ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

THE IMPACT OF ASSET DIVERSIFICATION ON FINANCIAL

PERFORMANCE OF COMMERCIAL BANKS IN ETHIOPIA

BY
HABTE G/MICHAEL

A THESIS SUMITTED TO THE DEPARTMENT OF ACCOUNTING & FINANCE IN

PARTIAL FULFILLMENT OF THE REQUAIRMENT FOR THE DEGREE OF
MASTERS OF SCINCE IN ACCOUNTING AND FINANCE

ADVISOR : TEKALIGN NEGA (PHD)

JUNE: 2022
ADDIS ABABA, ETHIOPIA
 Declaration

I Habte G/Michael hereby declare that this thesis entitled “Impact of Asset Diversification on
financial performance of Commercial Banks in Ethiopian” has been carried out by me under
the guidance and supervision of Dr. Tekalign Nega. The thesis is original and has not been
submitted for the award of any degree or diploma to any university or institutions.

Name: Habte G/Michael

Signature ____________________

Date _____________________

II
 Addis Ababa University

School of Graduate Studies

Certification

This is to certify that the thesis prepared by Habte G/Michael, entitled: The Impact of Asset
Diversification on financial performance of Commercial Banks in Ethiopia and submitted in
partial fulfillment of the requirements for Master of Science in Accounting and Finance complies
with the regulations of the university and meets the accepted standards with respect to originality
and quality.

Approved by:

External Examiner Dr. Dejene Mamo Signature_____________Date_______________

Internal Examiner Dr. Degefa Duressa Signature____________Date_______________

Advisor: Dr. Tekalign Nega Signature__________________Date_______________

III
Table of Contents
Declaration................................................................................................................................................... II
Certification ................................................................................................................................................ III
List of Tables .............................................................................................................................................. VI
Acknowledgments ..................................................................................................................................... VII
Abstract..................................................................................................................................................... VIII
CHAPTER ONE ......................................................................................................................................... 1
1.1 Back ground of the study................................................................................................................ 1
1.2 Statement of the problem ........................................................................................................... 2
1.3 Research Questions ........................................................................................................................... 4
1.4 Objective of the Study ...................................................................................................................... 4
1.4.1 General Objectives of the Study ............................................................................................... 4
1.4.2 Specific objectives of the study ................................................................................................. 4
1.5 Hypotheses of the Study ................................................................................................................... 5
1.6 Significance of the Study .................................................................................................................. 7
1.7 Scope and Limitations of the Study ................................................................................................. 7
CHAPTER TWO ........................................................................................................................................ 8
2. LITERATURES REVIEW .................................................................................................................... 8
2.1. Introduction ...................................................................................................................................... 8
2.2 Theoretical Review............................................................................................................................ 8
2.2.1 Modern Portfolio Theory .......................................................................................................... 8
2.2.2 Arbitrage Pricing Theory .......................................................................................................... 9
2.2.3 Agency Theory ......................................................................................................................... 10
2.2.4 Capital Market Theory ............................................................................................................ 10
2.3 Empirical review ............................................................................................................................. 11
2.4 Summary of Literature Review ..................................................................................................... 20
2.5 Conceptual framework of the study .............................................................................................. 22
CHAPTER THREE .................................................................................................................................. 24
3. RESEARCH METHODOLOGY ........................................................................................................ 24
3.1 Research Design .............................................................................................................................. 24
3.2 Research Approach ......................................................................................................................... 24

IV
 3.3 Method of Data Collection ............................................................................................................. 25
3.4 Population and Sample size............................................................................................................ 25
3.5 Data Analysis method ..................................................................................................................... 26
CHAPTER FOUR..................................................................................................................................... 29
4. DATA ANALYSIS AND PRESENTATION ...................................................................................... 29
4.1. Descriptive statistics....................................................................................................................... 29
4.2 Correlation Analysis ....................................................................................................................... 31
4.2.1 Correlation Analysis between the Dependent Variables on ROA and Explanatory ......... 33
4.3 Regression Analysis Results and Discussions ............................................................................... 34
4.3.1 Diagnosis tests............................................................................................................................... 35
4.3.1.1 Assumption one: the errors have zero mean (E (ε) = 0) .................................................... 35
4.3.1.2 Assumption Two: Test for Heteroscedasticity .................................................................... 35
4.3.1.3 Assumption Three: Test for normality ............................................................................... 37
4.3.1.4 Assumption Four: Test for Autocorrelation ....................................................................... 39
4.3.1.5 Assumption five: Multicollinearity test .............................................................................. 39
4.4 Choosing between Random effects (RE) and Fixed effects (FE) model ..................................... 41
4.5 Regression Result Analysis between Return on Asset and Explanatory Variables .................. 43
4.6 Analysis of the regression model.................................................................................................... 43
CHAPTER FIVE ...................................................................................................................................... 48
5. SUMMARY, CONCLUSION AND RECOMMENDATION ........................................................... 48
5.1 Summary.......................................................................................................................................... 48
5.2 Conclusion ....................................................................................................................................... 48
5.3 Recommendation............................................................................................................................. 49
Reference ................................................................................................................................................... 51
Appendixes ................................................................................................................................................ 56

V
 List of Tables

Table4.1 Descriptive statistics results …………………………………………………….…..31

Table4.2Correlation Matrix: Among each Variable………….…………………...................34

Table4.3 Heteroskedasticity Test: White……………………………………………...............37

Table4.4 Heteroskedasticity Test:Breusch-Pagan……………………………………………37

Table4.5 Normality Test-Shapiro-Wilk W. …………………..................................................38

Table4.6Auto-corelation test: Wooldridge test……………………………………………….40

Table4.7Multicollinearity test- Pearson correlation matrix………………............................41

Table4.8Hausman specification test for Fixed effect test…………………………………….42

Table 4.9 Lagrange multiplier test for random effect test…………………………………...43

Table 4.10 Results of Regression model………………………………………………………44

VI
 Acknowledgments

First, I would like to thanks the Almighty God giving me strength to accomplish this thesis.

I would like to express my deepest gratitude to my advisor, Dr. Tekalign Nega, for their constant
guidance, support and suggestions made me present this research work to produce in the present
form.

My sincere gratitude goes to the staff and management of the National bank of Ethiopia
providing all the necessary data including financial statement of all commercial banks.

Finally I would like to thanks my family, friends and classmate for their help and support during
the production of this thesis.

VII
 Abstract

The Objective of this study is to see how asset diversification affected the financial performance
(ROA) of Ethiopian commercial banks. The survey and analysis is conducted by eight
commercial banks in Ethiopia with a total of 80 observations were made using financial
statements throughout a ten-year period from 2011 to 2020. The data was evaluated utilizing
quantitative and secondary financial data using explanatory and regression analysis as a basis. To
evaluate the collected data, the researcher employed the fixed effect model. Besides the
descriptive interpretation, the researcher used tables and figures to present the findings of the
study. The empirical findings of this study suggest that loans and advances had positive
relationship with profitability with strongly statistically significant (p-value = 0.0001) at 1%
significance level. This is an implication that diversification into loans and advance affects
financial performance of commercial banks significantly and positively. Whereas financial asset
and cash and cash equivalent negative effect but statistically significant impact on the financial
performance on banks. On the other hand fixed asset don‘t have statistically significant effect on
profitability as measured by net interest income (ROA). Therefor from the result we can
conclude the findings, the majority of the variables have a statistically significant impact on the
profitability of the bank.

Keywords: Asset diversification, financial performance

VIII
 CHAPTER ONE

1.1 Back ground of the study

Financial institutions play a crucial role in the distribution of economic resources. One of the
primary goals of financial organizations is to continuously mobilize resources and channel them
to investors. This will only be accomplished when these institutions are able to earn enough
revenue to pay all of their operating expenses. In short, banks must be profitable and have a
long-term financial performance. Asset diversification is important for banks to reach this level
of sustainability and profitability.

Nowadays unpredictable economic situation needs well-organized and effective financial

structures for specialization (it means an area of activity or study that someone concentrates on)
in offering services and production, to win and maintain a friendly relationship with investors’
and maintain competitive advantage in the market so as to boost economic transaction (Marcia,
Otgontsetseg & Hassan, 2014). Therefore, having a financial system which is efficient and stable
is vital.

Due to volatile economic environment, commercial banks are focusing on new ways of
enhancing their operations. This is aimed at increasing profitability, reducing risk, increasing
share of the market, increasing debt ability, more growth and prolonging the life cycle of
business. Nevertheless, Marcia, Otgontsetseg and Hassan (2014) there opinion that banks’ target
of obtaining better returns/profits has been highly seen as the main motive contributing towards
increased progression of financial innovations, loans base widening and increase in asset prices
without economic basis.

Perez (2015) also argues that commercial banks need to have assets that earn more income
especially in this period of increasing adoption and utilization of technology-enabled products
and services. This is based on the fact that different assets achieve different performance when
subjected to different economic settings, and the performance realized from such assets seem to
have no correlated. Therefore, diversified assets can play a role in insuring a firm against market
conditions and economic variations. The size of individual class of asset in the portfolio can be
varied to obtain maximum returns under the existing economic environment. Perez (2015)

1
acknowledges that asset diversification is adopted by asset managers to very great extent aimed
at reducing risk and increasing returns. He concluded that the higher the earning possessions, the
better it turns to be for any bank.

Profitability is a measure of economic gains realized by a firm in relation to the capital invested.
This level of economic success can be determined by the amount of reported profits in a financial
year. Zopounidis (2001) stated that business environment is characterized by risks and
uncertainties. To effectively compete in the market place banks manage their assets
diversification taking into consideration the risk level, earnings, liquidity, profit, solvency, the
level of loans and deposits to mitigate losses and thus improve profitability.

Singh (2012), heard about two important figure of speech which talk about the role of
diversification in alternating ways i.e. “Don’t put all your eggs in one basket” supporting the
theory of diversification which means that one should not concentrate all efforts and resources
in one area as one could lose everything and the other “Put all your eggs in one basket and watch
that basket” which favors the focusing strategy i.e. confining organizations to specialized areas
of business. According to Gupta (2011) putting all your eggs in one basket is a risky decision.

1.2 Statement of the problem

Diversification and its implications for performance is now drawing considerable attention from
scholars, policymakers and donors, because of the relevance of the theme to policy and
development action. Chakrabarti et al. (2007) put forth an argument that diversification of assets
contributes to improving performance in developing institutional environments. Adding to this
argument, Ishak and Napier (2006) point out that diversification doesn’t lower value of firm,
however, the firm value escalations with increased diversification levels. Chakrabarti et al.
(2007), however warn that divergence of assets adversely effects performance in those
institutions which are more established. Hitt, et al. (1996) acknowledge that numerous
businesses' poor financial performance is due to assets that are performing poorly. They
conclude that poor performance arising from assets performing poorly is repeatedly linked to
strategic errors committed in the acquirement progression.

So many researchers like (Kipleting and Bokongo (2016), Kamwaro (2013) and Maina (2013)
etc.…) have empirically explored various factors of banks profitability even though the

2
definition & measures of profitability varies among the researchers. Regardless of profitability
measurements, most banking research have discovered that both the internal and external
environments of the company are essential drivers of high profitability. Internal bank
performance or profitability drivers are characterized as factors that are influenced by a bank's
management decisions, including asset diversification. Banks' operating results will undoubtedly
be impacted by such managerial consequences.

Although a quality management leads to a good bank performance, it is difficult, if not

impossible, to assess management quality directly. In fact, it is implicitly assumed that such a
quality will be reflected in the operating performance. As such, it is not uncommon to examine a
bank’s performance in terms of those financial variables found in financial statements, such as
the balance sheet and income statement (Krakah & Ameyaw, 2010). External determinants of
bank profitability are factors that are beyond the control of a bank’s management. They represent
events outside the influence of the bank. However, the management can anticipate changes in the
external environment and try to position the institution to take advantage of anticipated
developments. The two major components of the external determinants are macroeconomic
factors and financial structure factors (Krakah & Ameyaw, 2010).

