Financial Ratio's And Risk Analysis of Islamic Banks

Financial analysis of a company should include an examination of the financial statements of the company, including notes to the financial statements, and the auditor’s report. The auditor’s report will state whether the financial statements have been audited in accordance with generally accepted auditing standards.   Key financial statement ratios for analyzing financial statements the nature of the various important risks of Islamic Banks

Financial Analysis

Financial analysis of a company should include an examination of the financial statements of the company, including notes to the financial statements, and the auditor’s report. The auditor’s report will state whether the financial statements have been audited in accordance with generally accepted auditing standards.  The report also indicates whether the statements fairly present the company’s financial position, results of operations, and changes in financial position in accordance with generally accepted accounting principles. Notes to the financial statements are often more meaningful than the data found within the body of the statements.  The notes explain the accounting policies of the company and usually provide detailed explanations of how those policies were applied along with supporting details. Analysts often compare the financial statements of one company with other companies in the same industry and with the industry in which the company operates as well as with prior year statements of the company being analyzed.
Comparative financial statements provide analysts with significant information about trends and relationships over two or more years.  Financial statement ratios are additional tools for analyzing financial statements.  Financial ratios establish relationships between various items appearing on financial statements.  The key ratios can be classified as follows:
1 Capital Adequacy ratios: Measure for risk taking and the protection for long-term creditors and investors.
2 Liquidity ratios.  Measure the ability of the enterprise to pay its debts as they mature.
3 Activity (or turnover) ratios.  Measure how effectively the enterprise is using its assets.
4 Profitability ratios. Measure management’s success in generating returns for those who provide capital to the enterprise.
Financial statement analysis has its limitations.  Statements represent the past and do not necessarily predict the future. However, financial statement analysis can provide clues or suggest a need for further investigation.  What is found on financial statements is the product of accounting conventions and procedures that can sometimes distort the economic reality or substance or the underlying situation. Financial statements say little directly about changes in markets, the business cycle, technological developments, laws and regulations, management personnel, price-level changes, and other critical analytical concerns.

Shari’ah Audit of Financial Statements of Islamic banks

Islamic banks operations are examined yearly by external auditors in accordance with International Accounting Standards. There is no statutory requirement for external auditors to undertake a review of Shari’ah audit, over and above the normal financial audit. While the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has provided certain supervisory guidelines, these along with others are usually applied internally by a Shari’ah committee appointed by the Shari’ah Board of individual Islamic banks.
ACCOUNTING STANDARDS
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) based in Bahrain has issued guidelines for accounting standards in order to render  the financial statements of Shari’ah-compliant transactions and Islamic banks more comparable and transparent. This takes into consideration the national financial environment, and also includes the adaptation of the international accounting standards, core principles, and good practices to the specific needs of the Islamic finance. For strengthening the regulatory setup and making it acceptable for multinational financial institutions, development of Shari’ah compliant liquid money market instruments, designing prudential rules to reflect the specific risk characteristics of Islamic financial contracts (which is presently considered by Islamic Financial Services Board based in Malaysia), and development of internationally accepted accounting standards are essential.

AAOIFI Accounting Standards

AAOIFI has set out Objectives and Concepts of Financial Accounting for Islamic Banks and Financial Institutions (IFIs) as a prelude to its financial accounting standards so that varying accounting policies can be harmonised. These statements are in addition to the accounting standards, auditing standards, governance standards and code of ethics published till June 2008. 
A major achievement in the area of establishing concepts of financial accounting for Islamic banks and financial institutions, which improved disclosure, is the clarification of the position of investment account holders (depositors). Not a long ago, third party investment accounts were treated by IFIs either as deposits (similar to conventional bank deposits) or as funds under management, reported off balance sheet with no or little disclosure.
AAOIFI upholds that unrestricted investment accounts, the largest funding source for the IFIs, are part of the financial position (balance sheet) of an IFI to be classified between a liability and equity capital. It is maintained that these investment accounts are not a liability for an IFI because an IFI is not obligated in case of loss to return the original amount of funds received from the account holders unless the loss is due to negligence or breach of contract. This fact alone has a substantial impact on the risk profile of IFIs. As investment deposits are not treated equivalent to conventional bank deposits, where banks are obligated to return principal amount of the deposit to the deposit holders, the risk to the IFI, as an institution, is considerably reduced. Consequently, shareholders’ capital has now to absorb only that part of losses which arise as the share of IFI’s own funds in lending and investing. At the same time, however, unrestricted investment accounts, despite being a partner in profit and loss sharing with the IFI, are not treated similarly to the shareholders of the IFI. This is because holders of investment accounts do not enjoy the same ownership rights (voting rights and entitlement to an IFI’s profits in the form of dividends). The standards only recognise current accounts and other non-investment accounts as guaranteed by an IFI’s owners’ equity.
Funds provided by restricted investment accounts holders are not reflected as part of an IFI’s financial position. The relevant information about such accounts is provided in the statement of changes in restricted investments and their equivalent or as a footnote to the statement of financial position (balance sheet), a treatment similar to that for funds under management.
AAOIFI has also clarified concepts and provided guidance for accounting policies to be followed with regard to different financing and investment modes (Murabaha and Murabaha to the Purchase Orderer, Mudarabah Financing, Musharakah Financing, Salam and Parallel Salam, Ijarah and Ijarah Muntahia Bittamleek (ijarah wa iqtina), Istisna’a and Parallel Istisna’a). The assessment of disclosures with regard to credit, market and liquidity risks were key focus while examining the standards related to above mentioned modes.

