Working capital

requirements
186-192 Padmalatha Suresh- financial ratios
 Working capital
• Funds required to acquire current assets to enable
business/industry to operate at the expected levels.
• GROSS WORKING CAPITAL = CA
• These are in the system used/ consumed on a day to day
basis.
• NET WORKING CAPITAL = CA – CL= (SHF + TL) – (NFA +
NCA)
• NWC is the entrepreneur's margin available in the system
from Long term Funds
Regulations of Bank Finance
• Banks follow certain norms in granting working capital
finance to firms.
These norms are greatly influenced by the recommendations
of various committees appointed by the RBI.
• Banks followed the norms suggested by the “Tandon
Committee”.
• Further recommendations were made by the “Chore
Committee” to strengthen the procedures and norms.
The Tandon Committee Regulations
1.Operating Plan : The borrowers should prepare operating plans
and on that basis indicate the amount of working capital
finance requirement.
2.Production based financing : The bankers should finance only
the genuine production needs of borrower. The borrower
should maintain reasonable levels of inventory
andreceivables.
3.Partial bank financing : The bank should not finance the total
requirement of the borrower. Only a reasonable part of it
should be financed by the bank.
4.Reasonable level of Current Assets : The committee
further recommends that the borrower should be
allowed to maintain current assets specifically
debtors and inventories only up to a reasonable
level. Flabby, profit making or excessive
inventory should not be permitted under any
circumstance.
However, the bank also visualized the abnormal
circumstances such as strikes, power cuts etc. and
allowed flexibility to the bankers.
5.Maximum permissible bank finance (MPBF) :

The committee suggested the following three methods of

determining the MBFC.

1. The borrower will contribute 25% of the working capital gap,

the remaining 75% will be financed from bank borrowings.

W. C. Gap = CA-CL excluding bank borrowings.

2. The borrower will contribute 25% of the total current assets. The
remaining of the working capital gap will be financed by the
bank.

3. The borrower will contribute 100% of the core assets and 25%
of the balance of current assets. The remaining of the working
capital gap will be financed.
The Chore Committee Regulations

1. Reduced dependence on Bank Credit : The borrowers should contribute

more funds to finance their working capital requirements. The idea was
to place all borrowers in the 2nd method suggested by the Tandon
Committee.

2. Credit limits to be separated in to “Peak level” and “Non Peak Level”

limits :

Credit limits should be assessed and separated in to “Peak level” and

“Normal level” for borrowers with credit limits more than 10 lacs.
Borrowers should, in advance, inform the requirement of peak level
limits. Moreover, any deviation in utilization beyond 10% tolerance,
should be treated as an irregularity. Additional interest of 1% should be
charged on ad hoc borrowings.
The Chore Committee Regulations
3. Existing lending system to continue : The existing system had three types of
lending.
(a) Cash credit
(b) WCTL (WC term loan)
(C) Bill discounting.
Cash credit system should be replaced by the other two wherever possible.
Cash credit accounts of large borrowers to be scrutinized, at least once a
year.
4. Information System : The discipline regarding submission of quarterly
statements should be strictly adhered to, in respect of all borrowers having
limits of 50 lacs and above.
 Sources of WC
• Own funds
• Bank borrowings
• Sundry Creditors
• Advances from customers
• Deposits due in a year
• Other current liabilities
FACTORS INFLUENCING WORKING
CAPITAL REQUIREMENT
• Nature of business

• service/trade/manufacturing

• Seasonality of operations – peak/non peak

• Production Policy – Constant/seasonal

• Market conditions- competition/credit terms

• Conditions of supply of RM/stores/spares

• Quantum of production/Turnover(level of activity)

• Operating Cycle

• Current Assets to be maintained

Information/Data required for
assessment of working capital
• Borrowers past/projected production, sales, cost of
production, cost of sales, operating profit, etc. in order to
ascertain the financial position of the borrowers & the
amount of working capital needs to be financed by banks.
• Net worth, long term liabilities, current liabilities, fixed assets,
current assets
DATA TO BE OBTAINED

• Application
• Financial Statements of Previous years
• Estimates/ Projections (with quantitative details)
Bank Credit as a Source of Meeting
Working Capital Requirements

A].What should be the amount of working capital

assistance?
B].What should be the form in which working
capital assistance may be extended?
C].What should be the security that should be
obtained for extending the working capital
assistance?
WC finance

• A) Fund Based
Inventory finance
Bill Finance ( Post Sales Finance)
• B) Non Fund Based
Letter of Credit (LC)
Bank Guarantee.
 Fund based

• Loan
• Overdraft-company is allowed to withdraw in excess of the
balance standing in its Bank account. However, a fixed limit is
stipulated by the Bank beyond which the company will not be
able to overdraw the account
• Cash Credit: -

• In practice, the operations in cash credit facility are similar to those of overdraft
facility except the fact that the company need not have a formal current account.