There are few studies conducted locally related to this subject is done by Elefachew and
Hrushikesava (2016) examined the effect of industrial diversification on financial performance
of selected banks in Ethiopian, Eyerusalem (2019) examine the impact of asset structure on the
financial performance of selected private commercial banks in Ethiopia and Samuel (2018)
examined the Effect of Lending Diversification on the financial Performance of commercial
Banks in Ethiopia.

whereas globally so money related study is done for instances some of which was done
previously by Turkmen and Yigit (2012) explored diversification in banking and its effect on
banks performance using evidence from Turkey, Kipleting and Bokongo (2016) investigated the
effect of investment diversification on the financial performance of commercial banks in Kenya,
Kamwaro (2013) examined the relationship between investment portfolio choice and profitability
of investment companies listed in the Nairobi securities exchange, Maina (2013) investigated the
product diversification effect on financial performance of microfinance companies and Mutega
(2016)”Effect of asset diversification on financial performance of commercial bank in Kenya”.

3
However, in the context of Ethiopian banking industry, the subject has received a limited
research attention. In which case, in order to either prove the above premises or reach into some
other assertion regarding the relationship between asset diversification and financial performance
of Ethiopian banking sector, empirical investigation is lacking. As far as the knowledge of the
researcher is concern, I didn’t find any research work done in bank profitability over the asset
diversification locally.

Globally more related with my research topic is study by Mutega (2016). Mutega (2016) study
did not cover the effect of fixed asset necessity on the aspects of financial performance of the
bank. The study focused on asset diversification elements (financial asset, loan, cash and cash
equivalent and other investment) has a positive and significant impact on financial performances
of commercial banks in Kenya.

Nevertheless this study goes further to include other variables influencing Profitability with
relation to asset diversification which is fixed asset in addition to this target factors are financial
asset, cash and cash equivalent and loan, their effect on bank performance of commercial banks
in Ethiopia. Therefore, this paper is intended to fill this gap.

1.3 Research Questions

 What is the impact of financial asset on the financial performance of commercial banks?
 What is the impact of loan on the financial performance of commercial banks?
 What is the impact of cash and cash equivalent on financial performance of commercial
banks?
 What is the impact of fixed asset on the financial performance of commercial banks?

1.4 Objective of the Study

1.4.1 General Objectives of the Study
The general objective of the study is to examine the impact of asset diversification on the
financial performance of selected commercial banks in Ethiopia.

1.4.2 Specific objectives of the study

 To identify the effect of financial asset on the financial performance of commercial banks in
Ethiopia.
 To identify the effect of loan and advance on the financial performance of commercial banks
in Ethiopia.

4
 To identify the effect of cash and cash equivalent on the financial performance of
commercial banks in Ethiopia.
 To identify the effect of fixed asset on the financial performance of commercial banks in
Ethiopia

1.5 Hypotheses of the Study

To meet the study's goal, I'll develop some hypotheses on the impact of asset diversity on the
financial performance of Ethiopian commercial banks, based on several theoretical and empirical
research on asset diversification and financial performance evaluation.

Financial asset

Financial assets are intangible assets such as bank deposits, bonds, and stocks, the value of which
is determined by a contractual claim on what they represent. They are not physical (except from
the paper in the documents), unlike property or commodities. Creditor relationships with debtors
are established, and asset owners obtain unconditional claims on the economic resources of other
institutional entities.

According to Blume and Friend (1975) state that on private investor portfolio diversification,
point out that there a large pool of private investors who still have not diversified portfolios of
financial assets that are risky even with the outlooks from the theory of capital asset pricing.

According to Laurie (2013) financial asset is a contracts that initiates creditor relationship with
debtor and asset owners acquire unconditional claims on economic resources of other
institutional units. Laurie further notes that financial assets are easily liquidized compared to
other tangible assets including real estate, commodities, and tradable on financial markets.
Laurie (2013) concludes by saying that financial asset increases a company's worth.

 H1: there is a positive relationship between financial asset and financial performance of
commercial banks in Ethiopia.

Loans

Loan portfolio is typically the largest asset and source of revenue for banks. However, loans and
advance is the most profitable and liquid asset for the bank to maintain its maximum liquidity
obligation to their depositors or lenders; banks do not invest its entire fund in a profitable asset

5
(Nwankwo, 2000). Bank accept customer deposits and use that fund to diversify loans to
borrowers or invest in other assets that will yield a return higher than the amount bank pays the
depositor (McCarthy et al. 2010).

 H2: there is a positive relationship between loan and financial performance of commercial
banks in Ethiopia.

Cash and cash equivalent

Cash and cash equivalents are short-term commitments with temporarily idle cash and easily
convertible into a known cash amount.

Cash and cash equivalent constitute the amount of cash available to the bank for daily operations.
It is generally accepted as cash on hand and cash equivalent such as bank drafts, demand
deposits, cheques, Treasury bill, bond and cash balances including cash and restricted and non-
restricted deposits with the central bank. Cash equivalents are short term liquid investments that
are readily convertible to cash with original maturity of three months or less (Yahaya et la.,
2015)

The quality of cash and bank balances could improve the income of a bank and increase the
bank’s financial performance. This cash and bank balances have a positive impact on the
financial performance of deposit money banks in Nigeria (Yahaya et la., 2015).

 H3: there is a positive relationship between cash and cash equivalent and financial
performance commercial banks in Ethiopia.

Fixed Asset

Investing in fixed assets such as land, buildings, plant and machinery, fixtures, fittings, and
motor vehicles can increase a company's productive capacity and ensure long-term success.

A study by Olatunji and Adegbite (2014) examined the effect of investment in fixed assets on
profitability of selected banks in Nigeria. The relationship between this variables indicated that
there is a significant relationship between them. The study findings have indicated that
investment in fixed assets have positive and significant effect to the performance of the selected
banks: the higher the level of investment in fixed assets, the higher the profit of banks.

6
 H4: Investment in fixed asset is positive effect on financial performance of commercial banks in
Ethiopia.

1.6 Significance of the Study

Companies must carefully and deliberately identify the competitive advantage in today's
competitive world, with the rise and expansion of the economy. This study will be crucial to
Ethiopia's banking industry and financial systems since it will justify the case for strategic
banking adoption. Diversification of assets for better financial success. The study's findings are
useful to commercial bank management since it focuses on the impact of asset diversification on
Ethiopian banks' financial performance trends. The findings tell managers about the factors to
consider when determining the degree of asset diversification. The findings of this study will be
useful to policymakers and government entities in Ethiopia that regulate the banking sector. The
study will also be help to other researcher so as to builds on the literature on enhancing the
financial performance of banks through Asset diversification.

1.7 Scope and Limitations of the Study

To achieve the objectives, the scope of the study has selected eight commercial bank in
Ethiopian and also the study covered impact of asset diversification with respect to financial
performance of commercial bank in Ethiopia for the period 2011-2020. It is concerned with the
effect of financial assets, loans, cash and cash equivalents, and fixed assets on the financial
performance of a selected commercial bank in Ethiopia over the reference period. The researcher
relied on secondary data on financial performance and related performance drivers that had
already been published. The study was carried out in Ethiopia.

This study is limited by sample size or total number of banks used for the analysis, and it is also
constrained by the number of years covered.

7
 CHAPTER TWO

2. LITERATURES REVIEW
2.1. Introduction

This chapter reviews the theoretical and empirical literatures on impact of Asset diversification
in banks. We start on section 2.2 with the theoretical reviews of Asset diversification. Under this
section we will see factors that affect bank performance and related theories. In section 2.3 we
will review of empirical studies related to the impact of diversification on profitability of banks.
Section 2.4 provides conclusions on literature review. Finally in section 2.5 we will provide the
conceptual framework of the study.

2.2 Theoretical Review

This section will be conducted by four theories; Modern Portfolio Theory, Arbitrage Pricing
Theory, Agency Theory and Capital Market Theory. The research will be use for the theories in
developing the conceptual framework. These theories acknowledge that diversification as
important for risk mitigation and increasing returns.

2.2.1 Modern Portfolio Theory

The Modern Portfolio Theory (MPT) is a theory of portfolio choice developed by Harry
Markowitz (1952). The MPT is a sophisticated investment decision approach that aids in
classifying, estimating and controlling both the kind and amount expected risk and return (Khan
& Hildreth, 2002).

There are several government operations and projects that can be organized into portfolios, each
with its own budget in accordance with the MPT, which is utilized in financial decision-making
and asset management in risky and unpredictable situations. This means that MPT aims to
rebalance the returns of listed commercial banks by mixing multiple investment options whose
returns are not totally positively correlated. MPT aims to lower the total variance of a portfolio's
return while assuming rational investors and efficient markets. The MPT mathematically
expresses the concept of diversity in investing, with the goal of picking investments that have a
lower overall risk than any one product (Khan & Hildreth, 2002).

8
The MPT assists listed banks in explaining investment options in terms of inherent risks and
projected returns, allocating resources among investment classes, reconciling risks and returns,
and monitoring performance based on portfolio diversifications. The primary assumption of
MPT is that by combining assets from diverse asset classes that are not highly correlated, the
portfolio's volatility can be reduced and risk-adjusted performance can be improved.

To put it another way, combining assets that are not correlated will result in the most efficient
portfolio, the one that generates the highest return for a given amount of risk. When one asset in
the portfolio depreciates in value, the assumption is that another asset in the portfolio will
increase in value over the same time period by combining asset classes that are not completely
correlated. Even if all asset classes are very volatile on their own, when they are integrated in
one portfolio, the volatility is decreased (Taleb, 2007). For these considerations, the Modern
Portfolio theory predicts a positive relationship between diversification and profitability.

2.2.2 Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT) was advanced by Ross (1976). According to APT, the
anticipated returns on a financial asset are heavily dependent on its beta. This beta is a measure
of the present relationship between components in a company that have an impact on the
company's financial success as well as the broader market in which it operates.

According to APT, an asset's expected returns are positively related to and covariant with other
random factors. The covariance found measures the risk that investors face as a result of
diversification, which is unavoidable. The slope's gradient denotes a linear relationship between
predicted profits, whereas the covariance denotes a risk premium.

The basic attribute here is the combination of an efficient portfolio's return rate and an individual
asset's return rate. According to APT, a significant correlation between the return rate of a
portfolio and the return rate of an asset can indicate that it is worthwhile to claim a high risk
premium on that asset (Sciubba, 2006). APT can be used to design multiple investment strategies
based on an investor's long- and short-term objectives. The Arbitrage Pricing Theory (APT) was
used in this research because it supports the link between asset diversification and company
performance. Arbitrage Pricing Theory promotes diversification as an investment strategy for

9
businesses that can result in higher profits. However, the Arbitrage Pricing Theory points out that
diversity is linked to risk, hence asset diversification must be done with caution.

2.2.3 Agency Theory

The Agency Theory came about through the works of Jensen and Meckling in (1976). The theory
holds that in every business situation, managers may have conflicting interests from those of the
shareholders (Jensen and Meckling, 1976). This arises from the fact that the managers make
most managerial decisions in such a way that they benefit the most at the expense of the
business. Agency problems are thus likely to occur and should be anticipated by putting in place
mechanisms to monitor and regulate these managerial actions (Jensen and Meckling, 1976).

