significant impact on Return on Assets of Deposit Money Banks in Nigeria.

1.6 Scope of the Study

The study examines effect of financial ratios on the performance of Deposit Money Banks for a period of 5 years from 2009 to 2013. The period is also momentous because it coincided with the stress-testing period, in which the Central Bank of Nigeria examined the risk management framework and capital planning decisions of banks.

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Project Topic – EFFECT OF FINANCIAL RATIOS ON THE PERFORMANCE OF DEPOSIT MONEY BANKS

Project Topic – EFFECT OF FINANCIAL RATIOS ON THE PERFORMANCE OF DEPOSIT MONEY BANKS

Project Topic – EFFECT OF FINANCIAL RATIOS ON THE PERFORMANCE OF DEPOSIT MONEY BANKS

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