• A fixed limit is stipulated beyond which the company is not able to withdraw the
amount

• Bills purchased or discounted: -

• This facility enables the company to get the immediate payment against the credit
bills raised by the company.

• The bank holds the bill as a security till the payment is made by the customer. The
entire amount of bill is not paid to the company.

• The Company gets only the present worth of the amount of bill, the difference
between the face value of the bill and the amount of assistance being in the form
of discount charges.

• On maturity, bank collects the full amount of bill from the customer.
WC loans
• Packing Credit: - This type of assistance may be
considered by the bank to take care of specific
needs of the company when it receives some
export order. Packing credit is a facility given by
the bank to enable the company to buy the
goods to be exported
 Assessment
• Proper assessment of funds required for working capital is
essential not only in the interest of the concerned unit but
also in the national interest to use the scare credit according
to production requirements.
• Inadequate levels of working capital may result in under-
utilization of capacity and serious financial difficulties.
• Similarly excessive levels may lead to unproductive use of
credit and unnecessary interest Burdon on the unit.
• Norms for inventory and receivables:
• If the bank credit is to be linked with production requirements, it
is necessary to assess the requirements on the basis of certain
norms.

• The ‘study group to frame guidelines to follow-up of bank

credit’ (Tandon Study Group) appointed by Reserve Bank of
India had suggested the norms for inventory and receivables
regarding major industries on the basis of company finance
studies made by Reserve Bank in the different industries,
discussions with the industry experts and feed-back received on
the interim report.
• The norms suggested by Tandon Study Group are being
reviewed from time to time by the Committee of Direction
constituted by the Reserve Bank to keep a constant view on
working capital requirements.
 Computation of Maximum Permissible Bank
Finance (MPBF):
• a.Bank can work out the working capital gap. i. e. total current assets less current liabilities
other than bank borrowings and finance a maximum of 75 per cent of the gap; the balance
to come out of long-term funds, i.e. owned funds and term borrowings

• b. Borrower should provide for a minimum of 25 per cent of total current assets out of long-term
funds, i.e. owned funds and long term borrowings. A certain level of credit for purchases and
other current liabilities inclusive of bank borrowings will not exceed 75 per cent of current
assets.

• Borrower’s contribution from long term funds would be 25 per cent of the working capital gap
under the first method of lending and 25 per cent of total current assets under the second
method of lending.

• The above minimum contribution of long-term funds is called minimum stipulated Net Working
Capital (NWC) which comes from owned funds and term borrowings.
• In the first method, the borrower has to provide a minimum of 25 per cent of working capital gap from ling-term funds
and it gives a minimum current ratio 1.17:1.

• In the second method, the borrower has to provide a minimum of 25 per cent of total current assets from long-term
funds and gives a minimum current ratio of 1.33:1.
• While estimating the total requirement of long-term funds for new
projects, financial institutions/banks should calculate for working
capital on the basis of norms prescribed for inventory and
receivables and by applying the second method of lending.
• A project may suffer from shortage of working capital funds if
sufficient margin for working capital is not provided as per the
second method of lending while funding new projects.
Assessment Methods

• Operating Cycle Method

Service Sector
Traders
Manufacturing Activity
• Drawing Power Method
• Turnover Method
• MPBF method (II method of lending) for limits of Rs
6.00 crores and above
• Cash Budget method (Reason: Based on
procurement and cash inflow)
Seasonal Industries (Sugar/ Rice
Mills/Textiles/Tea/Tobacco/Fertilizers)
Contractors & Real Estate Developers
Educational Institutions
Operating Cycle Method
• Working capital requirement
Operating expenses/ No. of operating cycles in a year