Important managerial decisions, according to this notion, should not be made simply by the in-
charge manager, but rather by a selected board. This will ensure that the techniques implemented
are not motivated by personal interests. The hypothesis assumes that matching managers' and
stakeholders' interests will lead to increased performance. However, the Agency Theory has been
criticized since it may be difficult to apply because each partner constantly wants to get the most
for themselves first(Gleason, 2011).

In this study, agency theories propose that the creation of bank diversification plans is solely the
duty of the managers involved. In this regard, if the managers' interests are well matched with
those of the stakeholders, the strategies will have a favorable impact on the organization. They
should aim to maximize the use of the available resources to gain competitive advantage and
increased returns. This is by ensuring proper implementation and evaluation of the
diversification strategies.

2.2.4 Capital Market Theory

Capital market theories are concerned with explaining and predicting the relationship between
expected return and risk on investments in capital markets, the effect of investor's efficiently
diversified portfolios on the market pricing mechanism and whether the market is able to ensure
that security prices fully and correctly reflect all available information (Fama, 1976)

Capital market theory derived from modern portfolio theory by Markowitz, as researchers
explored the implications of introducing a risk-free asset. Sharpe is generally credited with

10
developing the CAPM, but Lintner and Mossin derived similar models independently in the
mid1960s. Assumptions made regarding Capital Market Theory include:

 All investors are Markowitz efficient investors who choose investments on the basis of
expected return and risk.
 Investors can borrow or lend any amount at a risk-free rate of interest.
 All investors have homogeneous expectations for returns.
 All investments are infinitely divisible.
 No transactions costs or taxes, no inflation or any change in interest rates and capital
markets are in equilibrium

2.3 Empirical review

This section present past empirical research on the impact of asset diversification on financial
performance in various nations and industries.

According to Kahloul and Hallara (2010), there was a link between diversification risk and
performance. They converse this study focused on 69 significant companies in France, with a
study period spanning 1995 to 2005. Both univariate and multivariate analyses were used in the
methodology. All 69 non-financial firms were included in the sample, which were chosen based
on their size, total period, and industrial activity. Because the data was cross-sectional and time-
series, regression analysis was used to analyze the panel data. The findings obliterated the link
between diversification and performance. As a result of this discovery, total risk was found to be
linearly unrelated to diversification. However, ownership structure has the potential to influence
the relationship between performance and diversification, as well as the relationship between
diversification and risk. The nature of ownership may play a role in having a thorough
understanding of diversity, risk, and performance links.

Turkmen and Yigit (2012) used evidence from Turkey to investigate banking diversification and
its impact on bank performance. The study looked at data from 40 commercial banks. Return on
Assets and Return on Equity were used to examine financial performance, while the Herfindahl
Index was used to assess location diversification (HI). The Herfindahl Index was used to
determine geographic diversification, which involved squaring market share and adding market
share for each bank in each market. The study also discovered that diversifying credit portfolios

11
affected banks' risk levels, with losses in one sector or one location being offset by gains in other
sectors. Therefore the research finding confirms whether a geographical diversification produces,
in terms of performance, negative effect for a sample of Turkish banks in the period 2007-2011.

Maina (2013) looked into the impact of product diversity on microfinance companies' financial
performance. The primary goal of this research was to determine the different types of
diversification available in the Kenyan microfinance industry and how they relate to
performance. The study used a descriptive survey approach with secondary data from
microfinance institution financial records and the Kenyan Central Bank. From 2008 to 2012,
major research findings revealed that the diversification indicator, ROA indicator, and ROE
indicator were all increasing. The study, however, was unable to determine the type of product
diversification, whether horizontal, vertical, or corporate, because each has its own impact on
financial performance. The finding of the study state that diversification of products
diversification was an appropriate strategy to increase the financial performance of microfinance
companies.

Kamwaro (2013) looked at the link between investment portfolio selection and investment
company profitability on the Nairobi stock exchange. A descriptive research design was used in
this study. A census of all investment businesses listed on the Nairobi Securities Exchange was
carried out as part of the research. In Nairobi Securities Exchange, there are five investment
businesses listed. From 2012 to 2014, the research was conducted across a three-year period. The
analysis relied on secondary data from the companies' books of account as well as the NSE or
CMA offices. To determine the effect of portfolio composition on financial performance of
investment businesses registered on the Nairobi Securities Exchange, the researchers employed
the multiple linear regression equation and the Ordinary Least Squares (OLS) estimation method.
The study discovered that bond investments have a positive impact on the financial performance
of NSE-listed investment companies. The study also discovered that investment businesses'
investments in real estate and equities had a good impact on their financial success, and that the
size of the company had a positive impact on investment companies' financial performance. As a
result of the research, it was discovered that the portfolio composition of investment businesses
registered on the Nairobi Securities Exchange had a considerable impact on their financial
success.

12
Kipleting and Bokongo (2016) looked into the impact of investment diversification on
commercial banks' financial performance in Kenya. An exploratory research design was adopted
in this study. The study's target demographic comprised of 40 commercial banks. The primary
data was obtained using data collection sheets as the primary data collection technique, and the
secondary data was acquired using an interview schedule as the primary data. Data was collected
using data collection sheets that were directed by the study's objectives. Explanatory and
inferential statistics, as well as multiple regression, were used to analyze the data. According to
the findings, a majority of Kenyan banks have used insurance investments to boost their financial
performance throughout the years.

According to Mutega (2016) looked into the impact of asset diversification on commercial banks'
financial performance in Kenya. The population of this study was 43 commercial banks in
Kenya, and the study used a descriptive research methodology. Annual reports from commercial
banks provided secondary data on financial performance and asset diversity. The study was
limited to a five-year period, beginning in 2011 and ending in 2015. The quantitative data was
evaluated descriptively and inferential statistics were utilized to make inferences. As independent
factors, financial assets, loans, cash and cash equivalents, and other investments are employed,
and the study's findings demonstrate that all independent variables have a positive and significant
impact on commercial banks' financial performance in Kenya.

Review of previous studies in Ethiopia

With the knowledge of researcher there are few studies have been conducted to examine the
impact of asset diversification on financial performance related to my topic in our country. It
would have been difficult to generalize the findings of the investigations if there had not been an
adequate number of empirical studies available on the subject of this research. Let us see few
research related with my topic:

Eyerusalem (2019) examine the impact of asset structure on the financial performance of
selected private commercial banks in Ethiopia. The study adopted explanatory research design to
understand cause and effect relation between components of asset and its financial performance.
In the meantime, quantitative approach was used to construct empirical model. Secondary data
was collected from thirteen private commercial banks for the period of 2011-2017. Out of

13
sixteen, thirteen private commercial banks and seven years period were purposely selected in
order to create constant panel and the availability of complete data for those banks with specific
period. Pooled panel regression model was applied to analyze the data. The result indicated that
cash holding has a positive but marginally insignificant effect on financial performance, fixed
asset and foreign banks deposit have positive and significant effect on financial performance and
NBE Bills has negative and significant effect on banks financial performance. Therefore the
investigation result show that Asset structure has a significant effect on the financial
performance in the banking sector.

Samuel (2018) used data from 15 chosen banks from 2012 to 2016 to investigate the impact of
lending diversification on the financial performance of commercial banks in Ethiopia. For the
bank performance metrics, the study used a quantitative research technique, with secondary
financial data evaluated using linear regressions models. Using the key roles of bank
performance determinants, the empirical results reveal that the effect of lending diversification
has a strong and moderate strong influence.

Elefachew and Hrushikesava (2016) looked at how industrial diversification affected the
financial performance of a few Ethiopian banks. The data covers ten private and two government
commercial banks during a six-year period, from 2008/09 to 2013/14. Overall, the banks in
Ethiopia may be said to have diversified their lending portfolios across several industries. The
regression was estimated using a fixed effects model, and industry diversification was found to
have a negative and significant impact on both asset and equity returns. According to a review of
the literature, a number of empirical studies on the impact of corporate diversification on
financial performance of banks and other sectors have been conducted, but their findings are
insufficient; therefore, more empirical evidence is needed, taking into account Ethiopia's
economic, financial, regulatory, and operating context.

When we see the similarity of the above local study they are use all the same research approach
where us the difference is according to (Eyerusalem , 2019) and (Samuel,2018) empirical results
suggest that Asset diversification has strong and significant effect on bank performance factors
on the other hand (Elefachew and Hrushikesava,2016) the investigation result suggest that the
industrial diversification was found to have a negative and significant effect on both return on
asset and equity.

14
Asset Diversification

Asset diversification is the use of multiple asset classes within an investment portfolio or fund, as
opposed to investing in a single class.

Diversification is a risk management strategy that mixes a wide variety of investments within a
portfolio. A diversified portfolio contains a mix of distinct asset types and investment in an
attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that
a portfolio constructed of different kinds of assets will, on average, yield higher long-term
returns and lower the risk of any individual holding or security.

Factors Affecting Banks Performance

Different studies undertaken on the performance of banks suggest that banks performance is
affected by both internal and external factors (Nassreddine et at. 2013; Okoth et at. 2013; Ezra,
2013) and these factors affect the performance of banks positively or negatively. Nassreddine et
al. (2013) stated that some of the elements that affect the bank's performance may be under
management's control, while others may be beyond management's control.

Internal or bank specific factors are those that may or may not be under management's control.
They are known as bank specific factors, according to Mohana et al. (2012), because the bank's
management can enhance (positive treatment) or decrease (negative treatment) them depending
on their expected impact on the bank's profitability. Capital structure, asset quality, managerial
efficiency, earning quality, liquidity, bank size, technology, human capital, loan performance,
and income diversification are some of the primary internal elements that determine bank
success. Furthermore, external or macroeconomic elements are those factors that are beyond the
control of management and are related to the industry and macroeconomic issues. Bank
concentration, inflation, real GDP growth, effective tax rate, and interest rate are some of these
characteristics

Components of Asset Diversification

Financial asset
Financial assets are intangible assets such as bank deposits, bonds, and stocks, whose values are
derived from a contractual claim of what they represent. Unlike property or commodities, they
are not physical (apart from the documents’ paper). Such contracts initiates creditor relationship

15
with debtor and asset owners acquire unconditional claims on economic resources of other
institutional units. Laurie (2013) A contract probably to be settled in the entity's own equity and
that is a non-derivative under which the entity may receive a variable amount of its own equity
instruments, or a derivative that probably will be settled other than through the exchange of cash
or similar for a fixed amount of the entity's equity. Laurie (2013).

According to Blume and Friend (1975) in private investor portfolio diversification, even with the
outlooks from capital asset pricing theory, there is a substantial pool of private investors that still
do not have diversified portfolios of hazardous financial assets.

Douglas (2014) holds similar views, arguing that a lack of diversification in enterprises is due to
investor variability in risk and revenue expectations, as well as investors' inability to effectively
sum up individual asset risks as well as portfolio hazards. Which means the expectation of
investors unless properly manage the diversified asset there is high risk on the portfolio.

Loan
For most banks, their loan portfolio is their most valuable asset and source of revenue. However,
the most profitable and liquid asset for a bank to maintain its maximum liquidity requirement to
its depositors or lenders is loans and advances; banks do not invest their whole cash in a profitable
asset (Nwankwo, 2000). Most banks accept deposits from customers and use the funds to
diversify loans to borrowers or invest in other assets that would offer a higher return than the
depositor's deposit (McCarthy et al. 2010).

The principal activity of commercial banks is making loans to its customers. The basic goal of
bank management when allocating funds is to generate profit while meeting the credit demands
of the community. Lending is the lifeblood of the banking business. Loans are the most valuable
asset, accounting for fifty percent to seventy-five percent of a bank's total assets. Loans account
for the majority of operating income in most banks, and they also represent the banks' greatest
risk exposure (Mac Donald and Koch, 2006).

