Comparative Studies on Financial Performance of Commercial Banks in Ethiopia. Problems and Prospects

TABLE OF CONTENTS

TABLE OF CONTENTS

ACRONYMS

ACKNOWLEDGEMENTS

LIST OF TABLES

LIST OF THE GRAPHS

CHAPTER ONE

INTRODUCTION

1.1 BACK GROUD OF THE STUDY
1.2 STATEMENT OF THE PROBLEM
1.3 RESEARCH QUESTION
1.4 OBJECTIVES OF THE STUDY
1.4.1 GENERAL OBJECTIVE
1.4.2 SPECIFIC OBJECTIVES
1.5 SCOPE and LIMITATION OF THE STUDY
1.6 SIGNIFICANCE OF THE STUDY
1.7 ORGANIZATION OF THE STUDY

CHAPTER TWO

REVIEW OF LITERATURE

2.1 DEFINITION OF IMPORTANT TERMS
2.2 MEASURES OF FINANCIAL PERFORMANCE
2.2.1 Ratio Analysis
2.2.2 Trend Analysis
2.2.3 Horizontal Analysis
2.2.4 Vertical Analysis

ACRONYMS

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ACKNOWLEDGEMENTS

“How can I repay the lord for his goodness to me?’’ oh you are almighty!!!

First of all, I would like to thank God for helping me a lot in all ways of my life.

Next my foremost appreciation and thanks goes to my principal-advisor Mr. Kahsu Mebrahatu (Asst. Professor) for his close supervision and professional advice and encouragement during the research work.

I would like to thank Mr.Assefa Worede (MBA) , my co-advisor for his continuous support for the successful completion of this study.

Finally, I would like to appreciate all my families and lovely friend MZ who assisted me in the course of my study.

LIST OF TABLES

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LIST OF THE GRAPHS

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CHAPTER ONE

INTRODUCTION

1.1 BACK GROUD OF THE STUDY

Commercial bank is financial institution that offers a wide variety of services including checking accounts and business loans (Ritter et al. 1997). Moreover, commercial bank can be defined as a deposit intermediary that accepts deposits and makes loans (Smith 1999). Thus, commercial bank is an institution that accept deposits, pay interest, clear checks, make loans, act as an intermediary in financial transactions, and provide other financial services to its customers.

There is a close relationship between the well being of the banking industry and the general growth of the economy as a whole, (Rajan et.al 1998). This demonstrates that a country banking sector development have a potential to the growth of the whole economy. Hence, knowledge of the core variables that influence the performance of the commercial bank are essential for the bank management, national banks, governments, and other interested parties.

Hossain and Bhuiyan (1990) stated that there is no universally accepted operational definition of performance measures. In broad sense performance level of an enterprise can be measured by the extent of its organizational effectiveness. In the context of services rendered towards public the performance of an organization can be viewed as the extent to which its work is carried out within established specifications for goods and services produced, to the general satisfaction of the clientele served, within given cost and time constraints, and in such a manner as to support or contribute to the achievement of the organization objectives.

Bhattacharya (2007) pointed out that six major recent policy measures that influence the performance of the commercial bank which includes reduction of bank rate and lending rate, linking classified loans to large loan sanctioning, rationalization and merger of bank branches, measures for loan recovery, and demarcation of responsibilities between the management and the board and decision on cash reserve ratio .

Jahangir et.al (2007) stated that the traditional measure of profitability through stockholder’s equity is quite different in banking industry from any other sector of business, where loan-to-deposit ratio works as a very good indicator of banks' profitability as it depicts the status of asset-liability management of banks. But banks' risk is not only associated with this asset liability management but also related to growth opportunity. Smooth growth ensures higher future returns to holders and there lies the profitability which means not only current profits but future returns as well. So, return on equity and loan-to-deposit ratio grab the attention of analyzing the banks’ profitability.

Chowdhury (2002) observed that the banking industry of Bangladesh is a mixed one comprising nationalized, private and foreign commercial banks. Many efforts have been made to explain the performance of these banks. Understanding the performance of banks requires knowledge about the profitability and the relationships between variables like banks risk with profitability. Indeed, the performance evaluation of commercial banks is especially important today because of the fierce competition in the industry as well the pressures that arise from both internal and external problems.