A. Length of operating Cycle

a. Procurement of Raw Material 30 days
b. Conversion / Process time 15 days

c. Average time of holding of FG 15 days

d. Average Collection Period 30 days
e.Operating Cycle (a+b+c+d) 90 days

f. Operating Cycle in a year (365days/e) 4 cycle

B. Total Operating Expenses per Annum Rs 60.00 lakhs
C. Total Turnover per Annum Rs 70.00 lakhs
D. Working Capital Requirement = Total Operating Expenses
(B)/ No. of operating Cycle (f as said earlier) Rs 15 lakhs
 Drawing Power Method

Particulars Stock value (lakh) Margin DP (lakh)

Paid stocks (RM-Creditors) 4 25% 3
Semi Finished goods 4 50% 2
Finished goods 4 25% 3
Book debts 4 50% 2
Total 16 10
Working capital finance
• Methods to assess WC requirements of borrowers.
• Projected Turnover Method: where fund-based WC requirements
are less than 2 crores.
• Assess at 25% of the projected turnover to be shared between
borrower and bank (borrower contributes 5% of turnover as NWC
and bank providing finance at minimum of 20% of the turnover).
• Alternatively, bank may use traditional method- cash-to-cash
cycle to determine capital requirements.
• If the credit requirement based on traditional processing cycle is
higher than that assessed on projected turnover, the bank at its
discretion, sanction the former as the credit limit, as the borrower
can be financed up to a minimum of 20% of the projected annual
turnover of the firm.
 Turnover Method
Applicable for limits upto Rs.6 crores
A Sales Turnover
B 25% of sales Turnover
C 5% of Sales Turnover projected as margin
D Actual NWC existing as per Last Financial Statement
EB–C
FB–D
G MPBF (E or F whichever is less)
H Additional margin to be brought in (C-D)
 COMPUTATION OF MPBF ON TURNOVER METHOD Rs. Lacs

Last Year’s Estimates for the Following

Audited current year Year Proj.
ending

Year Ending 2017-18 2018-19 2019-20

1 Net Sales 2000 2400 3000
2 25% of Net Sales is WC requirement 500 600 750
3 5% own margin from long term sources 100 120 150
4 MPBF 400 480 600
• Speed up credit sanctions for small/needy borrowers, without
diluting creditworthiness of borrowers
• Ask for borrower’s projections- scrutinise annual statements of
accounts, returns filed with sales tax/revenue authorities, ensure
that estimated growth is realistic.
• If NWC is 7 L, PBF 8L
• If actual WC is 20L, increase PBF, after deducting the requisite
margin

1.Projected turnover for the coming year 60 L

2. Gross WC (assessed at 25% of 1st line) 15 L

3. Borrower’s margin (min 5% of 1 or projected NWC, 3L

whichever is higher)
4. PBF (2-3) 12 L
 MPBF Method
(Tandon’s II method of lending)
A Current Assets
B Current Liab. other than Bank Borrowings
C Working Capital gap (A-B)
D Minimum Stipulated NWC (25% of CA excluding export receivables)
E Actual/projected NWC
FC–D
GC–E
H MPBF (F or G whichever is less)
I Excess borrowings/short fall in NWC (D-E)
Excess borrowing ( short fall in NWC ) shall be ensured by additional
funds to be brought in by the applicant or by additional bank
finance over MPBF
 COMPUTATION OF MPBF METHOD I Rs. CRORE

PROJECTED YEAR

1 Net Sales 200

2 Total Current Assets 100
Total Current Liabilities (Other than Bank
3 borrowings) 20
4 Working Capital Gap( 2-3) 80
5 Min. required margin (25% of WCG) 20
6 Maximum Permissible Bank Finance (4-5) 60

CURRENT RATIO
CA 100
CL 80
C/R 1.25
 COMPUTATION OF MPBF METHOD II Rs. CRORE

PROJECTED YEAR

1 Net Sales 200

2 Total Current Assets 100
Total Current Liabilities (Other than Bank
3 borrowings) 20
4 Working Capital Gap( 2-3) 80
Min. required margin (25% of CA
5 excluding export receivables) 25
6 Maximum Permissible Bank Finance (4-5) 55

CURRENT RATIO
CA 100
CL 75
C/R 1.33
Important aspects of MPBF

• Production/Sales estimates
• Profitability estimates
• Inventory/receivables norms
• Build up of Net Working Capital
 The permissible bank finance
method
• For over 2 crore; Banks decide minimum current ratio and determine wc requirements
according the perception of borrowers and their credit needs.

• Use cash flow projections or retain MPBF with necessary modifications; Ratios used to assess
reasonableness of the projections and the borrower’s capacity to repay.

