This document summarizes research analyzing the usefulness of various financial ratios in distinguishing between healthy and distressed companies that are clients of an Islamic bank in Bosnia and Herzegovina. The research analyzed ratios in five categories: liquidity, leverage, activity, efficiency, and profitability. The results found that profitability ratios and activity ratios were most important, with healthy companies exhibiting higher values. Liquidity and leverage ratios were generally not statistically significant. The researchers conclude key ratios include profit margins, returns on assets and equity, and activity turnover ratios. Future work is needed to develop a multi-factor distress prediction model for Islamic banks.

1. 3RD SARAJEVO ISLAMIC FINANCE AND ECONOMICS CONFERENCE
NEW CHALLENGES FOR ISLAMIC ECONOMICS AND
FINANCE DEVELOPMENT
Sarajevo, 20-21 November 2014
The Usefulness of Financial Ratios in
Discriminating Between Healthy and Distress
Companies: A Case of an Islamic Bank
Nerma Saračević & Nataša Šarlija

2. MOTIVATION OF THE RESEARCH (1/2)
 Financial ratios have important role in estimating
company’s creditworthiness.
 Financially healthy company can be distinguished from
the financially distressed company by examining
financial ratios.
 Financial ratios are usually divided into 5 groups:
 Liquidity
 Activity
 Profitability
 Efficiency
 Leverage

3. MOTIVATION OF THE RESEARCH (2/2)
 In focus of many researchers : Chan & Shimerda (1981)
reviewed 26 articles that classified 65 financial ratios incorporated
in predictive studies between 1966-1975
 41 financial ratios important in prediticion of company’s failure.
 Pinches, Mingo and Caruthers classified useful ratios in seven
factors:
 Return on Investment
 Capital Turnover
 Financial Leverage
 Short-term Liquidity
 Cash-position
 Inventory Turnover
 Receivables Turnover

4. THE AIM OF THE RESEARCH
 Investigate which set of financial ratios is important in
the analysis of companies which are clients of an
Islamic bank in Bosnia and Herzegovina.
 Some authors ( Zeni&Ameer,2010;
Ardiansyah&Quoyum,2010; Anwar&Watanabe, 2010;
Abdou et al.,2014, Pok, 2012; Ahmadi et al., 2012)
investigated the role of financial ratios in assessing the
quality of companies for financing by IBs.

5. PREVIOUS RESEARCH
 Investigation of the ratios belonging to each of the 5
groups: liquidity, activity, profitability, efficiency and
leverage:
 Healthy companies have higher liquidity ratios
 Increase in leverage ratio lead to financial distress
 Higher activity ratios mean higher chances of surviving during
the recession
 Healthy companies have higher efficiency ratios
 Lower profitability ratios for distressed companies
 Differences in diversity of the ratios

6. USEFUL LIQUIDITY RATIOS IN DISTRESS
PREDICTION
Financial ratio Interpretation Author, year
Current ratio = current
assets/ short-term
liabilities
Distressed companies ↓
Healthy companies↑
Beaver,1966; Deakin,1972;
Altman,1968,1977;
Ohlson,1980; Zmijewski, 1984
Quick ratio = current assets
- inventory/ short-term
liabilities
Distressed companies↓
Healthy companies ↑
Abdullah,N.A.H,2005;
Platt&Platt,2006;
Current assets/ total
assets
Distressed companies↓
Healthy companies ↑
Abdullah,N.A.H., 2005;

7. USEFUL LEVERAGE RATIOS IN DISTRESS
PREDICTION
Financial ratio Interpretation Author, year
Short-term financial debt /
total debt
Distressed companies 
Healthy companies 
Shamsher et al., 2001;
Zulkarnain et al., 2001;
Short-term debt / total debt Distressed companies 
Healthy companies 
Shamser et al., 2001;
Zulkarnain et al., 2001;
Debt ratio = liabilities / total
assets
Distressed companies 
Healthy companies 
Beaver, 1966; Altman,
1968, 1977; Platt & Platt,
2006; Zmijewski, 1984;
Zulkarnain et al., 2002;
Equity / total assets Distressed companies 
Healthy companies 
Šarlija &Jeger, 2011;
Cash flow coverage ratio =
cash flow/ total debt
Distressed companies 
Healthy companies 
Beaver, 1966; Abbas &
Rashid, 2011; Abdullah,
N.A.H. ,2005;
Cash flow coverage ratio 2
= cash flow / current debt
Distressed companies 
Healthy companies 
Abdullah, N.A.H. , 2005;
Shamsher et al., 2001;
Zulkarnain et. al., 2001;