A loan portfolio is a credit risk mitigation strategy employed by commercial banks. Some banks
spread out their lending portfolios, while others concentrate their loan portfolios. This is viewed
as a large loan portfolio management technique that captures the risk of individual loan

16
interrelationships as a portfolio. Traditional banking theory suggests that diversified institutions
can reduce risk by lowering monitoring costs. By resolving the agency problem between bank
owners and bank debtors, monitoring expenses can be minimized. Increases bank performance
by minimizing credit risk by strengthening monitoring incentives, according to Portfolio theory.

Tah et al. (2016) suggest that diversifying a company's loan portfolio lowers the risk of
bankruptcy and improves its financial performance. Loan portfolios, according to Maina (2013),
help to improve financial performance and are used as a technique to catch up with higher
performance levels. Diversifying the loan portfolio, according to Dionne and David (2005), helps
to reduce portfolio risk. According to Kashian and Tao (2014), a more concentrated loan
portfolio can lower return while increasing credit risk. Meanwhile, according to Lefcaditis,
Tsamis, and Leventides (2014), concentration risk increases bank credit loss due to the
likelihood of specialized sector payments defaulting. Increased diversification, according to
Aarflot and Arnegrd (2017), enhances performance. Furthermore, according to Freitakas (2013),
the provision for bad loans in Lithuanian banks has increased as a result of concentrated lending.

Only under moderate risk levels, according to Hayden et al. (2007), does loan portfolio
diversification increase bank performance. When enhancing the industrial, sector-wise, or
geographical loan portfolio diversification, banks should assess the riskiness of their decisions.
Banks with diverse loan portfolios can pool their domestically generated money and distribute
them appropriately depending on financial sector analyses.

According to Avila et al. (2013), concentrated loans produce credit portfolio losses since a single
portfolio causes concentration risk, despite the fact that concentrated loans help to assess capital
adequacy to some extent. Those who provide loan portfolios do so as a more effective approach
of lowering credit risk. According to Beck and De Jonghe (2013), loan concentration is strongly
linked to systemic risk. Because the purpose is to decrease the correlation between assets in the
portfolio, the benefit of a loan portfolio gains through the least associated asset.

Cash and cash equivalent

Cash and cash equivalent constitute the amount of cash available to the bank for daily operations.
Cash equivalents are short term liquid investments that are readily convertible to cash with
original maturity of three months or less (Yahaya et la., 2015).

17
These among others includes bank drafts, demand deposits, cheques, Treasury bill and cash
balances including cash and restricted and non-restricted deposits with the central bank. Cash
and cash equivalents are the most liquid current assets found on a business's balance sheet. Cash
equivalents are short-term commitments with temporarily idle cash and easily convertible into a
known cash amount

The banks have to possess enough funds to meet its financial obligations. When keeping
excessive amount of cash for unexpected circumstances as this idle money could leads to incur
loss because of cost of fund while keeping lower amount of cash face a shortage of operating
cash. These excess amounts of cash have to invest elsewhere to generate returns. Management of
cash is important to optimize the amount of cash available, obtain maximum benefit from return
on idle funds and minimizing losses caused by delays in the transmission of funds. This reduces
the growth of the business and it has impact on profitability. Even investing cash for a short
period of time can add to the profits of the business (Watson and Head, 2007).

According to Wayne and Megan (2003), the pressure of disciplining managers and
administrators is inversely proportional to the level of cash holdings, and seductive managers
have a tendency to spend available cash in various assets, even when they are not lucrative.
Wayne and Megan (2003) go on to say that companies with a lot of cash have the advantage of
being able to fund capital expenditures without depleting their reserves. The benefit is that
relying on internal funding is less expensive than relying on external funding.

One of the company's crucial health indicators is its ability to generate cash and cash equivalents.
So, a company with relatively high net assets and significantly less cash and cash equivalents can
mostly be considered an indication of non-liquidity. For investors and company’s cash and cash
equivalents are generally counted to be low risk and low return investments and sometimes
analysts can estimate company's ability to pay its bills in a short period of time by comparing
CCE and current liabilities. Nevertheless, this can happen only if there are receivables that can
be converted into cash immediately www.accountingtools.com (Cash and Cash equivalent,
2015).

18
Fixed Asset
Profits can be generated by investing in fixed assets like land, building, plant and machinery,
fixtures, fittings and motor vehicle enhances the productive capacity of firms to ensure long term
profitability. This category of assets does not change frequently and they are purchased to
produce and sell more. Assets have significant role in determining the efficiency and the profit
ratio of a firm. Since a firm acquires plant and machinery and other productive fixed assets for
the purpose of generating sales. Therefore, efficiency in the use of fixed assets should be judged
in relation to sales (Olatunji and Adegbite, 2014).

Fixed assets constitute an essential part of the overall resources that are available for
organizational use. Fixed asset investment plays vital roles in carrying out corporate activities
and also enhances the capacity of an organization in providing goods and services. No
organization can be sustained without some investment in fixed asset. High fixed assets turnover
ratio indicates efficient utilization of fixed assets in generating sales, while a low ratio indicates
inefficient management and utilization of fixed assets.

Banks have the opportunity to invest in fixed asset that relate to their objective to generate profit.
Banks can invest on fixed asset such as building to expand its business, information
communication technology in order to facilitate their service in advanced and reliable way, and
invest on machines like automated teller machine (ATM) is electronic telecommunications
device that enables customers to perform financial transaction at any time and increase market
share which contribute to increase the banks’ profitability (Eskedar, 2016).

Pandey, (1999) used fixed asset turnover ratio to evaluate utilization of fixed assets investment
and he also identified which firm is utilizing its investment in fixed assets efficiently or not. High
fixed assets turnover ratio indicates efficient utilization of fixed assets in generating sales, while
a low ratio indicates inefficient management on utilization of fixed assets. Likewise, Ibam (2007)
also stated that fixed asset turnover ratio show asset turnover trend of the firm and used as
comparison of the competitors in the industry. This gives the investor an idea of how effectively
a company’s management is using fixed asset. It is a rough measure of the productivity of a
company’s fixed assets with respect to generating sales.

19
2.4 Summary of Literature Review

According to the reviews diversification is a portfolio strategy that is established and

implemented in the banking industry to decrease risk, raise bank revenues, reduce profit
volatility, and improve overall bank performance by integrating various investments, assets, or
products.

Modern portfolio theory aims to maximize portfolio expected return for a given level of risk, or
to reduce risk for a given level of expected return, by carefully balancing asset allocations
(Fabozzi, Gupta, & Markowitz, 2002). This means that MPT tries to lower the overall variance
of the portfolio return for listed commercial banks by mixing different investment options whose
returns are not entirely positively correlated, while assuming that investors are rational and
markets are efficient. The theory’s proposition to this study is that the banks may reduce the risk
facing the investments by distributing the investment amounts among all those securities which
give a maximum expected return. This theory indicates that where the investment diversification
is well implemented as a performance improvement strategy, it may enable banks attain
competitive advantage. Arbitrage Pricing Theory promotes diversification as an investment
strategy for businesses that can result in higher profits. APT, on the other hand, points out that
diversification is linked to risk, therefore it's important to make sure that asset diversification is
done with caution.

The proposal of Agency Theory to this study, on the other hand, is that the creation of
diversification plans in banks is solely the responsibility of the managers involved. In this regard,
if the managers' interests are aligned with those of the stakeholders, the strategies will have a
favorable impact on the organization. All of the above hypotheses are related to asset
diversification and bank financial performance.

Several studies have been reviewed which are related to asset diversification and financial
performance such as Turkmen and Yigit (2012) using data from Turkey, investigated banking
diversification and its impact on bank performance. The study discovered that diversifying credit
portfolios affected banks' risk levels, with losses in one industry or location being offset by gains
in other sectors or locations. The influence of investment diversification on the financial
performance of commercial banks in Kenya was explored by Kipleting and Bokongo (2016),
who found that a majority of banks had in practice used insurance investment on the financial

20
performance of commercial banks in Kenya over the years. Kamwaro (2013) investigated the
link between investment portfolio selection and investment company profitability on the Nairobi
Securities Exchange while Maina (2013) looked into the impact of product diversity on
microfinance companies' financial performance. The study, however, was unable to determine
the type of product diversification, whether horizontal, vertical, or corporate, because each has
its own impact on financial performance. Kahloul and Hallara (2010) demonstrate the link
between diversification risk and performance. They also discovered that overall risk was
unrelated to diversification in a linear fashion. However, ownership structure has the potential to
influence the relationship between performance and diversification, as well as the relationship
between diversification and risk. Mutega (2016) looked into the impact of asset diversification
on the financial performance of Kenyan commercial banks. The study's findings show that all
independent factors have a favorable and significant impact on commercial banks' financial
performance in Kenya.

Some local research review in related with my research topic such as Elefachew and
Hrushikesava (2016) investigated the impact of industrial diversification on the financial
performance of selected Ethiopian banks, while Eyerusalem (2019) investigated the impact of
asset structure on the financial performance of selected Ethiopian private commercial banks,
concluding that asset structures have a positive impact on financial performance. Samuel (2018)
investigated the impact of loan diversification on commercial banks' financial performance in
Ethiopia, concluding that the impact of lending diversification is both substantial and moderate,
based on the key roles of bank performance determinants.

The majority of the arguers discovered that banks with risk diversification are more cost efficient
and profitable than banks with no risk diversification.

So far as the review of the literature disclosed prior studies are not inclusive all asset component
and never looked at other correlates of financial performance in the banks’ asset diversification.
Hence, to fill the knowledge gap this study has included fixed asset as one of the components of
asset that affect financial performance of commercial banks in Ethiopia.

21
2.5 Conceptual framework of the study

The relationship between asset diversification and financial performance of Ethiopian

commercial banks is depicted in the conceptual framework. The study consider asset
diversification of the commercial banks as independent variables, to determine how they affect
the dependent variable, which in this case is financial performance. The component of asset
diversification form independent variables namely financial asset, Loan, Cash and cash
equivalent and fixed asset. All independent variable are chose from internal factor of bank
performance but the study was not use external factor because they have the same impact on all
commercial banks financial performance. These independent variables are measure by getting
the ratio of each independent variable to the total asset. On the other hand, dependent variable,
financial performance is measured by various indicators such as ROA, ROE and NET PROFIT
MARGIN; however, the study use one dependent variable ROA as a measurement of financial
performance.

Although it may be skewed owing to off-balance sheet activities, return on asset (ROA) shows
the ability of a bank's management to make profits from the bank's assets. The return on equity
(ROE) is the amount of money returned to shareholders.

As per Sinkey, (1992) posits that return on asset (ROA) is a comprehensive measure of total
bank performance from an accounting standpoint. It is a primary indicator of managerial
efficiency since it shows how capable a bank's management has been in converting the bank's
assets into net earnings. Rose and Hudgins (2006) however maintain that from the standpoint of
shareholders, ROE is a solid indicator of accounting profitability. It approximates the net benefit
gained by stockholders as a result of their capital investment.

Ahmed and Khababa, (1999) in their assessment of bank performance in Saudi Arabia employed
three ratios as measures of performance that is return on equity (ROE), Return on Assets (ROA)
and percentage change in earnings per share.

According to Athanasoglou et al. (2008) and Sufian, (2011) suggest that ROA is the most
important metric for assessing bank profitability since it is unaffected by high equity multipliers,
whereas ROE ignores the dangers associated with high leverage and financial leverage. In this
regard, it is uncommon to discover a study that uses ROE as a single metric of profitability.