Many African countries those in sub-Sahara Africa have recently take on extensive financial sector reforms. This includes reforming and privatization of state owned banks, the introduction of private banking system along with bank supervisory, and regulatory schemes, the introduction of a variety to promote the development of financial market including money, and stock market. (Collins, 1980)

The FDRE since 1992 led a transition to a more market-based economic system. Although government control has been reduced and private investment on banks promoted the state still plays a significant role in the economy today. A series of financial sector reforms has been introduced since 1994 when private banks were permitted to be re-established. Among banks, three large state-owned banks continue to dominate the market in terms of capital, deposits and assets. The current government is committed to alleviating poverty through private sector development and through integrating Ethiopia into the global economy (K. Kozo, 2007).

Currently 13 commercial banks and two publicly owned specialized banks are operating in Ethiopia, of the thirteen commercial, one is publicly owned and twelve are privately owned banks. It is clear that the commercial bank of Ethiopia is one of the dominant commercial bank operating in the country as compared to other commercial banks (NBE, 2009).

1.2 STATEMENT OF THE PROBLEM

The main objective of preparing the financial statement is to disclose information about the operating performance and financial health of a business firm for periods such as for quarterly or annually to different economic units to help them make informed decision. Financial performance of a firm is studied by critically examining the financial statements both to evaluate the company’s past success in conducting its activities and to project its likely future activity (Stickney and Brown, 1999).

The banking industry is a mixed of nationalized, private commercial banks and foreign. Many efforts have been made to explain the performance of these banks. Understanding the performance of banks requires knowledge about the profitability and the relationships between variables like bank's risk and with profitability. Indeed, the performance evaluation of commercial banks is especially important today because of the fierce competition (Jahangir et.al, 2007).

Performance of the banks has to be viewed both in terms of profitability and stability. Hence, it is imperative to consider factors while measuring performance so as to see which bank is doing better in terms of maintaining a good balance between the conflicting goals of profitability and soundness (Bhattacharjee and Hariprasad, 2007).

The efficiency of the banking system has been one of the major issues in the new monetary and financial environment. The efficiency and competitiveness of financial institutions cannot easily be measured, since their products and services are of an intangible nature. Researchers have attempted to measure the efficiency of the banking industry using outputs, efficiency, and performance (Kyriaki and constantin, 2008).

Generally, the literature on performance of financial institutions suggests, from the policy point of view, that strengthening capital buffer, maintaining safety and soundness of the financial systems is preferred for better-functioning of banks (Jahangir et.al, 2007).

Kozo, (2007 ), made his Studies on the financial sector liberalization in Ethiopia, and revealed that the performance of private banks is typically better than state owned banks. The total asset and return on asset (ROA) of Ethiopia state-owned and private banks from 1998 -2006 shows that the share of assets of private banks grew 6.4 percent in 1998 to 30.4 in 2006. This in turn indicates that the share of state-owned banks significantly declined. It has to be noted, however, that the values of total assets increased from 1998 to 2006 for both state-owned and private banks. This suggests that the Ethiopian banking sector has grown rapidly.

The growth of private banks of Ethiopia has been much faster than state owned banks. More than two-third of asset is still held by state-owned banks and private banks show better performance than state-owned banks (Kozo, 2007).

Both private and public banks are operating and expanding their branches continually in Ethiopia. However, except their financial statement that shows the lump sum figure about the financial performance and condition of each bank, there is no comparative studies on commercial banks that shows whether there is sufficient utilization of resources or not. Therefore, an in-depth comparative analysis of the financial performance of banks is conducted with the help of financial techniques on the basis of data covered 2005-2009.

1.3 RESEARCH QUESTION

The study is guided by the following research questions:

1. What does the trend performance of banks look like in the five years?
2. What were the efficiency, profitability and liquidity position of banks?
3. What problems were be faced by the commercial banks in Ethiopia?
4. What are future prospects of banks regarding financial performance?
5. Why does banks’ performance differ?