• NWC/TCA

• Bank borrowings/TCA

• Sundry creditors/TCA

• Other current liabilities/TCA

• Inventory/sales (no. of days)

• Receivables to sales (no. of days)

• Trade creditors/purchases (no.of days)

• WC gap (WCG)= TCA (total current assets)-CL

Financing receivables

• Book debts or bills

• Book debts are part of assessed overall credit
limits
• Bills-self-liquidating instruments and financed
separately- banks agree to purchase/discount
bills
 Cash budget
• Statement showing forecast of cash receipts, cash payments
and net cash balance over a period of time
• Months-> 1 2 3 4 5 6 7 8 9 10 11 12
• Cash Receipts
• Cash Payments
• Surplus/deficit
• Peak deficit is financed and drawings regulated by monthly
budgets
Cash budget method
• For borrowers with fund-based limits of over 10 crore- construction industry, trade/service
sectors

• WC- determined by projected cash flows, not from projected assets and liabilities.

• Credit restricted to the peak level gap between cash inflows and outflows in the cashflow
projections.

• Maximum bank finance- peak gap of the four quarters; funds drawn as per
monthly/quarterly cash deficit in the projected cash flow after reporting the actual cash
flows during the preceding period.

• If significant changes in cash flows, submit revised cash flow budget-borrowing capped by
the assessed gap.

1. Total cash outflows from operations

2. Total cash inflows to operations

3. Cash gap in operations

4. Less: cash to be brought in from other sources (cash surplus under non-business
operations/capital accounts/sundry items

5. Net cash gap from operations

• Advantages:
Suitable for seasonal industries, contractors, software exporters
• Limitations:
• Will not reflect changes in various current assets and liabilities.
• Will it give a clue whether a company is earning profit or not.
• Funds flow statement is required to detect any diversion of funds.
Loan delivery system
• Objectives
• Loan delivery system (Fund based W/C limits of
Rs.10 crores & above from banking system)
Cash Credit - 20%
Demand Loan – 80%
• Domestic Credit portion to be bifurcated into
• loan component and Cash Credit
 Bill Finance -Post Sales Finance
(For Genuine Trade & Manufacturing Transactions)

DBPs (demand Bill purchase): Bills of Exchange accompanied with

I) Invoice and
ii) Documents of title of the Goods
A. Invoice– Maximum Tenor 180 days
B. Bill of Exchange / Promissory Notes
- Eligibility Carved out of MPBF
A. Export Bills :
- Security – Export Documents drawn against confirmed orders /
LCs
Book Debts Finance :
A. Service Industry / Contractors
B. Margin 50%
C. Age not more than 90 days
D. Collateral Security – 200% Urban / Semi Urban Security.
Current Ratio (CA/CL)
(norm – 1.15 upto Rs.6 crores/1.33 for above)
Adjusted Current Ratio
(reduce export bills discounted from CA)
Total debt equity (TOL/TNW)
(Maximum norm : 6)
Gearing Ratio (for NFB non-fund based
Limits) maximum norm 10
Total Outside Liabilities + 100% of NFB Limits
---------------------------------------------------------------------------

Net Worth – (NCA+ Investments in associate concerns)

TOL (excluding Sundry creditors representing stocks procured under
LC/BG and mobilisation advance outstanding against BGs)
NW (excluding Intangible Assets)

NCA (excluding advances given for capital goods for business

purpose)
Financing capital and non-
operating expenditure
• Instalment credit- loan is repaid I periodic instalments-term loans

• Finance projects/asset purchases

• DCF valuation methodology applied to assess the financial viability of projects

• Debt service coverage ration is used

• P2P lending-a separate category of NBFCs-crowd funding with financial returns

• Use online platform to bring lenders and borrowers together- unsecured finance

• Borrowers creditworthiness is assessed, fee is paid by borrowers and lenders to the platform-
flat interest as fixed by the platform or dynamic models (cost plus model)

• Rates are lower than moneylenders/unorganised sector; lenders get high return than
savings account.

• Banned in Japan, Israel; regulated as banks in France, Germany, Italy; exempt from
regulation in China/south Korea.
Exposure Norms for some
Categories
• Category Ceiling on borrowings
• Constructions contractors
• FB + NFB limits shall not exceed 15 times net owned funds
• Housing Finance Institutions
• Borrowings shall be restricted to 3 times the net owned
funds
Non fund based limits
• Letter of credit
ILC/FLC
Usance/Sight
• Bank Guarantee
Performance
Financial – Bid Bonds/Security Deposits/
Mobilisation advance/retention money
• Deferred Payment Guarantee
 Bank guarantee
• Suppose Company A is the selling company and Company B is the purchasing
company.

