The Usefulness of Financial Ratios in Discriminating Between Healthy and Distress Companies: A Case of an Islamic Bank

3RD SARAJEVO ISLAMIC FINANCE AND ECONOMICS CONFERENCE

NEW CHALLENGES FOR ISLAMIC ECONOMICS AND FINANCE DEVELOPMENT

Sarajevo, 20-21 November 2014

The Usefulness of Financial Ratios in Discriminating Between Healthy and Distress

Companies: A Case of an Islamic Bank

Nerma Saračević & Nataša Šarlija

MOTIVATION OF THE RESEARCH (1/2) Financial ratios have important role in

estimating company’s creditworthiness. Financially healthy company can be

distinguished from the financially distressed company by examining financial ratios.

Financial ratios are usually divided into 5 groups: Liquidity Activity Profitability Efficiency Leverage

MOTIVATION OF THE RESEARCH (2/2) In focus of many researchers : Chan & Shimerda (1981)

reviewed 26 articles that classified 65 financial ratios incorporated in predictive studies between 1966-1975

41 financial ratios important in prediticion of company’s failure. Pinches, Mingo and Caruthers classified useful ratios in seven

factors: Return on Investment Capital Turnover Financial Leverage Short-term Liquidity Cash-position Inventory Turnover Receivables Turnover

THE AIM OF THE RESEARCH

Investigate which set of financial ratios is important in the analysis of companies which are clients of an Islamic bank in Bosnia and Herzegovina.

Some authors ( Zeni&Ameer,2010; Ardiansyah&Quoyum,2010; Anwar&Watanabe, 2010; Abdou et al.,2014, Pok, 2012; Ahmadi et al., 2012) investigated the role of financial ratios in assessing the quality of companies for financing by IBs.

PREVIOUS RESEARCH Investigation of the ratios belonging to each of

the 5 groups: liquidity, activity, profitability, efficiency and leverage: Healthy companies have higher liquidity ratios Increase in leverage ratio lead to financial distress Higher activity ratios mean higher chances of surviving

during the recession Healthy companies have higher efficiency ratios Lower profitability ratios for distressed companies

Differences in diversity of the ratios

USEFUL LIQUIDITY RATIOS IN DISTRESS PREDICTIONFinancial ratio Interpretation Author, yearCurrent ratio = current assets/ short-term liabilities

Distressed companies ↓Healthy companies↑

Beaver,1966; Deakin,1972; Altman,1968,1977; Ohlson,1980; Zmijewski, 1984

Quick ratio = current assets - inventory/ short-term liabilities

Distressed companies↓Healthy companies ↑

Abdullah,N.A.H,2005; Platt&Platt,2006;

Current assets/ total assets

Distressed companies↓Healthy companies ↑

Abdullah,N.A.H., 2005;

USEFUL LEVERAGE RATIOS IN DISTRESS PREDICTIONFinancial ratio Interpretation Author, yearShort-term financial debt / total debt

Distressed companies Healthy companies

Shamsher et al., 2001; Zulkarnain et al., 2001;

Short-term debt / total debt


Shamser et al., 2001; Zulkarnain et al., 2001;

Debt ratio = liabilities / total assets


Beaver, 1966; Altman, 1968, 1977; Platt & Platt, 2006; Zmijewski, 1984; Zulkarnain et al., 2002;

Equity / total assets Distressed companies Healthy companies

Šarlija &Jeger, 2011;

Cash flow coverage ratio = cash flow/ total debt


Beaver, 1966; Abbas & Rashid, 2011; Abdullah, N.A.H. ,2005;

Cash flow coverage ratio 2 = cash flow / current debt


Abdullah, N.A.H. , 2005; Shamsher et al., 2001; Zulkarnain et. al., 2001;

USEFUL ACTIVITY RATIOS IN DISTRESS PREDICTIONFinancial ratio Interpretation Author, yearTotal assets turnover = revenues / total assets


Beaver, 1966 ; Altman, 1968, 1977; Abbas & Rashid, 2011; Šarlija & Jeger ,2011;

Short-term assets turnover = revenues / short term assets


Beaver,1968;Altman, 1968, 1977; Šarlija & Jeger, 2011; Shamsher et al., 2001; Zulkarnain et al., 2001;