22
 Other papers utilize ROE for checking the consistency with ROA While a bulk of studies employ
ROA as profitability measure in most of the previous studies on banking industry, return on
assets (ROA) is being used as a proxy of profitability (Tamiru 2013) ;( Thuku 2015) .Not only
the above reasons are chose ROA as profitability measure but also unlike other profitability
ratios, such as return on equity, ROA measurements include all of a Company’s assets –
including those which arise from liabilities to creditors as well as those which arise from
contributions by owners. Hence, ROA gives an idea about the efficiency of management in using
the Company’s assets to generate profit. Thus, this Research objectively to measure profitability
by using ROA like most of the aforementioned studies, ROA is measured as net interest income
divided by total assets. ROA=Net interest income /Total Asset.

Figure 2: Conceptual framework of the study

Independent variable Independent variable

23
 CHAPTER THREE

3. RESEARCH METHODOLOGY

The purpose of this chapter is to discuss the methods to be adopted throughout the study to
accomplish the research objectives. The research design, research approach, data collection
method, Population and sample size, and data analysis method the study were all covered in this
chapter.

3.1 Research Design

Rajendra (2008) defines research design as the linkage and organization of situations for
gathering and exploration of gathered data in a manner that intents at achieving the study goals.

Rajendra (2008) also argues that research plan focuses on the arrangement of an investigation,
which leads to the lowering of the chance of drawing the wrong casual inferences from the data.
Thus, explanatory research design is use in this research because the study identifies the cause
and effect of loan diversification on the financial performance which is appropriate for the
objective of the study

3.2 Research Approach

A quantitative study design will be used to generalize about the impact of asset diversification on
bank financial performance in order to fulfill the main research objectives. The goal of
employing this method is to collect data that will aid the researcher in investigating cause-and-
effect linkages. A quantitative strategy is one in which the investigator largely relies on
postpositive statements, such as cause and effect relationships between known variables of
interest, to develop knowledge (Cresswell 2003).

According to Cresswell (2003), a quantitative research strategy includes inquiry strategies such
as experiments and surveys, as well as data collection on specified instruments that provide
statistics. Quantitative research uses a survey of the existing literature to deductively construct
theories and hypotheses to be tested, i.e., the research topic is translated into particular variables
and hypotheses in this approach.

In this particular case, the effect is the company’s profitability and the research is target at
identifying significant causes, i.e. determinants on financial performance related to Asset

24
diversification. A brief explanation about the data collection and analyzing method adopt is
given below.

3.3 Method of Data Collection

This study is relying on secondary data. To gather data on Asset diversification component and
profitability, it is apparent to use survey of structured documentary review. As a result, audited
financial statements, particularly the balance sheet and income statement, will be used to achieve
its goal. Secondary data will be derived from annual audited reports of Ethiopian commercial
banks. To achieve the goal, the paper relies heavily on panel data gathered from secondary
sources.

3.4 Population and Sample size

A sample is a portion of the population that inferences are to be made about the population.
However, it is important that the sample be representative of the population from which it will
select. There are 19 commercial banks which are licensed and operating in Ethiopia as of June
2020.

The survey and analysis will be conducted by eight commercial banks in Ethiopia. It will be
engaged in order to infer from a sample to population. The sampling technique select for this
research is purposive sampling. Specifically the researcher adopts criterion sampling which is
above 15 years of establishment of date and one government and the others are privet bank.

 The justifications for Banks in the sample

Researchers usually draw conclusions about large groups by taking a sample. The sample should
ideally be representative, allowing the researcher to generate reliable estimates of the greater
population's thoughts and behavior (Leedy and Ormrod, 2005).

Eight Banks are chose from the nineteen existing commercial Banks. Data are source from the
Annual Reports of the Banks. However some of recently established commercial banks that less
than fifteen years which are operating in Ethiopian financial market are not include in the sample
because of three reason the first one is they have no full data in the sample period the researcher
needs, the second one is they may not be able to significantly influence the criteria use in the

25
sample and the last but not the least one is select based on capital, asset size, market share and
deposits.

I chose the commercial bank of Ethiopia from among the governmental institutions because its
goals are comparable to those of other private banks. The other state bank, Development Bank of
Ethiopia, is not included in the sample because its mission is different from that of a commercial
bank.

The time period select to this study by considering the availability of data, research time and
cost. Therefore the duration of the research will basically from 2011-2020. This study employs
annual data on the impact of asset diversification on financial performance of selected
commercial Banks in Ethiopia.

According to Baltagi (2005), panel data has the advantage of controlling for individual
variability, reducing co linearity across variables, and tracking trends in the data, which simple
time series and cross sectional data cannot provide. I'll use statistical tools to infer the research
outcome in quantitative notation from the data.

3.5 Data Analysis method

To investigate the association between asset diversification and financial performance of the
listed commercial banks, the data will be analyzed using descriptive and inferential statistics.
Fixed effect model will be used to examine the data collected by the researcher. The study
findings will be interpreted using descriptive statistical measurement such as percentages, means,
and standard deviation. The researcher used tables and figures to show the study's findings in
addition to the descriptive interpretation.

 Model Specification

The econometric model used in the study (which is in line with the literature) is given as:

Y= β0+ βnX + ε

Where,

Y is the dependent variable.

26
 β0 = Constant term,

βn =Coefficient of explanatory variable,

X= Explanatory variable and

ε=Error term

The regression function determines the relation of X to Y. β0 is the constant term and βn is the
coefficient of the function, it is the value for the regression equation to predict the variances in
dependent variable from the independent variables. This means that if βn coefficient is negative,
the predictor or independent variable affects dependent variable negatively: one unit increase in
independent variable will decrease the dependent variable by the coefficient amount.

In the same way, if the βn coefficient is positive, the dependent variable increases by the
coefficient amount. β0 is the constant value which dependent variable predicted to have when
independent variables equal to zero Finally, ε is the disturbance or error term, which expresses
the effect of all other variables except for the independent variables on the dependent variable.

Therefore based on the above basic econometric model the following regression model will be
used to establish the relationship among the study variables.

Y = β0+ β1 (FINA.ASSETS) + β1 (LOAN) + β3 (C & C EQ) + β4 (FIX.ASSET) + ε

Whereby;

Y = Financial performance of banks measured by Return on Asset

FINA.ASSETS = Financial Assets as measured by Total Asset

LOAN AND ADVANCE = Loan Portfolio as measured by Total Asset

C & C EQ = Cash and Cash Equivalent as measured by Total Asset

FIX.ASSET = Fixed Asset as measured by Total Asset

β0 = regression constant

β1, β2, β3 and β4 = coefficients associated with predictor variables

ε = Residual (error) term

27
 Variable definition and measurement

Dependent Variable

As per Sinkey, (1992) posits that return on asset (ROA) is a comprehensive measure of total
bank performance from an accounting standpoint. It is a primary indicator of managerial
efficiency since it shows how capable a bank's management has been in converting the bank's
assets into net earnings. ROA is measured as net interest income divided by total assets.
ROA=Net interest income /Total Asset.

Independent Variable

The component of asset diversification form independent variables namely financial asset, Loan
and advance, Cash and cash equivalent and fixed asset. These independent variables are measure
by getting the ratio of each independent variable to the total asset.

Financial asset

Financial assets are intangible assets such as bank deposits, bonds, and stocks, the value of which
is determined by a contractual claim on what they represent.

Cash and cash equivalent

Cash and cash equivalent constitute the amount of cash available to the bank for daily operations.
It is generally accepted as cash on hand and cash equivalent such as bank drafts, demand
deposits, cheques, Treasury bill, bond and cash balances including cash and restricted and non-
restricted deposits with the central bank.

Loan and Advance

For most banks, their loan portfolio is their most valuable asset and source of revenue. However,
the most profitable and liquid asset for a bank to maintain its maximum liquidity requirement to
its depositors or lenders is loans and advances; banks do not invest their whole cash in a profitable
asset (Nwankwo, 2000).

Fixed Asset

Investing in fixed assets such as land, buildings, plant and machinery, fixtures, fittings, and
motor vehicles can increase a company's productive capacity and ensure long-term success.
28
 CHAPTER FOUR

4. DATA ANALYSIS AND PRESENTATION

This chapter deals with the analysis and presentation of the results of the study. STATA was
used to conduct the analysis. There was a discussion on descriptive statistics and correlation
analysis. The diagnostic test is then performed to ensure that the classical linear regression
model's assumptions are met. Then there was an econometric analysis and explanation of the
study's major finding. Finally, utilizing a commercial bank's yearly financial report, the
regression analysis' findings were reviewed (which is Secondary data).

4.1. Descriptive statistics

The descriptive statistics of dependent and independent variables utilized in the study for the
sample banks are shown in this section. The study's dependent variables were ROA, which is a
measure of the profitability of a bank's business operations based on Net Interest Income.
Financial asset, cash and cash equivalent, loan, and fixed asset were the independent factors. As
a result, there were 80 observations overall for each dependent and explanatory variable (panel
data of 8 commercial banks for 10 years). The mean, standard deviation, minimum, and
maximum values for the dependent and independent variables for sample banks from 2011 to
2020 are shown in table 4.1.

Descriptive Test

Table 4.1: Descriptive Statistics of the significance of components of assets diversification on

return on assets of selected banks in Ethiopia

Table 4.1 Descriptive statistics results

29
Source: Stata 12. Output from Annual financial Report of Commercial Banks.

The descriptive statistics of the analysis presented in Table 4.1 above shows that the mean of Net
Interest Income which means ROA was 4.36% and standard deviation of 1.09%. This means
commercial banks in Ethiopia, under the period of study, earned on average 4.36% net interest
income on total asset employed. This also means that on average, for each one birr asset of
commercial banks there was 0.043625 cent return in the form of net interest income. The highest
net interest income ratio for a bank in a particular year was 0.06 and in the same way the
minimum ratio for a bank in a year was 0.02. Regarding the standard deviation, it means that the
value of net interest income ratio deviates from its mean to both sides by 0.0109. This
descriptive statistics support by empirical study. According to Mutega (2016) the finding shows
that average financial performance of commercial banks was 0.0257, according to the statistics.
Over the research period, this represents an average Return on Asset (ROA) of 0.0257. The
descriptive statistics finding of (Samuel, 2009) shows that the average value of return of asset
(ROA) was 0.0314 which shows that both research result were lower return generate when we
compare to in my descriptive statistics result.

Financial assets (FIA) had a mean of 0.27425 which is the second highest total asset of
commercial bank of in Ethiopia cover next to loan and advance. Standard deviation of 0.1123261
with a minimum value of 0.12 and a maximum value of 0.59. According to Mutega (2016)
between 2011 and 2015, the mean of financial assets was 24.0218 units, with a standard
deviation of 1.2697.
30
The table also shows that cash and cash equivalent (CCE) had a mean of 0.223 and a standard
deviation of 0.1046199 with a minimum value of 0.06 and a maximum value of 0.51. A higher
cash to asset ratio means that the company is more liquid and can more easily fund its debt.
Creditors are particularly interested in this ratio because they want to make sure their loans will
be repaid. The implication is when low cash to asset ratio the bank has faced high risk in order to
settle short term obligation.

During the study period, the average loan and advance ratio of the tested banks was 47.08
percent. It demonstrates that loan and advances account for almost 47% of commercial banks'
total assets in Ethiopia. The greatest loan and advance to total asset ratio for a bank in a given
year was 65 percent for Bank of Abyssinia in 2020, while the lowest ratio for a bank in the study
years was 28 percent for Commercial Bank of Ethiopia in 2020. The loan and advances to asset
ratio might differ from its mean by 9.09 percent on both sides. From the summary of statistics it
was observed that 47% of the total asset of commercial banks in Ethiopia in the period under
study was made up of loan. To sum up the loan to total asset ratio compares a bank's liquidity to
its loan and total assets; the higher the ratio, the less liquid the bank. It signifies that banks have
given out more loans than they can handle, and they may have trouble meeting their short-term
obligations. This support by in the literature review loans are the most valuable asset, accounting
for fifty percent to seventy-five percent of a bank's total assets. Loans account for the majority of
operating income in most banks, and they also represent the banks' greatest risk exposure to meet
short term obligations (Mac Donald and Koch, 2006).