• Company A does not know Company B and as such is concerned whether

Company B will make the payment or not. D is the Bank of Company B, opens the
Bank Guarantee in favour of Company A in which it undertakes to make the
payment to Company A if Company B fails to honour its commitment to make the
payment in future.

• As such, interests of Company A are protected as it is assured to get the payment,

either from Company B or from its Bank D.

• As such, Bank Guarantee is the mode which will be found typically in the seller’s
market.

• As far as Bank D is concerned, while issuing the guarantee in favour of Company A,

it does not commit any outflow of funds. As such, it is a Non-Fund Based Lending for
Bank D.
• If on due date, Bank D is required to make the payment to Company A due to
failure on account of Company B to make the payment, this Non-Fund Based
Lending becomes the Fund Based Lending for Bank D which can be recovered
by Bank D from Company B.

• For issuing the Bank Guarantee, Bank D charges the Bank Guarantee
Commission from Company B which gets decided on the basis of two factors-
what is the amount of Bank Guarantee and what is the period of validity of
Bank Guarantee.

• In case of this conventional for of Bank Guarantee, both company A as well as

Company B get benefited as it is able to make the credit purchases from
Company A without knowing Company A.

• Bank Guarantee transactions will be applicable in case of credit transactions

 LC
• The non-fund based lending in the form of letter of credit is very
regularly found in the international trade. In case the exporter and
the importer are unknown to each other.
• Under these circumstances, exporter is worried about getting the
payment from the importer and importer is worried as to whether he
will get the goods or not.

• In this case, the importer applies to his bank in his country to open a
letter of credit in favour of the exporter whereby the importer’s bank
undertakes to pay the exporter or accept the bills or drafts drawn by
the exporter on the exporter fulfilling the terms and conditions
specified in the letter of credit.
LC assessment

1 Annual purchase/import FLC (Foreign LC)/ILC (Inland LC)

2 Out of (1) on credit basis
3 Out of (2) on usance LC basis
4 Average of (3) per month
5 Lead time (no. of months)
6 Usance period (no. of months)
7 Usance LC requirement (5+6) X (4)
• For constituents borrowers with regular sanctioned credit
facilities for genuine transactions.
• LCs shall not be opened with clause without recourse to
drawer.
• Bank Guarantees:
Performance and Financial Guarantees
Security: Cash Margin +Counter Guarantee +Collateral
Security (Immovable / Liquid Security)
Restrictive Clause.
Forms
1. Particulars of the existing/proposed limits from the banking system
(form I)

Particulars of the existing credit from the entire banking system as also
the term loan facilities availed of from the term lending institutions/banks
are furnished in this form.

Maximum & minimum utilization of the limits during the last 12 months
outstanding balances as on a recent date are also given so that a
comparison can be made with the limits now requested & the limits
actually utilized during the last 12 months.
• 2. Operating Statement (Form II)
• The data relating to last sales, net sales, cost of raw material,
power & fuel, direct labour, depreciation, selling, general
expenses, interest, etc. are furnished in this form.

• It also covers information on operating profit & net profit after

deducting total expenditure from total sale proceeds.
• 3. Analysis of Balance Sheet (Form III)
• A complete analysis various items of last year’s balance sheet,
current year’s estimate & following year’s projections is given, in
this form.

• The details of current liabilities, term liabilities, net worth, current

assets, other non-current assets, etc. are given in this form as per
the classification accepted by banks.
• 4. Comparative statement of current assets & current liabilities (Form
IV)
• This form gives the details of various items of current assets and
current liabilities as per classification accepted by banks.

• The figures given in this form should tally with the figures given in the
form III where details of all the liabilities & assets are given.
• In case of inventory, receivables and sundry creditors; the
holding/levels are given not only in absolute amount but also in
terms of number of month so that a comparative study may be
done with prescribed norms/past trends.
• They are indicated in terms of numbers of months in bracket below
their amounts.
• 5. Computation of Maximum Permissible Bank Finance (Form
V)

• On the basis of details of current assets & liabilities given in

form IV, Maximum Permissible Bank Finance is calculated in
this form to find out credit limits to be allowed to the
borrowers.