8. USEFUL ACTIVITY RATIOS IN DISTRESS
PREDICTION
Financial ratio Interpretation Author, year
Total assets turnover =
revenues / total assets
Distressed companies 
Healthy companies 
Beaver, 1966 ; Altman, 1968,
1977; Abbas & Rashid, 2011;
Šarlija & Jeger ,2011;
Short-term assets turnover
= revenues / short term
assets
Distressed companies 
Healthy companies 
Beaver,1968;Altman, 1968,
1977; Šarlija & Jeger, 2011;
Shamsher et al., 2001;
Zulkarnain et al., 2001;
Fixed assets turnover =
revenues / long term
assets
Distressed companies 
Healthy companies 
Beaver,1968; Altman, 1968;
1977;

9. USEFUL PROFITABILITY RATIOS IN
DISTRESS PREDICTION
Financial ratio Interpretation Author, year
Gross margin = Gross profit
from sales / income from
sales
Distressed companies 
Healthy companies 
Abdullah, N.A.H. , 2005;
Net profit margin = Net profit/
total income
Distressed companies 
Healthy companies 
Abdullah, N.A.H. , 2005;
Šarlija at al.,2009;
ROA = Net profit / Total assets Distressed companies 
Healthy companies 
Laitinen & Suvas , 2013;
Zmijewski, 1984 ;
Retained earnings / total
assets
Distressed companies 
Healthy companies 
Altman, 1968, 1977 ;
Abbas&Rashid, 2011;
Abdullah, N.A.H., 2005;

10. PREVIOUS RESEARCH (1/2)
 Analysis of financial ratio is a step to the development
of distress prediction model.
 Most famous prediction models:
 Altman z-score Model (1968) composed of the following ratios:
working capital/ total assets , retained earnings/total assets,
market value equity/book value of total debt, sales/total
assets;
 Olson o-score Model(1980) included the following ratios: size,
total liabilities/total assets, working capital/total assets,current
liabilities/current assets, net income/total assets, funds
provided by operational/total liabilities, and change in net
income.

11. PREVIOUS RESEARCH (2/2)
 Some others models in developing countries
 Abbas & Rashid (2011) composed Model for non-financial
companies in Pakistan. It consists of three ratios: sales/ total
assets, EBIT/ current liabilities, and cash flow ratios.
 Sarlija & Jeger (2011) analyzed Model composed of the four
ratios ( total revenue/total assets, total revenue/short-term
assets, ((short term assets- inventory)/ sales), equity/total
assets) during the time before recession and period at the
beginning recession in Croatia.
 Altman et al (2014) made the study in international context
where they found that re-estimated z”-score Model is
improved for B&H.
 Laitinen & Suvas (2013) made model for 30 European
countries including B&H. Most important variables for B&H are
assets and return of assets.

12. METHODOLOGY
 Available data set is consisted of 419 companies from one
IB in B&H
 Financial statements over the period 2009-2013:
 Distressed company - if it wasn’t able to pay a single
obligation continously over the period longer than 90 days
 Calculated financial ratios of liquidity, leverage, activity,
efficiency and profitability
 Mann-Whitney and t-test
Year 2009 2010 2011 2012 2013
% N % N % N % N % N
H 89.69 174 89.59 241 83.59 219 82.62 328 75.86 176
D 10.31 20 16.41 28 16.41 43 17.38 69 24.14 56
T 100 194 100 269 100 262 100 397 100 232

13. RESULTS (LIQUIDITY RATIOS)
Ratio
Descriptive statistics (means and st.dev.)
p-valueHealthy companies Distressed
companies
Current
assets / total
assets
2009 0.57 (0.24) 0.52 (0.23) 0.406
2010 0.52 (0.26) 0.41 (0.23) 0.045**
2011 0.54 (0.26) 0.49 (0.26) 0.373
2012 0.54 (0.28) 0.50 (0.26) 0.284
2013 0.55 (0.28) 0.57 (0.26) 0.537
- 5 ratios were analyzed
- no significant differences in liquidity ratios between healthy
and distressed companies

14. RESULTS (LEVERAGE RATIOS)
Ratio Descriptive statistics (mean and st.dev.)
p-valueHealthy companies Distressed
companies
ST FD / TD 2012 0.56 (0.34) 0.34 (0.30) <0.001***
ST FD / TD 2012 0.74 (0.25) 0.62 (0.24) <0.001***
TD /TA 2013 1.28 (0.24) 1.21 (0.19) 0.091*
CF /TD 2012 0.06 (0.35) 0.01 (0.06) 0.072*
2013 0.46 (3.11) 0.01 (0.14) 0.089*
CF /CD 2013 0.48 (3.15) 0.02 (0.15) 0.082*
- 9 ratios were analyzed
- Most are not statistically significant
- Short-term financial debt/TD, Short-term debt/TD
- Total debt/total assets
- Coverage ratios