Disclosure of Credit Risk

With regard to credit risk, information on concentrations of financing assets by sectors/industries, geographical distribution, maturity and currency profile of the financing portfolio together with break up of financing facilities by collectability is considered important. General disclosure in the financial statements of IFIs, as required by AAOIFI standard, cover concentration of assets risks (economic sectors, geographical areas), distribution of assets in accordance with their respective period to maturity or expected periods to cash conversion, disclosure of related party transactions.
However, the standard is ambiguous on the most critical information from collectability point of view, which helps the reader of financial statements to determine the extent of doubtful (non-performing) financing assets (sales receivables). The related disclosure that standard requires is that accounting policies adopted by the IFI’s management for the recognition and determination of doubtful receivables and policies of writing off debts be disclosed. 
Under AAOIFI standards, disclosure regarding Murabaha sales receivables, the major type of financing conducted by IFIs, is largely focused on two factors. One, on the separation between financing jointly financed by the IFI’s and unrestricted investment account holders’ funds and financing exclusively financed by the IFI’s own funds. The purpose of this disclosure requirement is to separate an IFI’s own assets from the assets managed for others (investment account holders) and thereby helping in the assessment of fiduciary risk, to some extent. Second, on the maturity profile of assets and liabilities, to help in the estimation of liquidity risk taken by the IFI by identifying maturity mismatches.

Disclosure of Investment / Market Risk

The assessment of risk that arises from investments in equities or other investments (e.g., property) is as important as financing or credit risk due to the high proportion of such assets in the financial position of IFIs. This is because these investments are considered more Shari’ah-compliant than murabaha financing which differs from conventional lending only in semantics.
If we look at the financial statements of IFIs which have adopted AAOIFI standards, we observe that investment in shares/securities has been classified into marketable securities, related/associated companies investments, investment in funds portfolios and short term/long term mudarabah investments. From a risk assessment point of view, the market value of marketable securities should be given together with movement in provisions for securities.

Disclosure with regard to Liquidity Risk

Liquidity of IFIs is generally good because of the concentration of their financing operations in self-liquidating short-term murabaha financing and commodity backed placements with banks. However, there are serious concerns regarding their macro level liquidity – ability of these institutions to generate funds from other banks (including central banks) in the event of financial distress. The fears arise principally because of IFI’s rejection of interest as a cost for the use of money. Although, by practice, majority IFIs does have arrangements to keep compensating balances with other financial institutions and even with central banks, to meet or provide for the urgent liquidity needs of the respective counterparties, these balances are generally not disclosed in the financial statements.

Disclosure of Operational Risk

Operational risk is defined as the risk of loss resulting from the inadequacy or failure of internal processes, as related to people and systems, or from external risks. Operational risk also includes the risk of failure of technology, systems, and analytical models. It is argued that operational risks are likely to be significant for Islamic banks due to their specific contractual features and the general legal environment.
Specific aspects of Islamic banking could raise the operational risks of Islamic banks
  Cancellation risks in the non-binding mudarabah (partnership) and istisna’a (manufacturing) contracts;
  Failure of the internal control system to detect and manage potential problems in the operational processes and back-office functions as well as technical risks of various sorts;
  Potential difficulties in enforcing Islamic contracts in a broader legal
environment;

  Need to maintain and manage commodity inventories often in illiquid markets;
  Failure to comply with Shariah requirements;
• Potential costs and risks of monitoring equity-type contracts and the  associated legal risks.

Disclosure of Risk of Shari’ah non-compliance

Shari’ah compliance is extremely important to the operations of Islamic banks and hence a failure to comply with such principles may result in a transaction being cancelled and income being considered as illegitimate. Shari’ah compliance should be considered at the time of accepting deposits and investment funds, while providing finance and conducting investment activities for their customers. A Shari’ah compliance review should form part of existing internal or external audits
 

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