Financial Analysis using CAMELS Ratios: Predicting Bank Performance and Bankruptcy, Slides of Accounting

Download Financial Analysis using CAMELS Ratios: Predicting Bank Performance and Bankruptcy and more Slides Accounting in PDF only on Docsity! 9   Universitas Indonesia   CHAPTER 2 THEORITICAL BACKGROUNDS 2.1 Financial Ratio Analysis 2.1.1 Overview As discussed earlier that one of the tools for the analysis of financial statements is the ratio analysis. This analysis describes a particular relationship between elements of one with the other elements in a financial report. Financial statements referred to is the balance sheet and income statement. Balance sheet shows assets, debt and the company's capital at a given time. Income statement reflects the results achieved by the company within a certain period (usually one year). Financial ratio analysis of a company used to assess the situation and trends also measure the performance of management. Through analysis of the ratio can be used as a basis to assess whether management's performance has reached a predetermined goal or not, and early knowing on trends or trends that management performance can be anticipated earlier. The results of analysis can be used to observe the weakness of the company during the period of time to walk, is there any weaknesses in the company can be repaired, while the results are good enough to be maintained in the future. Further historical ratio analysis can be used for the preparation of plans and policies in the coming years in order to determine the right policy direction. 2.1.2 Financial Ratio Analysis Financial analysts often compare financial ratios (of solvency, profitability, growth, and other conditions): • Past Performance - Across historical time periods for the same firm (the last 5 years for example), • Future Performance - Using historical figures and certain mathematical and statistical techniques, including present and future values, This extrapolation 9   Comparasion in performance..., Abdur Razzaq, FE UI, 2010. 10   Universitas Indonesia   method is the main source of errors in financial analysis as past statistics can be poor predictors of future prospects. • Comparative Performance - Comparison between similar firms. Comparing financial ratios is merely one way of conducting financial analysis. Financial ratios face several theoretical challenges: • They say little about the firm's prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms. • One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm's performance. • Seasonal factors may prevent year-end values from being representative. A ratio's values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible. • Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values. • They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis). There are many ratios analysis that can be used by the analysts in accordance with the needs and specifications of the business or organization that will be analyzed. In this paper analysis of financial ratios used are CAMELS and DuPont analysis. 2.2 CAMELS Analysis 2.2.1 Overview Based on the provisions in the Law on banking, Bank Indonesia has issued Circular No. 26/5/BPPP dated May 29, 1993 which regulates the level of assessment Comparasion in performance..., Abdur Razzaq, FE UI, 2010. 13   Universitas Indonesia   • operating profit outlook. e. Liquidity Quantitative and qualitative assessment of liquidity factor done through assessment of the components as follows: • Current assets of less than one month compared with the current liability of less than one month; • One-month maturity mismatch ratio; • Loan to Deposit Ratio (LDR); • The projection of future three months cash flows; • Dependence on interbank placements and primary depositors; • Asset and liabilities management (ALMA); • The ability of the bank to gain access to the money market, • capital markets or other funding sources; and • Stability of third party funds. f. Sensitivity to market risk Quantitative and qualitative assessment of sensitivity to market risk factor done through assessment of the components as follows: • Capital or reserves established to cover fluctuations of interest rates compared to potential losses as a result of fluctuations (adverse movement) of interest rates; • Capital or reserves established to cover fluctuations exchange rates compared to potential losses as a result fluctuations (adverse movement) of exchange rate; and • The adequacy of market risk management system implementation. In the dictionary of Banking (Indonesian Institute of Bankers), second edition 1999: CAMELS is the most influential aspect of the financial condition of banks, which also affect bank soundness, CAMELS is an object of the benchmark bank examinations conducted by the bank supervisor. Composed of five criteria CAMELS namely capital, assets, management, earnings and liquidity. Based on the dictionary Comparasion in performance..., Abdur Razzaq, FE UI, 2010. 14   Universitas Indonesia   Banking (Indonesian Institute of Bankers), the second edition in 1999, CAMELS ratings below 81 shows a weak financial condition reflected by the bank's balance sheet, such as increasing non performing loan ratio to total assets, if it is not solved the banks, it will disrupt business continuity, supervision of banks listed on regarded as banks in problem and supervisors checked more frequently by the bank if compared with banks that are not in problem. Banks with CAMELS ratings above 81 is a bank with strong revenue and less noncurrent assets. However, CAMELS ranking of the bank were never widely disseminated. The ratio of CAMELS is to describe a relationship or comparison between a certain amount from the amount stated. ratio analysis can be obtained picture of a good or bad condition or the financial position of a bank. 2.2.2 Evaluating Bank Performances using CAMELS Ratio Machfoedz (1994) examine the benefits of financial ratios to predict corporate earnings future. Financial ratios used are cash flow / current liabilities, net worth and total liabilities / fixed assets, gross profit / sales, operating income / sales, net income / sales, quick assets / inventory, operating income / total liabilities, net worth / sales, current liabilities / net worth and net worth / total liabilities. Found that the financial ratios used in the model useful for predicting earnings one year forward, but not useful for predicting more than one year. Research related to the bankruptcy prediction of banks in Indonesia was performed by Wilopo (2001). Sampling in this study conducted in clusters of 235 banks at the end of 1996 was divided into 16 banks liquidated and 219 banks that are not liquidated, then the sample was taken 40% as estimated, consists of 7 banks liquidated and 87 liquidated banks that are not liquidated. Then from 215 banks at the end of the year 1997 which consists of 38 banks liquidated and 177 banks in 1999 that not liquidated, 40% is taken as a validation sample consisting of 16 banks liquidated and 70 banks that are not liquidated. Variables used in this study for predicting bankruptcy of the bank are the financial ratios of CAMELS model (13 ratio), scale (size) of banks as measured by the logarithm of assets, and dummy Comparasion in performance..., Abdur Razzaq, FE UI, 2010. 15   Universitas Indonesia   variables (current credit and management). The results of this study indicate that overall levels of prediction variables used in this study is high (more than 50% as the cutoff of its value). But when viewed from the types of errors that occurred it appears that the strength prediction to the bank that was liquidated 0% because from the sample of liquidated banks, all are predicted not liquidated. Thus the results of the study was not supports the hypothesis that "CAMELS financial ratio model, the quantity (size) banks, and compliance with Bank Indonesia" can be used to predict bank failures in Indonesia. This conclusion was taken based on the type of error occurs, as a special case in Indonesia apparently CAMELS ratios and variables other independent used in this study can’t predicted bank failures. Thus need further exploration of other variables in external financial ratios in order to obtain a more accurate model to predict bank failures. Meanwhile, research conducted by Swandari (2002) attempted to analyze whether the high risk behaviors from shareholders, institutional ownership and performance affect the bank bankruptcy. The research sample consisted of bank categorized fail and a health bank that consists of 25 banks that fail categorized and 35 healthy bank or survive. In this study, the performance variables were proxy with NITA (net income / total assets) and FUTL (operating income / total liabilities), other than that in this study also included control variables which are firm size and total capital. Predicted that the risk profile affect positively on bank’s insolvency while the share of institutional ownership and performance negatively affect against bank’s insolvency. The results of this study show that: • Risk profile variables have signs in accordance with the prediction but statistically not significant or it can be said that the hypothesis stated in this study was rejected. These results are consistent with the theory of agency cost of debt which states that companies with high debt levels will cause the manager or banks owner to behave more risk on the cost of the depositors or debtholders. With words others, the owners will seek to increase the value of call options stock that they possess. Comparasion in performance..., Abdur Razzaq, FE UI, 2010.