1.4 OBJECTIVES OF THE STUDY

1.4.1 GENERAL OBJECTIVE

The general objective of the study was to compare the financial performance of the commercial banks by using their average ratio covers the period of 2005-2009.

1.4.2 SPECIFIC OBJECTIVES

In order to accomplish the above general objective, the study was addressed the following specific objectives:

i. To assess the performance trend of commercial banks
ii. To measure the profitability of commercial banks
iii To measure the liquidity of commercial banks
iv.To measure the solvency of commercial banks
v. To measure the efficiency of commercial banks
vi. To assesses the problems and future prospects of commercial banks related to financial performance.

1.5 SCOPE and LIMITATION OF THE STUDY

This study was focused on six banks, namely CBE, DB, WB, UB, NIB, and BOA. It has been done to analyze the financial performance of the bank by using both the trend and comparative approaches. Year of establishment, amount of capital reserve, and number of branches were taken as a criterion for selecting those commercial banks for analysis purpose.

There are different types of financial analysis methods like fund flow analysis, common size statement analysis, cost-volume-profit analysis, profitability of capital, and leverage analysis. But this study focused only on the financial ratio analysis and presents the trend changes on the different ratios. Even though there are a number of important determinant variables which have significant influence on the financial performance of any company like political affairs, inflation, and economy was not considered in this study.

1.6 SIGNIFICANCE OF THE STUDY

This study is believed to portray the differences in the performance of banks in Ethiopia which is expected to help management, regulators, policy makers, shareholders and other stakeholders in evaluating the soundness of the banking industry in the country. Furthermore, the study is expected to induce academicians to make further research.

1.7 ORGANIZATION OF THE STUDY

This study has been organized in five chapters. Chapter One includes background information, statement of the problem, research questions, objectives, significance of the study, scope of the study, and limitation of the study. Chapter Two were presents literature review related to the study, while research methodology is in chapter three. Research findings and discussion are discussed in chapter four. The last Chapter Five were presents conclusion and recommendations.

CHAPTER TWO

REVIEW OF LITERATURE

2.1 DEFINITION OF IMPORTANT TERMS

Bank

A bank is a financial institution that accepts deposits and channels those deposits into lending activities. Banks primarily provide financial services to customers while enriching investors. Government restrictions on financial activities by banks vary over time and location. Banks are important players in financial markets and offer services such as investment funds and loans (Mishkin, 2006).

Financial statement

Financial statements are firm-issued accounting reports with past performance information that a firm issues periodically (usually quarterly and annually). Financial statements are important tools through which investors, financial analysts, and other interested outside parties (such as creditors) acquire information about a corporation. Financial statements are useful for managers within the firm as a source of information for corporate financial decision making (Berk & DeMarzo, 2007). Companies normally produce financial statements such as balance sheet and the income statement to provide investors and creditors with an overview of the firm’s financial performance.

Balance Shee t

The accounting balance sheet is one of the major financial statements used by accountants and business owners. The balance sheet is also referred to as the statement of financial position. The balance sheet presents a company's financial position at the end of a specified date. Some describe the balance sheet as a "snapshot" of the company's financial position at a point time (Berk & DeMarzo, 2007

Income Statement

The profit and loss statement links the balance sheets at the beginning and the end of an accounting period. After an appropriate period the income statement is prepared to demonstrate the wealth generated over that period. A balance sheet is also prepared to disclose the new financial position at the end of the period (Atrill & Mclaney, 2008 pg. 72).

2.2 MEASURES OF FINANCIAL PERFORMANCE

2.2.1 Ratio Analysis

Ratio analyses are the most important tools to evaluate the operating as well as the firm’s financial performance. It was designed to help one to evaluate financial statements (Brigham and Hauston, 1998). It is an instrument that analyst used to compare and gauge relationships between financial variables found in the balance sheet and income statement of organization. Ratios are to be calculated over a period of years and the analyst can study the composition of changes to determine whether there has been an improvement or decline in the financial situation and organizations performance over time (ACCA, 1996).

2.2.1.1 Liquidity ratio

The dangerous problem faced by a lending institution is that the borrowers will suffer illiquidity problems in which borrower’s inability to raise cash to pay its debt. This situation can arise for many reasons, one of which is loss of ability to raise new capital to pay off existing creditors. However, illiquidity marked itself as a surplus of current cash payments due over cash current available (Fridson, and Fernando, 2002).