Finally fixed asset (FA) had a mean value of 0.028 and standard deviation of 0.0173862 and a
minimum value of 0.0 and with a maximum value of 0.07. A higher ratio implies
that management is using its fixed assets more effectively. But high fixed asset ratio does not tell
anything about a company's ability to generate solid profits or cash flows. Because when we see
the mean value relatively lower than other independent variable.

4.2 Correlation Analysis

The outputs and explanations of the correlation analysis are presented in this section of the study.
To show the relationship between ROA of commercial banks in Ethiopia and financial asset,

31
cash and cash equivalent, loan, and fixed asset of correlation coefficients were used. The
correlation coefficient's values were consistently between -1 and +1. A correlation value of -1
shows a perfect negative association between the two variables, whilst a correlation coefficient
of 0 implies no linear relationship between the two variables. Furthermore, a correlation
coefficient of +1 indicates that the two variables are perfectly positive in their relationship
(Gujarati, 2004).

According to (Wajahat, 2010), it is useful to check the correlation test between the dependent
and independent variables before conducting regression analysis. However, the fundamental goal
of correlation analysis is to determine the strength or degree of linear relationship between
variables. Furthermore, in correlation analysis, there is no separation between dependent and
independent variables. This means that the researcher cannot make cause-and-effect inferences
about the link between the specified variables using correlation analysis.

A correlation matrix is used to guarantee that variables are related. According to Cooper &
Schindler (2009), a correlation coefficient of more than 0.8 between explanatory variables should
be corrected because it indicates an issue with multicollinearity. According to Mashotra (2007),
the correlation coefficient can be as high as 0.75. Finally, Hair et al. (2006) claimed that a
correlation coefficient of less than 0.9 does not necessarily indicate a major multicollinearity
problem. As a result, if one explanatory variable has a correlation coefficient of more than 0.8
with other variations, it is eliminated from the regression model to prevent multicollinearity. The
correlation matrix between dependent and independent variables are depicted in the following
table.

32
Table 4.2 Correlation Matrix: Among each Variable

_____________________________________________________________________________________

ROA FIN CASH LOAN & ADV FIXED

AS

-------------+------------------------------------------------------------------------------------------------------

ROA 1.0000

Financial Asset -0.1054 1.0000

Cash and cash Eq -0.5849 -0.5824 1.0000

Loan 0.7389 -0.5051 -0.3920 1.0000

Fixed asset 0.2237 -0.2237 -0.3370 0.4823

1.0000

______________________________________________________________________________

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

4.2.1 Correlation Analysis between the Dependent Variables on ROA and Explanatory

The ROA reflects the ability of a bank’s management to generate profits from the bank’s assets
and this financial performance measure is correlated with other explanatory variables either
positively or negatively. Return on Asset (ROA), the net interest income per birr of total Asset,
which is more concerned about how much the bank is earning on their Asset diversification. In
table 4.2 above, the correlation analysis was undertaken between performance measures; return
on asset and explanatory variables. As it can be seen from the table above, there was a positive
correlation between return on asset and loan and advance & fixed asset. Whereas, there is a
negative correlation between commercial banks performance measure; return on asset with cash
and cash equivalent and financial asset. That means the greater the loan and advance and fixed-
asset-to-total-asset ratios, the higher the net interest income (ROA) of Ethiopian commercial

33
banks. Since commercial banks are more concerned with increasing their loan and advancing
their net interest revenue per birr of total asset, their net interest income per birr of total asset has
increased. As a result, all correlation findings are less than 0.80, indicating that multicollinearity
is not a concern for this study. The correlation result of both financial asset and cash and cash
equivalent negative which is contradict to the null hypothesis result there is a positive
relationship between financial asset and cash with the financial performance of commercial
banks in Ethiopia. When we see the empirical study cash and bank balances have a positive
impact on the financial performance of deposit money banks in Nigeria (Yahaya et la., 2015).
According to Laurie (2013) concludes by saying that financial asset increases a company's worth
because financial assets are easily liquidized compared to other tangible assets.

The positive association between loan and advance in the above table indicates that an increase
in the amount of loan to customers from deposits has a beneficial impact on the profitability of
Ethiopian banking. The interest income linked with loans and advances could have been more
than the costs or interest paid to depositors. Customer deposits are accepted by banks, who then
utilize the funds to diversify loans to borrowers or invest in other assets that would produce a
higher return than the amount paid to the depositor (McCarthy et al. 2010). It has similar to the
null hypothesis there is a positive relationship between loan and financial performance of
commercial banks in Ethiopia. Which means the higher loan and advance increase the net
interest income of the bank industry.

The correlation result for fixed assets is positive, which is consistent with the hypothesis that
fixed asset investment has a favorable impact on commercial banks' financial performance in
Ethiopia. A study by Olatunji and Adegbite (2014) selected banks in Nigeria the finding have
indicated that investment in fixed assets have positive and significant effect to the performance
of the selected banks, the higher the level of investment in fixed assets, the higher the profit of
banks.

4.3 Regression Analysis Results and Discussions

In this section regression analysis for banks performance measures by return on asset and
explanatory variables. To assure that the estimation technique, ordinary least squares (OLS), had
a number of desirable properties, and so that the hypothesis tests regarding the coefficient

34
estimates could validly be conducted. Five assumptions were made relating to the classical linear
regression model (CLRM), (Brooks 2008). That is, the error has zero mean, hetroskedasticity,
normality autocorrelation and multicollinearity.
4.3.1 Diagnosis tests

In this research, five assumption are used for diagnostic tests were carried out to ensure that the
data fits the basic assumptions of the model; which are presented as follows:

4.3.1.1 Assumption one: the errors have zero mean (E (ε) = 0)

A constant term is add in the regression model employ in this investigation. As per Chris brooks
(2008), the first assumption required that the average value of the errors is zero (E (ε) = 0). This
assumption will not be violated if a constant term is included in the regression equation. As a
result, in the study, this assumption was not violated.

4.3.1.2 Assumption Two: Test for Heteroscedasticity

This test verifies one of the CLRM's assumptions: that the error terms in the population
regression function are homoscedastic, meaning that they all have the same variance. If the errors
do not have a constant variance, they are said to be heteroscedastic. Heteroskedasticity refers to a
systematic pattern in which the error variances are not constant. The hypothesis for
Heteroskedasticity is presented as follows:

Ho: There is no heteroskedasticity problem in the model (Constant variance)

Ha: There is heteroscedasticity problem in the model

Even if the estimators are still linear and unbiased the presence of heteroscedasticity does not
make the regression estimates BLUE (Best Liner unbiased Estimator) (Brooks, 2008).
Furthermore; heteroscedasticity makes the regression estimates not efficient which means that
there is some other linear estimator, which has a low variance. Finally, the existence of
heteroscedasticity makes to have incorrect standard error, this ultimately results in incorrect
values of t-test, and F-test leads to wrong conclusion. The Whites test and Breusch -pagan is the
most popular method to detect the presence of Heteroscedasticity. According to Brooks (2008)

35
the P-value should be bigger than 0.05 not reject the null hypothesis of homoscedasticity at the
5% significance level but if it is below 0.05 then there is sufficient evidence to say that
heteroscedasticity is present. In this study, both whites test and Breusch -pagan test was used to
detect the existence of heteroscedasticity and the result is presented as follows:

Table 4.3 Heteroskedasticity Test: White

. estat imtest, white

White's test for Ho: homoskedasticity

against Ha: unrestricted heteroskedasticity

chi2(14) = 11.52
Prob > chi2 = 0.6450

Cameron & Trivedi's decomposition of IM-test

Source chi2 df p

Heteroskedasticity 11.52 14 0.6450

Skewness 5.53 4 0.2372
Kurtosis 0.02 1 0.8938

Total 17.06 19 0.5856

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

The test for heteroscedasticity demonstrates that the data is homoscedastic, as seen in the table
above. The null hypothesis in this test is that the data is homoscedastic because the P-value is
greater than 0.05, as the result we fail to reject the null hypothesis. Therefore, we can conclude
that heteroscedasticity does not exist.

36
Table 4.4 Breusch-Pagan / Cook-Weisberg test for heteroscedasticity

__________________________________

Ho: Constant variance

Variables: fitted values of roa

__________________________________

chi2 (1) = 0.10

Prob > chi2 = 0.7520

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

As the result in table 4.4 shows, the P-values are 0.7520 and this versions of the test statistic
gives the same conclusion that supports the absence of heteroscedasticity since the P-values is
greater than 0.05. This indicates that the assumptions of homoscedasticity or errors have a
constant variances is not violated

4.3.1.3 Assumption Three: Test for normality

The purpose of this test is to confirm CLRM's assumption that the disturbance terms are
normally distributed. The Shapiro-Wilk test is one of the most widely used normality tests.
Shapiro Wilk uses the feature of a normally distributed random variable that the first two
moments, the mean and variance, define the entire distribution (Brooks 2008). According to the
same source, the data is normal if the residuals are normally distributed and the Shapiro-Wilk
Test Significant value is greater than 0.05. If it is less than 0.05, the data significantly deviate
from a normal distribution. This means if the p-value is greater than 0.05 the null hypothesis of
normality should not be rejected at 5% level. The hypothesis for the normality test is established
as follows:
Ho: Error term is normally distributed
Ha: Error term is not normally distributed
Decision rule: Reject Ho if P-value of Shapiro wilk test is less than 0.05 at 5% significant level.
Otherwise, do not reject Ho.

37
 In case of this study, as shown in Table 4.5 below, the p- value of Shapiro-Wilk test is more than
0.05 as a result we fail to reject the null hypothesis for residual normality.

Table 4.5 Shapiro-Wilk W test for normal data

. predict u, residuals

. swilk u

Shapiro-Wilk W test for normal data

Variable Obs W V z Prob>z

u 80 0.97414 1.775 1.257 0.10439

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

In addition to the shapiro-Wilk W test analysis for testing normality the following histogram
shows the absence of normality problem. Because if the histogram is bell shaped the normality
assumption is not violated.

Figure 2: Histogram for normality test

60
40
Density

20
0

-.02 -.01 0 .01 .02

Residuals

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

38
4.3.1.4 Assumption Four: Test for Autocorrelation

The CLRM assumes that the disturbance term associated with one observation is unaffected by
the disturbance term associated with another. In other words, the errors are assumed to be
unrelated to one another. If the errors are not uncorrelated with one another, it would be stated
that they are autocorrelated. According to the rules, the null hypothesis is rejected and the
existence of autocorrelation presumed if the P-value in Wooldridge test (XTserial) for
autocorrelation is less than 0.05 values; the null hypothesis is not rejected and no significant
residual autocorrelation is presumed if the P-value in Wooldridge test for autocorrelation is
greater than 0.05 values. So based on ours result below in the test having a P-value of 0.1816 we
fail to reject the null hypothesis which states that there is no first order auto correlation between
the error terms since the P-value is higher than 0.05 and confirm the absence of autocorrelation
problem in our model.

