Effectiveness of Ratio Analysis in Predicting Financial Performance of Commercial Banks in Kenya

Abstract

A firm's capacity to remain profitable is believed to be strongly connected to characteristic such as liquidity, financial leverage, and efficiency. Notable, however, is the fact that despite the key company features described here being factors that can predict performance, previous empirical investigations have been unable to establish this as fact. While some studies hold that liquidity ratios, capital adequacy ratios, credit risk ratios and management quality ratios are predictors of financial performance. This view has been challenged by some past studies which have found that some financial ratios cannot be used in predicting financial performance. This research sought to establish the effectiveness of ratio analysis in predicting financial performance among commercial banks in Kenya. The independent variables for this study were liquidity ratio, leverage ratio, efficiency ratio, capital adequacy ratio and credit risk ratio while bank size was used as the control variable in the model. Descriptive research design was used. The target population was the banks in Kenya. There are 38 banks in Kenya as at 2020 but only 37 provided complete data set. Research variables data were derived from CBK and audited bank's annual financial statements from 2016 to 2020 for all 37 banks making 185 observations. Regression and correlation analysis were used to test the study hypotheses by establishing the relationship between ratio analysis and ROA. The study found that efficiency (β=0.006, p=0.001) and bank size (β=0.006, p=0.002) had a positive and significant effect on ROA among banks in Kenya. Leverage (β=-0.071, p=0.000) and credit risk β=-0.005, p=0.000) had a significant negative effect on ROA while liquidity and capital adequacy were not statistically significant. The results also indicated R2 of 0.525 which implied that the selected independent variables contributed 52.5% to variations in ROA. The study recommends the need for investors to analyze efficiency, leverage, credit risk and bank size when predicting financial performance as these four are effective predictors. Managers and directors of commercial banks should also work on improving their efficiency and reducing their credit risk in a bid to enhance their performance and to remain competitive in the ever-changing environment.