• 6. Fund Flow Statement (Form VI)

• In this form, fund flow of long term sources & uses is given to
indicate whether long term funds are sufficient for meeting the
long term requirements.

• In addition to long term sources and uses, increase/decrease

in current assets is also indicated in this form.
 59
Recommended Margins:

Approved Securities Minimum Margin (%)

1 FDR held in the name of the borrowers 10

2 Fixed deposits in the name of the third party 25

3 Gilt edged securities viz., bonds / stocks issued by 25

Central/ State Government/Statutory/quasi-Government

Corporation or Body repayment of which is guaranteed by

the Central/ State Government (including Post office)

4 National Saving Certificates with accrued value 20

5 Surrender value of Life Insurance Policies issued by LIC 10

of India and other Life Insurance Companies.

6 Kisan Vikas Patra (KVP) with accrued value 25

7 Shares and debentures (on Bank’s approved list – In Dematerialized form 50

8 Stocks of tradable commodities / goods having realizablevalue (RM, SIP, FG) 25

9 Book Debts.

- For Book debts Up to 90days 25

- For Book debts beyond 90 days and up to 180 days 35

10 Plant and Machinery (New) 25

11 Plant and Machinery (Secondhand) 40 (of residual value of second hand machinery).

12 Bills of Exchange with Documents / acceptances Nil

13 Gold Ornaments 40

14 Vehicles 25

15 Furniture / Fixtures 25

16 Consumer durables 25

17 Live Stocks 25

18 Land and Buildings / Free Hold Plots 40

 61
While considering fresh/ new credit proposals the following Financials shall be kept in view:
Ratio Benchmark
Current Ratio 1.33
Current Ratio (Trading) 1.20
Current Ratio (Seasonal Industry) 1.00
Current Ratio (NBFC-MFI) 1.11
TOL/TNW 5:1
TOL/ATNW 4:1
TOL/TNW (Trading) 6:1
TOL/TNW (NBFC/MFI) 8:1
TOL/TNW (Infrastructure Projects) 7:1
Debt-Equity TL (other than Infra) 3:1
Debt-Equity TL (Infra, SEZ & SPVs created for Infra ) 5:1
Bank Borrowing/TNW 4:1
DSCR-Debt service coverage ratio(Avg.) 1.5
Interest Coverage Ratio 2.1
Asset Coverage Ratio (ACR) 1.5:1
Fixed Assets Coverage Ratio (FACR) 1.5:1
TOL/ TNW + Quasi Equity 4:1
(Quasi Equity= Unsecured Loans equal to 100% of
TNW)
Bank allows deviations in the above ratios, if it is
properly justified. Powers of deviations in the
above ratios falls with various higher authorities
committee.
Financial performance of
banks
 Introduction
• Banks today are under great pressure to perform due to ever rising
expectations of their
• Stockholders, Employees, Depositors etc.

• Banks entry in open market for funds raising means their financial
statements are being scrutinised by investors and general public
regularly

• As a result there is a need of performance evaluation not only for banks

itself but whole community of stockholders, employees, depositors,
borrowing customers, and government regulators.
Introduction
• Two important dimensions for any bank-profitability and
risk

• Some banks want to grow faster and achieve some long

range growth objectives. Others seem to prefer a quiet
life, minimising risk and conveying the image of a sound
bank but with modest rewards for their shareholders

• If stock fails to rise in value correspond to stockholders

expectations, current investors may seek to unload their
shares and the bank will have difficulty in raising new
capital to support its future growth.
Value of the Bank’s Stock

Po= Expected stream of future stockholder dividends 

Discount factor (based on the minimum required market
rate of return on equity capital given each bank
perceived level of risk)


E(D t)
P0  
t 0 (1  r) t

E(Dt)= expected dividend stream

r = cost of capital ~ risk free return + equity risk premium
Value of a Bank’s Stock Rises
When:
• Expected Dividends Increase
• Risk to the Bank Falls
• Combination of Expected Dividend
Increase and Risk Decline
 Profitability Ratios in Banking

• Bank Profitability: The net after tax income or net earning

of a bank (usually divided by a measure of bank size).
• Some of key ratios are given below:

Net Income After Taxes

Return on Equity Capital (ROE) 
Total Equity Capital

Net Income After Taxes

Return on Assets (ROA) 
Total Assets

Net Interest Income

Net Interest Margin 
Total Assets
Profitability Ratios in Banking

Net Noninteres t Income

Net Noninteres t Margin 
Total Assets

Total Operating Revenues -

Total Operating Expenses
Net Bank Operating Margin 
Total Assets

Net Income After Taxes

Earnings Per Share (EPS) 
Common Equity Shares Outstandin g
Profitability Ratios in
Banking
• Banks normally borrow from savers and lend to the
investors.
• A key measure of the success of this intermediation
function is certainly the spread between the yield on
average earning assets to the cost rate on interest-
bearing sources of funds.
• That is, to measure the true cost of intermediation, we
must look at:
• Yield Spread = (Percent yield on average earning assets --
Percent cost on interest-earning sources of funds)
Profitability Ratios in
Banking
• Are ROA and ROE equal good proxies for the return
of ownership of a financial institution? Does it
matter which earnings ratio we use?
• The answer is yes, because ROA and ROE reveal
different information about a bank or other financial
institution.
• ROA is a measure of efficiency. It conveys
information on how well the institution’s resources
are being used in order to generate income.
Profitability Ratios in
Banking
• ROE is a more direct measure of returns to the
shareholders.
• Since the reward to the owners are a key goal for
the whole organization, ROE is generally superior
to ROA as a measure of profitability.
• ROE is strongly influenced by the capital structure
of a financial institution, in particular, how much
use it makes of equity financing.
Profitability Ratios in
Banking
• Management may be able to boost ROE simply
by greater use of financial leverage- that is,
increasing the ratio of debt to equity capital.
ROE = ROA x (total assets/total equity capital)
or equivalently,
ROE=ROA x ((total equity+total debt) / total
equity)
Profitability Ratios in
Banking
• The elements which make up ROE can be
derived by multiplying together three other
financial ratios:
• Ratio of net income to total operating income
(revenue). This is known as the profit margin.
• Ratio of operating income to total assets--known as
asset utilization ratio.
• Ratio of total assets to equity capital--known as equity
multiplier.
• ROE=(NI/TE) = (NI/OI) x (OI/TA) x (TA/TE)
Profitability Ratios in
Banking
• ROE = (Profit margin x Asset utilization x
Equity multiplier)
• The importance of the above formula is that it
can aid management in pinpointing where the
problem lies if a financial institution’s ROE is lower
or falling.
• For example, if the profit margin is falling, this
implies that less net income is being recovered
from each rupee of operating revenue.
Profitability Ratios in
Banking
• The causes of this problem would be due to:
• lack of adequate expense control
• below-par tax management practices
• inappropriate pricing of services
• ineffective marketing strategies
• If ROE, is low or declining due to a decreasing asset
utilization ratio- need to review the institution’s asset
management policies-particularly the yield and mix of its
loans and security investment and the size of its cash or
liquidity.
Profitability Ratios in
Banking
• Finally, the equity multiplier sheds light on the
financing mix of the institution -- what proportion
of assets are supported by owner’s equity
(particularly stock and retained earnings) as
opposed to debt capital.
Breakdown Analysis of ROE

ROE = Tax management efficiency x Expense control efficiency

x Asset management efficiency x Funds management
efficiency
Breakdown Analysis of Bank’s
ROA

ROA = Interest margin + Non-interest margin – Special

income margin
• (Where special income and expense items = Provision for
loan losses + taxes + securities gain or losses +
extraordinary income or losses)
Bank Risks

• Credit Risk
• Liquidity Risk
• Market Risk
• Interest Rate Risk
• Earnings Risk
• Solvency Risk
 Credit Risk

• The Probability that Some of the

Bank’s Assets Will Decline in Value
and Perhaps Become Worthless
 Credit Risk Measures
1. Non-performing Loans/Total Loans

2. Net Charge-Offs (Written Off Loans)/Total Loans

3. Provision for Loan Losses/Total Loans

4. Provision for Loan Losses/Equity Capital

5. Total Loans/Total Deposits

Credit Risk

• Total loans to total deposits: As this ratio

grow, banks examiners may become more
concerned because they may endanger
the interest of depositors.
• Non-performing loans to total loans and
leases: The rise in this ratio signals that bank’s
credit risk is increasing. If this ratio persistently
rise, then bank’s failure may be just around
the corner.
• Annual provision for loan losses/Total loans
and leases: The increase in this ratio signals
that the management is having enough
funds to control the bad loans. More is
better.
Liquidity Risk