Fixed assets turnover = revenues / long term assets


Beaver,1968; Altman, 1968; 1977;

USEFUL PROFITABILITY RATIOS IN DISTRESS PREDICTIONFinancial ratio Interpretation Author, yearGross margin = Gross profit from sales / income from sales


Abdullah, N.A.H. , 2005;

Net profit margin = Net profit/ total income


Abdullah, N.A.H. , 2005; Šarlija at al.,2009;

ROA = Net profit / Total assets


Laitinen & Suvas , 2013; Zmijewski, 1984 ;

Retained earnings / total assets


Altman, 1968, 1977 ; Abbas&Rashid, 2011; Abdullah, N.A.H., 2005;

PREVIOUS RESEARCH (1/2) Analysis of financial ratio is a step to the

development of distress prediction model. Most famous prediction models:

Altman z-score Model (1968) composed of the following ratios: working capital/ total assets , retained earnings/total assets, market value equity/book value of total debt, sales/total assets;

Olson o-score Model(1980) included the following ratios: size, total liabilities/total assets, working capital/total assets,current liabilities/current assets, net income/total assets, funds provided by operational/total liabilities, and change in net income.

PREVIOUS RESEARCH (2/2) Some others models in developing countries

Abbas & Rashid (2011) composed Model for non-financial companies in Pakistan. It consists of three ratios: sales/ total assets, EBIT/ current liabilities, and cash flow ratios.

Sarlija & Jeger (2011) analyzed Model composed of the four ratios ( total revenue/total assets, total revenue/short-term assets, ((short term assets- inventory)/ sales), equity/total assets) during the time before recession and period at the beginning recession in Croatia.

Altman et al (2014) made the study in international context where they found that re-estimated z”-score Model is improved for B&H.

Laitinen & Suvas (2013) made model for 30 European countries including B&H. Most important variables for B&H are assets and return of assets.

METHODOLOGY Available data set is consisted of 419 companies from one IB

in B&H Financial statements over the period 2009-2013:

Distressed company - if it wasn’t able to pay a single obligation continously over the period longer than 90 days

Calculated financial ratios of liquidity, leverage, activity, efficiency and profitability

Mann-Whitney and t-test

Year

2009 2010 2011 2012 2013

% N % N % N % N % NH 89.6

9174 89.5

9241 83.5

9219 82.6

2328 75.8

6176

D 10.31

20 16.41

28 16.41

43 17.38

69 24.14

56

T 100 194 100 269 100 262 100 397 100 232

RESULTS (LIQUIDITY RATIOS)

RatioDescriptive statistics (means and

st.dev.) p-valueHealthy companies Distressed

companies

Current assets / total assets

2009 0.57 (0.24) 0.52 (0.23) 0.406

2010 0.52 (0.26) 0.41 (0.23) 0.045**

2011 0.54 (0.26) 0.49 (0.26) 0.373

2012 0.54 (0.28) 0.50 (0.26) 0.284

2013 0.55 (0.28) 0.57 (0.26) 0.537

- 5 ratios were analyzed- no significant differences in liquidity ratios between healthy and distressed companies

RESULTS (LEVERAGE RATIOS)Ratio Descriptive statistics (mean and

st.dev.) p-valueHealthy companies

Distressed companies

ST FD / TD 2012 0.56 (0.34) 0.34 (0.30) <0.001***ST FD / TD 2012 0.74 (0.25) 0.62 (0.24) <0.001***TD /TA 2013 1.28 (0.24) 1.21 (0.19) 0.091*CF /TD 2012 0.06 (0.35) 0.01 (0.06) 0.072*

2013 0.46 (3.11) 0.01 (0.14) 0.089*CF /CD 2013 0.48 (3.15) 0.02 (0.15) 0.082*- 9 ratios were analyzed- Most are not statistically significant- Short-term financial debt/TD, Short-term debt/TD- Total debt/total assets- Coverage ratios

RESULTS (ACTIVITY RATIOS)