Liquidity refers to the capacity of a company’s to meet its short-term debt. These ratios demonstrate the relationship of a firm’s cash and other current assets to its current liabilities (Brigham and Houston, 1998).

Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets to short-term liabilities. The higher liquidity ratios mean bank has larger margin of safety and ability to cover its short-term obligations. Because saving accounts and transaction deposits can be withdrawn at any time, there is high liquidity risk for both the banks and other depository institutions. In general, the greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting its obligations. Measures of bank liquidity include Loan to Deposit Ratio (Brigham and Houston, 1998).

1. Loan to Deposit Ratio (LDR)

This refers to the amount of a bank's loans divided by the amount of its deposits at any given time. The higher the ratio, the more the bank is relying on borrowed funds, which are generally more costly than most types of deposits. Bank with low LDR is considered to have excessive liquidity, potentially lower profits, and hence less risk as compared to the bank with high LDR (Block and Hirt 1997).

2. Loans to Assets ratio (LAR)

The loan to assets ratio measures the total loans outstanding as a percentage of total assets. The higher this ratio indicates a bank is loaned up and its liquidity is low. The higher the ratio, the more risky a bank may be to higher defaults (Block and Hirt, 1997).

2.2.1.2 Profitability ratio

Profitability is the capacity of the organization to generate revenues in excess of expenses (Foster, 1986). High profits maintain abundance of cash flowing through the system and verify the importance of productive assets such as plant and equipment. The narrower the profit margin, the greater the risk that a modest deteriorate in selling prices or self-effacing increase in costs will produce losses. Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company's bottom line. Profitability measures are important to company managers and owners alike. If a small business has outside investors who have put their own money into the company, the primary owner certainly has to show profitability to those equity investors (Fridson, and Fernando, 2002).

1. Return on Assets (ROA)

The Return on Assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm's level of investment in total assets. The return on assets ratio is related to the asset management category of financial ratios (Fridson and Fernando, 2002).

2. Return on Equity (ROE)

The Return on Equity ratio is perhaps the most important of all the financial ratios to investors in the company. It measures the return on the money the investors have put into the company. This is the ratio potential investors look at when deciding whether or not to invest in the company (Fridson and Fernando, 2002).

3. Net Interest Margin (NIM)

Analysts focus on Net Interest Margin (NIM) ratio because small changes in a bank’s lending margin can translate into large bottom line changes. The higher the ratio the cheaper the funding or the higher the margin the bank is obtaining. A bank’s net interest margin is a key performance measure that drives ROA. Net interest income is the difference between interest income and interest expense. It is the gross margin on a bank’s lending and investment activities (Horne and James, 1997)

4. Noninterest Income to Total Assets (NITA )

Noninterest Income to Total Assets (NITA) is an indicator of the operational performance. It indicates the proportion of fees and other income in respect of total assets of banks. This ratio is used as a measure of profitability indicator (Horne and James, 1997)

2.2.1.3 Efficiency Ratio

The efficiency ratios and other ratios are key ratios to understanding financial statements. It measure the quality of a business' receivables and how efficiently it uses and controls its assets, how effectively the firm is paying suppliers, and whether the business is overtrading or under trading on its equity (Brigham and Houston, 1998).

1. Asset Utilization Ratio (AUR)

How effectively the bank is utilizing all of its assets is measured by assets utilization ratio. The bank is presumably said to using its assets effectively in generating total revenues if the AU ratio is high. If the ratio of AU is low, the bank is not using its assets to their capacity and should either increase total revenues or dispose of some of the assets (Brigham and Houston, 1998)

2. Income Expense Ratio (IER)

This is the most commonly and widely used ratio in the banking sector to assess the managerial efficiency in generating total income vis-à-vis controlling its operating expenses. Income to expenses is the ratio that measures amount of income earned per dollar of operating expense. High income expense ratio is preferred over lower one as this indicates the ability and efficiency of the bank in generating more total income in comparison to its total operating expenses (Brigham and Houston, 1998).

