Definition:
Loan Loss Reserve Ratio is described as the ratio used in the bank to represent the reserve that the company has in percentage terms to cover the estimated losses that they would have suffered as a result of defaulted loans.
The nature of the Loan Loss account is described as a contra account to gross loan outstanding. This particular ratio is used to identify and measure the performance of the existing loan portfolio of the company as a comparison to other players in the market.
The Loan Loss Reserve Ratio basically shows the probability of debtors failing to settle their debts in due time. This basically reflects the company’s position in terms of the collection rate.
A higher Loan Loss Reserve Ratio means a lower collection (from the total loans issued), whereas a Lower Loan Loss Reserve Ratio means a higher collection.
Formula:
Loan Reserve Ratio is calculated using the following formula:
Loan Loss Reserve Ratio = (Loss Loan Reserves) / (Gross Loan Portfolio)
Therefore, this calculation describes the overall probability of customers defaulting as a percentage of the overall gross loans withdrawn from the company.
Additionally, it can also be seen that the lower ratio indicates that the bank or the financial institution is a safer institution to invest in, from the investors’ perspective.
On the other hand, if the bank or the financial institution has a higher loan loss reserve ratio, it means that the organization has a higher risk profile. Therefore, it might not be a suitable investment for risk-averse investors.
Example:
In order to further explain the concept of Loan Loss Reserve, the following illustration is given:
Metro Bank has made around $200,000 in loans to various other institutions and individuals. The managers at Metro Bank only lend out loans to individuals with a low and medium-low risk profile.
Therefore, they only handpick individuals they know are going to pay back those loans in time. However, they can still never be certain if all the debtors will pay back the amount they had drawn as loans.
Therefore, they are supposed to create a loan loss reserve in order to be prudent that the net receivables might not necessarily be equal to the actual amount of loan that was outstanding.
In this regard, Metro Bank assumes that the arbitrary percentage that they need to account for around 1% of the total amount of the loans that have been drawn.
In the example mentioned above, it can be seen that the total amount of loan reserves for the company amounts to $2,000. This means that out of the $200,000 that the organization has given out in loans, Metro Bank expects $2,000 not to be recovered at all.
Analysis:
Loss Loan Reserves are mentioned in the balance sheet. They are used to show the amount parked as a provision for these loans not being honored by the company.
In this regard, it is imperative to recognize that it is considered provisions that are in place to reflect circumstances that might reduce the total collectibles.
Hence, the impact of the loan loss reserve ratio is seen as increasing the amount of loan loss provision, or a decrease in the amount of net-charge offs for the respective year.
Loan Loss Reserve Ratio is created based on the company’s historical default rates and the statistics mentioned for the customer default existing within those banks.
Hence, many factors are based on credit losses existing within the bank and other different factors that impact the collection of the business.
Loan Loss Reserve Ratio is often used alongside Loan Loss Provisions to estimate the existing risk profile of the bank or the financial institution.
However, it must be noted that loan loss provision is also expensed in the Income Statement, and therefore, it reduces the organization’s net income.
The main usage of this ratio is mainly from a stakeholder perspective. It shows the business’s existing risk profile and its ability to manage all the due collections successfully.
When the financial statements are issued, investors and the board of directors gauge the risk profile by directly comparing the loan loss reserve ratio of the bank with other competitors.
Having a lower loan reserve ratio is favorable, but it should not come at the cost of compromising on the prudence principle in accounting.
