The Usefulness of Financial Ratios in Discriminating Between Healthy and Distressed Companies: The Case of an Islamic Bank

Abstract

Financial ratios have an important role in evaluating a company’s performance. When analysing the creditworthiness of a company, one of the most important elements in the analysis is financial ratio analysis. There are many previous studies that aimed to discover which of the financial ratios are more important compared to others. However, most of them are oriented to conventional banks. The aim of this chapter is to discover the usefulness of financial ratios in discriminating between healthy and distressed companies for one Islamic bank in Bosnia and Herzegovina. The available dataset for this research consisted of 419 companies that were clients of the Islamic bank. The companies were financed on the basis of diminishing musharakah. Thirty-three financial ratios were analysed for healthy as well as distressed companies. The results showed that the financial ratios of profitability and turnover are distinguished from others. This means that in the process of creditworthiness analysis more attention should be paid to these ratios. The analysis made in this research is one step toward the development of a rating model which would predict the probability of default. The quantification of risk in Islamic finance and their inclusion in the mapping process of risk management is one of the most important processes in the successful development of Islamic finance.