2.2.1.4 Risk and Solvency

One of important ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size of a company's after-tax income; excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations

(Lawrence and Charles, 1991)

1. Debt-Equity Ratio (DER )

The Debt to Equity Ratio measures how much money a company should safely be able to borrow over long periods of time. It does this by comparing the company's total debt (including short term and long term obligations) and dividing it by the amount of owner's equity. This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. A high debt to equity ratio could indicate that the company may be overleveraged, and should look for ways to reduce its debt. Equity and debt are two key figures on a financial statement, and lenders or investors often use the relationship of these two figures to evaluate risk. The ratio of your business' equity to its long-term debt provides a window into how strong its finances are. Equity will include goods and property your business owns, plus any claims it has against other entities. Debts will include both current and long-term liabilities (Lawrence and Charles, 1991)

2. Debt to Total Assets Ratio (DTAR)

The debt to asset ratio is the percentage of total debt financing the firm uses as compared to the percentage of the firm's total assets. It helps you see how much of your assets are financed using debt financing. The lower the Debt to Asset Ratio, the better, as companies with high amounts of debt introduce more risk. You certainly want to look very hard at companies that have more Total Liabilities than Total Assets, as this is a precarious position for a company to be in. Depending on the industry of the company, you might expect the company to have two or three times as many assets as liabilities. Anything less than this might be a signal that the company is running into trouble (Lawrence and Charles, 1991)

Shortcoming of Ratio Analysis

Financial Ratio analysis affords the critical information regarding a firms operations and financial situation. Even if, ratio analysis is the most important for companies as well as for shareholders it has limitations that require care and judgments by users (Block and Hirt 1997).

Those limitation include

1. Since there is deference in accounting and operating practice, ratio analysis distorts comparisons. For example, inventory valuation and depreciation methods can affect financial statements thus, distort comparisons. It is complicated to generalize about whether or not a particular ratio is good. For example, a high current ratio may indicate a strong liquidity position, which is good or excessive cash that is bad because excess cash in the bank is a non-earning asset.

2. Inflation that may occur in particular country has greatly distorted the company’s balance sheet, that is, recorded values are often substantially different from true values. Therefore, depreciation charges, inventory costs and profits may also be affected.

3. Bank also uses window dressing techniques to make their financial statements look better than they really are so as to attract interested parties such as investors and Financial Institutions.

4. Since accounting periods differ from one bank to another it was unsuitable to compare them.

2.2.2 Trend Analysis

Trend analysis helps to analyze performance made over a number of years in order to determine major patterns (Block and Hirt, 1997). It is a comparison of items within the same company’s financial reports for different periods of time. Early recognition of a trend may help an organization to capitalize on good performance and to take appropriate actions over poor performance. Ratios are snapshots of the picture at particular point of time, but there may be trends in activity that are in that process of rapidly wear away a relatively good present position (Brigham and Houston, 1998).

Trends in the ratio over a period of years are one of the criteria used in evaluating the rationale of a financial ratio. In reviewing this, trend analysts are able to determine whether a firm’s performance is improving or failing (Brigham and Houston, 1998).

2.2.3 Horizontal Analysis

When an analyst compares financial information for two or more years for a single company, the process is referred to as horizontal analysis, since the analyst is reading across the page to compare any single line item, such as sales revenues. In addition to comparing dollar amounts, the analyst computes percentage changes from year to year for all financial statement balances, such as cash and inventory. Alternatively, in comparing financial statements for a number of, years, the analyst may prefer to use a variation of horizontal analysis called trend analysis. Trend analysis involves calculating each year's financial statement balances as percentages of the first year, also known as the base year. When expressed as percentages, the base year figures are always 100 percent and percentage changes from the base year can be determined (Hyytinen, 2003).

2.2.4 Vertical Analysis

When using vertical analysis, the analyst calculates each item on a single financial statement as a percentage of a total. The term vertical analysis applies because each year's figures are listed vertically on a financial statement. The total used by the analyst on the income statement is net sales revenue, while on the balance sheet it is total assets. This approach to financial statement analysis, also known as component percentages, produces common-size financial statements. Common-size balance sheets and income statements can be more easily

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