Table 4.6 Autocorrelation test using -Wooldridge test

. Xtserial roanetinterestincome financialassettotalassetratio cashandcasequivalenttotalasset

> loanandadvancetotalassetratio fixedassettotalassetraio

Wooldridge test for autocorrelation in panel data

Ho: no first-order autocorrelation

F( 1, 4) = 12.491

Prob > F = 0.1816

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

4.3.1.5 Assumption five: Multicollinearity test

The CLRM further assumes that no multicollinearity exists among the regressors included in the
regression model. Multicollinearity is a problem that occurs when the explanatory variables are
highly correlated with one another. This assumption reflects the fact that the explanatory
variables do not have a perfect relationship. The best regression models are those in which the

39
predictor variables all have a strong correlation with the dependent variable but have a minor
correlation with each other (Gujarati, 2004).
According to Hair et.al (2006) the correlation coefficient below 0.9 may not cause serious
multicollinearity problem. Additionally Cooper & Schindler (2009) suggested that a correlation
above 0.8 should be considered as a problem of multicollinearity. Furthermore Malhotra (2007)
argues that the problem of multicollinearity exists where the correlation coefficient among
explanatory variables should be greater than 0.75.

Due to the presence of multicollinearity, regression coefficient estimations have a large variance
and standard error, resulting in low t-statistics and insignificant coefficients. Furthermore,
multicollinearity among explanatory variables leads to a misleading sign of the regression
coefficient as well as a significant F-test with insignificant individual coefficients. Pearson
correlation matrix detects the presence of multicollinearity among independent variables.
In this study to check the existence of multicollinearity the following Pearson Correlation matrix
between independent variables is calculated by using Stata. Table 4.7 shows that in this study
there is no correlation coefficient that exceeds or even close to 0.90. Accordingly, in this study
there is no problem of multicollinearity.

Table 4.7 Results of Multicolleneourity test using Pearson correlation matrix

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

[[

40
4.4 Choosing between Random effects (RE) and Fixed effects (FE) model

While this study makes use of panel data to examine the impact of a specified independent
variable on the ROA ratio of Ethiopian commercial banks, there are two types of panel data
models that are commonly employed. The random effect (RE) model and the fixed effect (FE)
model are the two types of panel data models.

Therefore, there is a need to choose one model that gives consistent estimates for this study to
show the cause and effect relationship between independent and dependent variables. To do so,
the Hausman specification test or Lagrange Multiplier test for random effect method is applied
and the hypothesis is developed as follows:

Ho: Random effect model is appropriate.

Ha: Fixed effect model is appropriate.

Table 4.8 Result of model selection test: Hausman specification test

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

41
Table 4.9 Result of model selection test: Lagrange multiplier test for random effect

Source: Stata 12. Output from Annual financial Report of Commercial Banks.

For the random effect p-value of a model, the Hausman specification and Lagrange Multiplier
test show 0.0035 and 0.0000, respectively, which are less than 5% significance levels. The null
hypothesis is that of random effect model is appropriate and alternate hypothesis is that of fixed
effect model is appropriate. Since the p-value is less than 5%, level of significance we reject the
null. Therefore fixed effect model is appropriate than random effect model to estimate the effect
of different selected independent variable on asset diversification of commercial banks in
Ethiopia.

42
4.5 Regression Result Analysis between Return on Asset and Explanatory Variables

Table 4.10 Regression result of the model.

Source: Stata 12. Output from Commercial banks financial statements

From the data in the above table the established regression equation is

Y = 0.0734 -0.0559 X1 - 0.9345 X2 + 0.016X3 -0.0538 X4

4.6 Analysis of the regression model

This section presents the empirical findings from econometric studies on the relationship
between asset diversification and bank profitability in Ethiopia. This section also discusses the
empirical regression model used in this study, as well as the regression analysis results.

The significance of the model is determined, and table 4.10 of linear regression reveals that the
regression model significantly predicts the outcome variable with a p-value of (0.0410),

43
indicating that the overall model utilized was considerably good enough in predicting the
outcome variable.

It demonstrates that the independent factors explain 65.13 percent of the dependent variable (Net
Interest Income), which is a good result. Because only less than 34.87% fluctuation of the
dependent variable can be explain by other independent variable those are not mention in the
above variable. That is way the above selected independent variable jointly are significantly
explain the dependent variable. To conclude, the regression model utilized in this study
explained the overall model, indicating that the study did not lose highly essential variables that
influence the study's outcome.

From the above regression equation it was revealed that holding financial asset, Cash and cash
equivalent, loan and advance and fixed asset of asset diversification to a constant zero, financial
performance of banks would stand at 0.073.

Financial asset; the result show that a negative but Significant impact on regression equation
conducted for commercial bank at 5% significant level in terms of ROA. Which means even if
the coefficient is negative but it is significantly explain the dependent variable because of the P
value is below 5%. For every 1% change (increase or decrease) in bank‘s financial asset with
asset ratio keeping the other thing constant has a resultant change of 0.055% (Coeff. = 0.055972)
on the net interest income in the opposite direction. This result also shows that an increase in
amount of financial asset has a negative impact on profitability of Ethiopian banking industry.
But since we are considering a 95% confidence level we take this variable as insignificant to
affect profitability as measured by net interest income. This leads to reject the hypothesis which
stated that financial asset has a positive relation to financial performance of bank that means
there is no sufficient evidence to support the positive relationship between financial asset and
profitability in my research finding. On the other way it fail to reject the hypothesis significant
effect on the financial performance of commercial banks in Ethiopia because of the p-value has
below 5%. The result is consistence with Elefachew and Hrushikesava (2016) the regression was
estimated using a fixed effects model, and industry diversification was found to have a negative
and significant impact on both asset and equity returns.

Cash and cash equivalent unit increase in diversification of Cash and cash equivalent would
lead to decreases in financial performance (ROA) of diversification of banks by a factor of -

44
0.093. Even if the coefficient is negative but it is significantly explain the dependent variable
because of the P value is below 5%. This means banks have to possess enough funds to meet its
financial obligations and also by lending this amount increases the interest income of the bank.
While implication of keeping excessive amount of cash for unexpected circumstances as this idle
money could leads to incur loss because of cost of fund while keeping lower amount of cash face
a shortage of operating cash. These excess amounts of cash have to invest elsewhere to generate
returns. The same result find by Yahaya et la., 2015, in the study cash and bank balances have a
positive impact on the financial performance of deposit money banks in Nigeria. Whereas
according to Eyerusalem (2019) the study result indicated that cash holding has a positive but
marginally insignificant effect on financial performance of asset structure on selected private
commercial banks in Ethiopia. But in my research result is negative effect but it is significant
effect.

Loan and advance; Commercial banks rely heavily on interest revenues from loans and
advances to fund their operations. Because interest rates on loans are much greater than interest
expenses on deposits, the more deposits that are converted into loans, the higher the profitability
of banks. As a result, during the analyzed period, the sample banks loans to total asset ratio had a
positive and highly significant impact on bank profitability. It is indicated that Loans and
advances had positive relationship with profitability with strongly statistically significant (p-
value = 0.0001) at 1% significance level. This is an implication that diversification into loans and
advance affects financial performance of commercial banks positively. The findings concur with
Perez (2015) who acknowledges that loans ranks as the key and the most valuable types of asset
that is held by banks because it’s from them that banks receive income. This also implies that
every 1 birr change (increase or decrease) in bank‘s loans & advances ratio keeping the other
thing constant has a resultant change of 1.6 cents (Coeff. = 0.01675 on the net interest income in
the same direction. This result also shows that an increase in amount of loan and advances to
customers from deposit has a positive impact on profitability of Ethiopian banking industry. The
possible reason could be that the interest income associated with loan and advances was greater
than the costs or interest paid to depositors. The result was fail to reject the hypothesis which
stated that loan and advance has a positive and significant impact on the financial performance of
commercial banks in Ethiopia. The finding was also consistent with Kipleting and Bokongo
(2016),Kamwaro (2013) and Mutega (2016).

45
Fixed Asset; Holding all other independent variables constant, a unit change (increase or
decrease) in fixed asset diversification would result in a factor of 0.0538 opposite direction in
financial performance (ROA) of bank diversification. This is not consistent with the expected
sign and opposes the assumption which states there is a positive relationship between asset
diversification proxy by fixed asset with other banks to asset ratio and profitability as measured
by net interest income. But since we are considering a 95% confidence level we take this
variable as marginally insignificant effect on financial performance as measured by net interest
income because the p-value is 0.114 which is above 5%. According to Olatunji and Adegbite
(2014) the study findings have indicated that investment in fixed assets have positive and
significant effect to the performance of the selected banks: the higher the level of investment in
fixed assets, the higher the profit of banks. The result of this study is consistent with the finding
of Eyerusalem (2019) on fixed asset and foreign banks deposit have only positive relationship on
financial performance of sample bank in Ethiopia. Investment in fixed assets is beneficial in a
highly inflationary country like Ethiopia, but it had a marginally inconsequential influence on
financial performance as assessed by net interest income because the p-value is 0.114, which is
over 5%. Because financial entities are restricted from investing in fixed assets. The National
Bank of Ethiopia has issued a directive on fixed asset investment, stating that no bank may invest
more than 10% of its paid-up capital in real estate acquisition and development outside of its
own premises without NBE approval.

Brooks (2008) claims that the standard error of the estimate is sometimes employed as a general
measure of the regressions fit. It's a measure for how convinced you are about the coefficient
estimate you got in the first stage. When the standard error is minimal, the test statistic's value is
high compared to when the standard error is large.

Large standard error is undesirable; everything else being equal, the smaller this quantity is the
closer is the fit of the line to the actual data. In this study, Financial asset, Cash and cash
equivalent, loan and advance and fixed asset their corresponding standard error amount were
(0.0803), (0.0823), (0.0801) & (0.0956) respectively.

Furthermore, as seen in the table above, the R-Square value, also known as the Coefficient of
Determination, is a widely used statistic to assess model fit. The square of a correlation
coefficient is specified as R-squared; it must be between 0 and 1. If this correlation is high, the

46
model fits the data well; if the correlation is low (around 0), the model does not match the data
well. The adjusted R-squared compares the explanatory power of regression models that contain
different numbers of predictors and it could control the extremes and the lateness of the model.
The value measures how well the regression model explains the actual variations in the
dependent variable (Brooks, 2008). The model's R-squared statistics and adjusted R-squared
statistics were respectively 65.1 percent and 63.2 percent. Changes in the independent variables
explain 63.2 percent of the changes in the dependent variable, according to the results of this
estimation, notably the adjusted R-Squared. This suggests that the independent variables
(financial asset, cash and cash equivalents, loan, and fixed asset) account for 63.2 percent of the
variation in profitability. As a result, the variables are good explanatory factors for determining
the influence of asset diversification on Ethiopian bank profitability. However, other factors not
included in the model accounted for the remaining 34.9 percent of changes. The result of the
study is consistence with the empirical finding of (Kipleting and Bokongo, 2016).

F-statistic and Probability of (F-statistic) are also used together to test the hypothesis that none of
the explanatory variables truly explain the dependent variable. To put it another way, the F-
statistic calculates the standard F-test of the joint hypothesis that all coefficients, except the
intercept, are equal to zero. The p-value corresponding to the reported F-statistic is displayed in
Probability (F-statistic), therefore the F-statistic in the above table was 35.02 and the Probability
(F-statistic) value (0.0410), which indicates strong statistical significance, substantially
strengthened the model's overall reliability and validity. The overall model is highly significant
at 1%, and all of the independent variables are jointly significant. According to Eyerusalem
(2019) and Samuel (2018) empirical results suggest that Asset diversification has strong and
significant effect on bank performance factors of commercial banks in Ethiopia.

Table 4.10 above shows that three explanatory variables had significant impact on Profitability
of Ethiopian commercial banks. The significant variables are financial asset, cash and cash
equivalent, and loan and advance were significant at below 5% significant level since the p-value
for those variables were (0.030), (0.018), & (0.014), respectively. Only one variable had
insignificant impact which is fixed asset is (0.114) therefore above 5% of the variables is
significant in this study.

