Definition:

Loan Loss Reserve Ratio is described as the ratio that is used in the bank in order to represent the reserve that the company has in percentage terms in order 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describes the overall probability of customers defaulting, as a percentage of the overall gross loans that are withdrawn on the company.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, and 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 that have 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 are going to 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 $2000.  This means that out of $200,000 that the organization has given out in loans, Metro Bank expects $2000 to not be recovered at all.

Analysis:

Loss Loan Reserves are mentioned in the balance sheet. They are used to show the amount that is parked as a provision for these loans not being honored by the company.

In this regard, it is imperative to recognize the fact that are considered as provisions that are in place to reflect for 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 historical default rates of the company, and the statistics that are mentioned for the customer defaults existing within those banks.

Hence, it is a multitude of a number of factors that are based on credit losses existing within the bank, as well as other different factors that impact the collection of the business.

Loan Loss Reserve Ratio, is often used alongside Loan Loss Provisions in order 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 net income of the organization.

The main usage of this ratio is mainly from a stakeholder perspective. It shows the existing risk profile of the business, and the ability of the business to successfully manage all the due collections.

When the financial statements are issued, investors, as well as 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 a cost of compromising on the prudence principle in accounting.