• Probability the Bank Will Not

Have Sufficient Cash and
Borrowing Capacity to Meet
Deposit Withdrawals and Other
Cash Needs
 Liquidity Risk Measures
1. Purchased Funds (Eurodollars, large value certificate of
deposits (CDs) and commercial papers)/Total Assets)

2. Net Loans/Total Assets

3. Cash assets and Due from Banks/Total Assets

4. Cash assets and Government Securities/Total Assets

Liquidity Risk

• Net loans to total assets: Higher the value of

the ratio, lower cash available and higher
chance to liquidity crunch.
• Cash and due to total assets: The higher the
value higher the liquidity. More is better.
• Cash asset and government securities to
total assets: Higher the value, more easily the
bank can convert these securities into cash.
More is better.
• Purchased funds to total assets: Higher use of
purchased funds increase the chances of
liquidity crunch
Market Risk

• Probability of the Market

Value of the Bank’s
Investment Portfolio
Declining in Value Due to a
Rise in Interest Rates
 Market Risk Measures

1. Book-Value of Assets/ Estimated Market Value of Assets

2. Book-Value of Equity/ Market Value of Equity

3. Market Value of Bonds/Book-Value of Bonds

4. Market Value of Preferred Stock and Common Stock

 Interest Rate Risk
• The Danger that Shifting Interest
Rates May Adversely Affect a
Bank’s Net Income, the Value
of its Assets or Equity
 Interest Rate Risk Measures

1. Interest Sensitive Assets/Interest Sensitive Liabilities

2. Uninsured Deposits/Total Deposits
 Earnings Risk

• The Risk to the Bank’s Bottom Line –

Its Net Income After All Expenses
 Earnings Risk Measures

1. Standard Deviation of Net Income

2. Standard Deviation of ROE

3. Standard Deviation of ROA

Solvency or Default Risk
• Probability of the Value of the
Bank’s Assets Declining Below
the Level of its Total Liabilities.
• The Probability of the Bank’s
Long Run Survival
 Solvency Risk Measures
1. Stock Price/Earnings Per Share

2. Equity Capital/Total Assets

3. Purchased Funds/Total Liabilities

4. Equity Capital/Risk Assets

Solvency/Default Risk

• PE: This ratio often falls if investors come to

believe that a bank is undercapitalised
relative to the risks it has taken on.
• Ratio of equity capital to assets: A decline in
equity funding relative to assets may indicate
increased risk exposure for the banks
shareholders and debtholders.
• Ratio of equity capital to risk assets: It reflects
how well current bank capital covers
potential losses from these assets most likely
to decline in value.
Interest Rate Risk

• Ratio of interest sensitive assets to interest sensitive

liabilities: When interest sensitive assets exceeds
interest sensitive liabilities in a particular maturity
range, a bank is vulnerable to falling interest rate.
Same is the case for opposite.
Earning Risk

• Standard Deviation: The higher the standard

deviation or variance of bank income, the more
risky the banks earning picture is.
Some analysts criticize traditional earnings
measures such as ROE, ROA, and EPS because they
provide no information about how a bank’s
management is adding to shareholder value.

• If the objective of the firm is to maximize

stockholders’ wealth, such measures do not
indicate whether stockholder wealth has
increased over time, let alone whether it has
been maximized.
• Stern, Stewart & Company has introduced the
concepts of market value added (MVA) and its
associated economic value added (EVA) in an
attempt to directly link performance to
shareholder wealth creation.
Market and economic value added

• MVA represents the increment to market value and is

determined by the present value of current and expected
economic profit:
MVA = Mkt Value of Capital - Hist. Amt of Invested Capital
• Stern Stewart and Company measures economic profit with
EVA, which is equal to a firm's operating profit minus the
charge for the cost of capital:
EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge
where the capital charge equals the product of the firm’s
value of capital and the associated cost of capital.
 Difficulties in measuring EVA
for the entire bank
• It is often difficult to obtain an accurate measure of a firm's cost
of capital.
• The amount of bank capital includes not just stockholders'
equity, but also includes loan loss reserves, deferred (net) tax
credits, non-recurring items such as restructuring charges and
unamortized securities gains.
• NOPAT should reflect operating profit associated with the
current economics of the firm. Thus, traditional GAAP-based
accounting data, which distort true profits, must be modified to
obtain estimates of economic profit.