47
 CHAPTER FIVE

5. SUMMARY, CONCLUSION AND RECOMMENDATION

5.1 Summary

The major objective of this research was to look at the impact of asset diversification on the
financial performance of Ethiopian commercial banks. The study uses quantitative techniques
and panel data analysis methodology to achieve its goals. Over the period 2011-2020, the panel
data were gathered from audited financial statements, specifically balance sheets and income
statements, of a sample of eighty observations in eight banks. The collected data were analyzed
by employing a fixed effect model using statistical package STATA 12.

This chapter discussed also the results of the data analysis and the discussion of these results
using the appropriate method. Accordingly, the chapter discussed the descriptive statistics, the
tests for the Classical Linear Regression Model (CLRM) assumptions, and the regression
analyses; they illustrate the relationship between dependent and independent variables as well as
the impact of asset diversification on the profitability of banks in Ethiopia.

In order to conduct the empirical analysis, one dependent variable and four independent variables
were selected and used by taking in to account the nature of banks operation. Net interest income
was taken as dependent variable, while the independent variables were financial asset, cash and
cash equivalent, loans & advances and fixed asset.

5.2 Conclusion

To cope with the changes in the environment, banks have been forced to effectively manage their
asset diversification to mitigate various risks that arise due to choosing the best combination of
asset diversification, Risk is inherent to any business, but it can be controlled to mitigate its
impact on profitability.

In the above result of regression analyses show that the independent factors explain 65.13 % of
the dependent variable (Net interest income) which is only less than 34.87% fluctuation of the
dependent variable can be explain by other independent variable those are not mention in the
above variable this indicate that the above independent variables are good to explained the
dependent variable.

48
According to the study's findings, loans and advances have the greatest impact on commercial
banks' profitability in Ethiopia, as well as a favorable effect. This leads us to generalize that the
spreads realized from loans and advance in the Ethiopian commercial banking market is
attractive. Financial assets, cash, and cash equivalent, on the other hand, have a negative
coefficient so this asset is not that much attractive the main reason for this effect is NBE is
enforce all Privet commercial bank in order to buy bone with 5% interest rate but a statistically
significant impact on a bank's profitability because the p-value strongly explains the dependent
variable. However, fixed asset has negative and insignificant effect on a bank's profitability.

To conclude the findings, the majority of the variables have a statistically significant impact on
the profitability of the bank.

5.3 Recommendation

The study established that even though financial assets, loans, and cash and cash equivalents
have significant impacts on the financial performance of banks, there was insignificant impact on
the bank's performance by fixed assets in the study. From these findings, it is recommended that
policymakers and decision-makers at commercial banks should give high concern and set
direction in order to set the optimum arrangement of asset diversifications so as to maximize the
bank's profit.

 Income from loans and advances are the major source of revenue for commercial banks. The
more the deposit that are transformed in to loans, the higher the profitability of banks due to
interest rate on loans are much higher than interest expense on deposits. Therefore, the loans
to total asset ratio of the sample banks during the studied period shows positive and highly
significant impact on bank profitability. Therefore from the above study result the researcher
recommend to bank manger as well as bank policy makers should be more focuses on
diversification there on asset in loan and advance because of most of bank income generate
form this asset.

 The impact of financial asset in financial performance of banks have negative coefficient
even though it’s significant impact on financial performance at significance level, this
indicated that they may have good investment in financial asset like bond and other security

49
 of asset, thus the result will assist to bank managers should focus how diversify their
financial asset in order to invest at minimum or risk free government security and bond, it
means financial asset increases a company's worth because financial assets are easily
liquidized compared to other tangible assets.

 When we see the impact of cash and cash equivalent in financial performance banks have
negative coefficient but it’s significant at 5% significance level, this indicated that banks
have to possess enough funds to meet its financial obligations and also by lending this
amount increases the interest income of the bank, thus the bank managers should focus how
diversify their cash and cash equivalent by using ROA at relatively low risk investment of
those idle money. For the reason that the impact of keeping excessive amount of cash for
unexpected circumstances as this idle money could leads to incur loss because of cost of
interest paid to the depositor.

The study is valuable to commercial bank managers as its focus is on the impact of asset
diversification on the financial performance of commercial banks in Ethiopia. The findings
would inform the managers on necessary considerations to make while selecting the degree of
asset diversification.

Further, study is valuable to the policy makers and the government institutions that regulate the
banking sector in Ethiopia. Since one of the independent variable that is fixed asset is
insignificant impact on the financial performance of bank because national bank directive all
financial entities are restricted from investing in fixed asset not more than 10% of their paid up
capital. Hence, the researcher recommends for further research into the fixed asset
diversification in banks in addition to NBE directive in order to have a detailed conclusions of
causes behind such trends.

Thus, the researcher recommends to other researcher should also focus the remaining 34.87%
variation explain the financial performance of banking industry.

50
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 Appendixes

Appendix I: List of the sample commercial Banks of Ethiopia

Sources: National Bank of Ethiopia

56
Appendix II: Descriptive statistics results

Appendix III: Correlation Matrix

_____________________________________________________________________________________

ROA FIN CASH LOAN & ADV FIXED

AS

-------------+------------------------------------------------------------------------------------------------------

ROA 1.0000

Financial Asset -0.1054 1.0000

Cash and cash Eq -0.5849 -0.5824 1.0000

Loan 0.7389 -0.5051 -0.3920 1.0000

Fixed asset 0.2237 -0.2237 -0.3370 0.4823

1.0000

57
Appendix IV: Hausman test

58
 Appendix V: Histogram for normality test
60
40
Density

20
0

-.02 -.01 0 .01 .02

Residuals

Appendix VI: Panel Data

ROA(NET Cash and cash Loan and Fixed Asset to

INTEREST Financial Asset to equivalent to Total Advance to Total Total Asset
INCOME) Total Asset Ratio Asset Ratio Asset Ratio Ratio
0.031459826 0.421331488 0.264834985 0.307174406 0.00665912
0.036817528 0.452497496 0.158049405 0.383719933 0.00573317
0.040250633 0.461059795 0.180099523 0.353491995 0.00534869
0.0387956 0.558604466 0.062084543 0.372110804 0.00720019
0.043281382 0.549935486 0.070306969 0.371950425 0.00780712
0.043621849 0.535760447 0.083510491 0.358193366 0.0225357

59
0.03839127 0.56087982 0.109339937 0.306590425 0.02318982
0.042441748 0.586985849 0.090615627 0.301439949 0.02095857
0.039818014 0.582516751 0.120046433 0.277565261 0.01987156
0.03797209 0.575188689 0.119036472 0.284503101 0.02127174
0.020612536 0.14639014 0.424681537 0.415686184 0.01324214
0.03029842 0.201711549 0.329600598 0.453730237 0.01495762
0.028490838 0.238215996 0.306926597 0.43870841 0.016149
0.027219927 0.245458583 0.297912622 0.429357207 0.02727159
0.031970498 0.291487106 0.223305426 0.457645795 0.02756167
0.029277068 0.294916549 0.240430147 0.436676544 0.02797676
0.03331971 0.312494785 0.151762373 0.511702302 0.02404054
0.045249383 0.275466855 0.155002739 0.507591483 0.06193892
0.046704765 0.262220397 0.108326423 0.575721971 0.05373121
0.05406721 0.190866876 0.135996628 0.616272043 0.05686445
0.020512653 0.194617123 0.400176655 0.37975816 0.02544806
0.034804007 0.259160489 0.245912726 0.448677328 0.0274
0.039374967 0.220651692 0.230275403 0.506924742 0.03205315
0.035171572 0.267802039 0.252653743 0.447760616 0.0317836
0.037479502 0.285560647 0.162633079 0.513832338 0.03797394
0.042662596 0.251231264 0.195622717 0.513855319 0.0392907
0.048787253 0.219252551 0.179544016 0.570567339 0.03063609
0.057765065 0.183893416 0.210470606 0.561789786 0.04384619
0.060957459 0.185731642 0.152359487 0.627778506 0.03413037
0.063652943 0.174660815 0.161695969 0.630319579 0.03332364
0.030737389 0.149807934 0.397900977 0.440399293 0.0118918
0.037252985 0.2213161 0.306221038 0.460865447 0.01159741
0.031470186 0.350385103 0.194603139 0.454967531 4.4228E-05
0.039063512 0.26445075 0.24353554 0.448814767 0.04319894
0.038698223 0.292902846 0.211064691 0.432061667 0.0639708
0.042307134 0.275294294 0.184438448 0.476086197 0.06418106

60
0.046991435 0.265259809 0.1358075 0.549944444 0.04898825
0.058112324 0.244458664 0.140436422 0.555949865 0.05915505
0.056028091 0.237892805 0.113812634 0.596045037 0.05224952
0.063182833 0.170263396 0.111728347 0.646821419 0.07118684
0.03110315 0.127294786 0.513715653 0.344604825 0.01438474
0.036784304 0.211834843 0.311639699 0.416785779 0.03702977
0.044082193 0.257156937 0.246844248 0.441138691 0.03470224
0.039704157 0.372772897 0.159153991 0.471814869 0.00309707
0.045078181 0.331967337 0.178442865 0.442838339 0.04675146
0.045590712 0.299287079 0.191317747 0.463656797 0.04573838
0.047303827 0.27963694 0.186384402 0.488570514 0.04540814
0.056419122 0.263143249 0.147817491 0.539779188 0.04926007
0.052201292 0.267610872 0.143804631 0.540674412 0.04791008
0.059206568 0.161967719 0.166762422 0.609260105 0.06200975
0.028489241 0.119286426 0.460707529 0.412419982 0.00758606
0.038757737 0.208950733 0.325788769 0.45410372 0.01115678
0.037760828 0.316558507 0.206668912 0.463354317 0.01341826
0.040074524 0.27531008 0.284963792 0.420715682 0.01901045
0.042857568 0.313507651 0.189641323 0.471852467 0.02499856
0.044271747 0.314965736 0.169005798 0.487749733 0.02827873
0.046667199 0.280217796 0.145482841 0.540929099 0.03337026
0.049568438 0.263527652 0.16149439 0.530481842 0.04449612
0.052575849 0.244235525 0.10716643 0.604754735 0.04384331
0.060786283 0.177801596 0.123746801 0.634546641 0.06390496
0.03066669 0.115492484 0.504772113 0.36863209 0.01110331
0.035391036 0.181034815 0.42187323 0.387985688 0.00910627
0.041873233 0.213742116 0.303671219 0.442137091 0.0098626
0.041232125 0.247355281 0.312704088 0.426521995 0.01341864
0.046505073 0.243702633 0.262048683 0.483084995 0.01116369
0.05116299 0.232797531 0.225860294 0.530024225 0.01131795

61
0.054767907 0.246322814 0.243365558 0.499801152 0.01051048
0.059211444 0.263797838 0.210812203 0.514961454 0.01042851
0.061222958 0.243044134 0.176970479 0.569960931 0.01002446
0.064654215 0.141647468 0.216882599 0.600385817 0.04108412
0.02431065 0.173703667 0.486723144 0.314260383 0.02531281
0.036557482 0.268196313 0.295965063 0.371464573 0.02360402
0.033502122 0.124982317 0.477695854 0.318062244 0.03729906
0.046268034 0.235036046 0.25130973 0.495721611 0.01793261
0.059983016 0.197346638 0.212608816 0.572849907 0.01719464
0.053854501 0.225285888 0.200812031 0.550682201 0.02321988
0.055051493 0.230890087 0.196735059 0.546122167 0.02625269
0.051653065 0.229446046 0.256851262 0.492221184 0.02148151
0.0496171 0.295131077 0.171560447 0.512182058 0.02112642
0.055470847 0.290025332 0.129999201 0.558855158 0.02112031

62