Question

a. Detail and give examples of two (2) financial ratios often used to provide a direct measure of a commercial bank’s credit risk exposure.

b. Find annual (yearly) data to calculate and graph the two ratios discussed in part (a) for the top four Australian banks over 2014-2019. Conduct trend and peer analyses based on your graphs, and comment on these banks’ credit risk management approaches.

Answer 1

Credit Analysis Ratios - These ratios are the tools that assist in the credit analysis process. Investors and analysts often use these ratios to determine whether the individuals or corporations are capable of fulfilling financial obligations..They involve both quantitative and qualitative aspects.Credit Analysis ratios are of 4 types

1) Profitability ratios - These ratios measure the ability of the company to generate profit relative to revenue, balance sheets assets and shareholder's equity.Investors use it for ascertaining the stock prices of the projects which are likely to appreciate or vice-versa. Lenders use these ratios to determine the growth rate of corporations and whether they are able to pay back loans. Types of profitability ratios are

A) Margin ratios which include Gross Profit margin, EBITDA margin and operatin profit margin.

B) Return ratios include Return on Assets(ROA), Risk-adjusted return and Return on Equity(ROE).

2) Leverage Ratios - It compares the level of debt against other accounts on balance sheet, income statement and cash-flow statement.Analyists use them to gauge the ability to pay back loans of a individual or corporate.A lower leverage ratio means less asset or capital funded by debt. Banks or Creditors prefer this as it indicates less risk of turning into non-performing asset (NPA).They are of four types mainly-

1)Debt to Asset ratio

2)Asset to Equity ratio

3)Debt to Equity ratio

4)Debt to Capital ratio

Another type of Credit Analysis ratio is Coverage Credit Analysis Ratio which measures the coverage that income, cash or assets provide for debt or interest expenses. The higher the coverage ratio the more better it will be in to meet its financial obligations. They are further divided into 4 types which are

1)Interest Coverage Ratio

2) Debt-Service Coverage Ratio

3) Cash Coverage Ratio

4) Asset Coverage Ratio

Last but not the least are Liquidtiy Ratios which indicate the ability of companies to convert assets into cash . In other words it shows the borrower's ability to pay off current debt. Higher the liquid ratio means lower the chance of company becoming bankrupt and vice versa.

Liquidity ratios are of various types but the 4 mainly applied by the analyst to determine the capability of any individual or corporate paying off its current debt is ascertained by

A) Current Ratio

B) Quick Ratio

C) Cash Ratio

D) Working Capital Ratio.