RatioDescriptive statistics (mean

and st.dev.) p-valueHealthy companies


Inv / COGS 2009 0.75 (4.84) 62.49 (270.40) 0.011**

Rev/ TA 2010 1.60 (1.64) 0.89 (0.98) <0.001***

2012 1.50 (1.53) 0.88 (0.75) <0.001***Revenues / short term assets

2009 2.93 (2.01) 2.60 (2.84) 0.091*

2010 3.26 (2.78) 2.60 (2.84) 0.010**

2011 2.78 (3.39) 1.98 (1.32) 0.017**

2012 3.36 (3.69) 2.05 (1.35) <0.001***

2013 2.76 (1.99) 2.00 (1.38) 0.004***

Rev / long term assets

2010 13.41 (59.19) 4.91 (15.51) <0.001***2012 15.49 (51.11) 7.56 (19.12) 0.043**

Coll. period 2013 79.15 (83.37) 115.77 (136.07) 0.078*Days AP 2010 680.56 (4129.49) 673.89 (879.38) 0.016**

RESULTS (ACTIVITY RATIOS)

6 activity ratios were analyzed All of the activity ratios are statistically different

in at least one of the analyzed years Short-term assets turnover is different in healthy

and distressed companies during the whole period

All of the significant turnover ratios are higher in healthy companies.

RESULTS (EFFICIENCY RATIOS)



Distresesed companies

Revenue op. / total cost

2009 1.03 (0.13) 0.94 (0.19) 0.005***

Operating income / operating expense

2011 1.04 (0.16) 0.96 (0.21) 0.047**

financial income/financial expenses

2012 3.91 (30.27) 0.34 (0.93) 0.056*

- 4 ratios were analyzed- 3 ratios statistically significant in 3 different years

RESULTS (PROFITABILITY RATIOS) (1/2)




Operating margin 2011 0.02 (0.20) -0.13 (0.44) 0.050**

Net profit margin2009 0.73 (1.31) 0.48 (0.57) 0.010**2012 5.82 (47.87) 1.17 (1.51) 0.097*2013 1.10 (1.61) 0.20 (3.75) 0.019**

Cost/Income ratio 2011 0.98 (0.20) 1.13 (0.44) 0.050**

ROA = Net profit / Total assets

2009 0.03 (0.09) 0.00 (0.05) 0.012**2011 0.04 (0.08) -0.02 (0.10) 0.001***2012 0.05 (0.11) 0.01 (0.13) 0.042**2013 0.05 (0.09) 0.01 (0.14) 0.070*

ROIC = profit / liabilities + equity

2009 -0.02 (1.24) -0.57 (2.25) 0.007***2010 0.09 (0.55) -0.19 (0.80) 0.001***2011 0.09 (0.36) -0.10 (0.52) 0.048**2013 0.13 (0.19) 0.41 (1.48) 0.021**

RESULTS (PROFITABILITY RATIOS) (2/2)




Net profit/ equity

2009 0.16 (0.60) -0.51 (2.77) 0.096*2011 0.14 (0.45) -0.08 (0.68) 0.061*2012 0.15 (0.47) -1.02 (8.02) 0.015**2013 0.23 (0.37) -0.15 (2.36) 0.059*

Retained earnings / total assets

2009 0.12 (0.20) 0.07 (0.15) 0.027**2010 0.14 (0.18) 0.11 (0.18) 0.057*

2011 0.16 (0.19) 0.10 (0.22) 0.070*rate for self-financing 2013 0.35 (0.28) 0.27 (0.18) 0.023**- 9 ratios were analyzed- Net margin, ROA, ROE, ROIC and ratio of retained

earnings to assets are statistically significant in most of the analyzed years

- healthy companies have higher profitability ratios.

CONCLUSION The most important ratios: profitability ratios

and activity ratios. Liquidity ratios are not found to be significant Unusual: liquidity ratios as well as leverage

ratios are not proven to be important in distinguishing between healthy and distressed companies

FUTURE RESEARCH Develop multi-factor model Include other financial indicators related to income

statement e.g. total liabilities/total income, cash flow

Include ratios which indicate companies’ performance over time.

The specificity of Islamic financial instruments should be included

This study is the first step towards developing a model of the internal rating in the Islamic bank which predicts probability of default

THANK YOU FOR YOUR ATTENTION!

Data & Analytics

The Usefulness of Financial Ratios in Discriminating Between Healthy and Distress Companies: A Case of an Islamic Bank