15. RESULTS (ACTIVITY RATIOS)
Ratio
Descriptive statistics (mean and
st.dev.) p-value
Healthy companies Distressed
companies
Inv / COGS 2009 0.75 (4.84) 62.49 (270.40) 0.011**
Rev/ TA 2010 1.60 (1.64) 0.89 (0.98) <0.001***
2012 1.50 (1.53) 0.88 (0.75) <0.001***
Revenues /
short term
assets
2009 2.93 (2.01) 2.60 (2.84) 0.091*
2010 3.26 (2.78) 2.60 (2.84) 0.010**
2011 2.78 (3.39) 1.98 (1.32) 0.017**
2012 3.36 (3.69) 2.05 (1.35) <0.001***
2013 2.76 (1.99) 2.00 (1.38) 0.004***
Rev / long
term assets
2010 13.41 (59.19) 4.91 (15.51) <0.001***
2012 15.49 (51.11) 7.56 (19.12) 0.043**
Coll. period 2013 79.15 (83.37) 115.77 (136.07) 0.078*
Days AP 2010 680.56 (4129.49) 673.89 (879.38) 0.016**

16. RESULTS (ACTIVITY RATIOS)
 6 activity ratios were analyzed
 All of the activity ratios are statistically different in at
least one of the analyzed years
 Short-term assets turnover is different in healthy and
distressed companies during the whole period
 All of the significant turnover ratios are higher in healthy
companies.

17. RESULTS (EFFICIENCY RATIOS)
Ratio
Descriptive statistics (mean and
st.dev.) p-value
Healthy
companies
Distresesed
companies
Revenue op. /
total cost
2009 1.03 (0.13) 0.94 (0.19) 0.005***
Operating income
/ operating
expense
2011 1.04 (0.16) 0.96 (0.21) 0.047**
financial
income/financial
expenses
2012 3.91 (30.27) 0.34 (0.93) 0.056*
- 4 ratios were analyzed
- 3 ratios statistically significant in 3 different years

18. RESULTS (PROFITABILITY RATIOS) (1/2)
Ratio
Descriptive statistics (mean and
st.dev.) p-value
Healthy
companies
Distressed
companies
Operating margin 2011 0.02 (0.20) -0.13 (0.44) 0.050**
Net profit margin
2009 0.73 (1.31) 0.48 (0.57) 0.010**
2012 5.82 (47.87) 1.17 (1.51) 0.097*
2013 1.10 (1.61) 0.20 (3.75) 0.019**
Cost/Income ratio 2011 0.98 (0.20) 1.13 (0.44) 0.050**
ROA = Net profit / Total
assets
2009 0.03 (0.09) 0.00 (0.05) 0.012**
2011 0.04 (0.08) -0.02 (0.10) 0.001***
2012 0.05 (0.11) 0.01 (0.13) 0.042**
2013 0.05 (0.09) 0.01 (0.14) 0.070*
ROIC = profit / liabilities +
equity
2009 -0.02 (1.24) -0.57 (2.25) 0.007***
2010 0.09 (0.55) -0.19 (0.80) 0.001***
2011 0.09 (0.36) -0.10 (0.52) 0.048**
2013 0.13 (0.19) 0.41 (1.48) 0.021**

19. RESULTS (PROFITABILITY RATIOS) (2/2)
Ratio
Descriptive statistics (mean and
st.dev.) p-value
Healthy
companies
Distressed
companies
Net profit/ equity
2009 0.16 (0.60) -0.51 (2.77) 0.096*
2011 0.14 (0.45) -0.08 (0.68) 0.061*
2012 0.15 (0.47) -1.02 (8.02) 0.015**
2013 0.23 (0.37) -0.15 (2.36) 0.059*
Retained earnings / total
assets
2009 0.12 (0.20) 0.07 (0.15) 0.027**
2010 0.14 (0.18) 0.11 (0.18) 0.057*
2011 0.16 (0.19) 0.10 (0.22) 0.070*
rate for self-financing 2013 0.35 (0.28) 0.27 (0.18) 0.023**
- 9 ratios were analyzed
- Net margin, ROA, ROE, ROIC and ratio of retained
earnings to assets are statistically significant in most of the
analyzed years
- healthy companies have higher profitability ratios.

20. CONCLUSION
 The most important ratios: profitability ratios and activity
ratios.
 Liquidity ratios are not found to be significant
 Unusual: liquidity ratios as well as leverage ratios are
not proven to be important in distinguishing between
healthy and distressed companies

21. FUTURE RESEARCH
 Develop multi-factor model
 Include other financial indicators related to income
statement e.g. total liabilities/total income, cash flow
 Include ratios which indicate companies’ performance
over time.
 The specificity of Islamic financial instruments should
be included
 This study is the first step towards developing a model
of the internal rating in the Islamic bank which predicts
probability of default

22. THANK YOU FOR YOUR ATTENTION!