A Tripartite Financial Rating Framework for the Banking Industry: Financial Performance, Strength and Distress Rating

Amir Hosseinrahdari, Armin Nobakht, Omid Esmailpour
Financial evaluation is the part and parcel of the business performance evaluation and it is more tangibly discussed in the banking industry due to the central role that banks play in the supply and demand mechanisms of money and credit in the economic system.However, financial evaluation, by and large,has been confined to financial performance assessment. In this study, we present a tripartite framework for assessing and rating banks in accordance with their financial performance, financial
more » ... mance, financial strength and financial distress status using 33 criteria. We utilize entropy and TOPSIS methods respectively for weighting and rating of banks. We utilize data from ten commercial banks listed on Tehran Stock Exchange (TSE). The contributions of the study is two-fold. Firstly, we utilize diverse quantitative and qualitative factors to account for the financial performance, financial strength and financial distress positions of the banks which give new perspectives into the financial stability of the banks. Secondly, the proposedframework can be used extensively in the banking industry as well as other settings for short-term, medium-term and long-term evaluations.The result of the study shows that banks A10, A6 and A3 have averaged the best along all three ratings. KEYWORD Financial Performance, Financial Strength, TOPSIS, Rating, Banking. F method including weighting, ranking and sampling steps are elaborated on. Then, we move on to results and discussions and the last main section concludes. At the end, three appendices are placed to explain the selected criteria, their descriptive statistics and the correlation between them respectively. A) MATERIAL In the following section, we present financial performance, financial strength and financial distress variables for financial evaluation in details. A list of variables and their formulas and measurement approaches are presented in the appendices section. Then, we present the triangular financial rating framework. A, A)FINANCIAL EVALUATION: PERFORMANCE, STRENGTH AND DISTRESS Return in Investment (ROI) is an efficiency measure showing how effectively a company has used its resources (assets) to generate earnings. ROI shows how much a company is able to generate for each dollar of assets invested. The second-generation of accounting indicators were focused on efficiency by comparing return with the equity utilized. The archetype ratio of efficiency ratios was named return on equity, or ROE. This indicator is also not flawless. A company can use a high leverage and present a very high ROE while putting itself in great debt, meaning increasing its profitability by taking on a great deal of risk which are not explicitly reflected in accounting data. Hitherto the mid-1980s, Earnings per Share (EPS) was a major financial performance indicator but it is key accounting parameter that is also very easy to manipulate. The practice of manipulating EPS is called "window dressing" or enhancing the presentation of the accounts by adjusting exceptional items, provisions, etc. The rising emphasis on operating profit or Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) represents an improvement because it considerably mitigates the impact of exceptional items or non-cash expenses. Despite this, EPS has been an indispensable measure in financial performance evaluation. The price to earnings per share (P/E) ratio indicates how much investors are willing to pay per dollar of current earnings. P/E is the most important performance analysis measure for investors [3] . It shows how market sees value prospects for the stock in the future. Return on Capital Employed (ROCE) attempts to dodge ROE's bias and has become a major measure of performance. Total capital employed, used in the ROCE calculations, is calculated by subtracting current liabilities fro, total assets. One of the flaws of accounting measures is their high vulnerability to manipulation. Therefore, alongside accounting measures, market and economic measures were introduced to measure financial performance. Market value added (MVA) represents the difference between the value of equity and net debt, and the book value of capital employed. Total Shareholder Return (TSR) is the return received by the shareholder who bought the stock at the beginning of a period, earning dividends (reinvested in new shares) and values his stocks with the last stock price at