Bank Administration

Ratio Analysis
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• Frequently used measures of rate of return for
financial institutions
– ROA and ROE
• ROA = Net income / Total assets
• ROE = Net income / Total equity
– Total assets are a measure of the total resources available
to the institution. Total equity capital includes:
• Value of any stock issued (including surpluses)
• Retained earnings
• Reserves held for future contingencies
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• 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.
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• 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.
• One point should be obvious here: ROE is
strongly influenced by the capital structure of
a financial institution, in particular, how much
use it makes of equity financing.
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• Management may be able to boost ROE simply
by greater use of financial leverage- that is,
increasing the ratio of debt to equity capital.
This can be seen clearly if we note that
ROE = ROA x (total assets/total equity capital)
or equivalently,
ROE=ROA x ((total equity+total debt) / total
equity)
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• The elements which make up ROE can be derived
by multiplying together three other financial
rations:
– 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)
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• 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 dollar
of operating revenue.
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• 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
• However, if ROE, is low or declining due to a decreasing
asset utilization ratio, we 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.
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• 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.
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• The elements which make up ROA can be
derived by the following way:
– ROA= (NI/TA) = (Interest revenues / TA) -- (Interest
expenses / TA) + (Noninterest revenue / TA) -- (Noninterest
expenses / TA) -- (Taxes / TA) + (Provision for possible loan
losses / TA) + (Income or losses from special nonrecurring
transactions / TA) + (Securities gains or losses / TA)
• By analyzing the changes overtime in each component of ROA
we can readily identify what has caused that earnings ratio to
rise or fall. If change is unfavorable, the management can take
remedial action.
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• Alternative measures of a financial institution’s rate of
return
– Facing with increasing tax rates, many financial institutions have
developed great proficiency at reducing their tax liabilities
through the use of allowable tax shelters, such as:
• investment in tax-exempt municipal bonds
• leasing and depreciation of capital assets
• development of foreign sources of income which results in domestic tax
credit
• accelerated depreciation on bank assets
• tax - free allocations to reserves for loan losses and other future
contingencies.
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• Therefore, financial analysts seek an indicator
of an institution’s net earnings that truly
reflects the efficiency of the institution in
generating revenues and in controlling
expenses, independent of tax considerations.
• Two possible earnings candidates which net out
at least some of the impact of tax management
decisions are the following:
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• Income before securities gains or losses
(IBSG) = (Income before securities gains or
losses / TA)
• Restated income before securities gains or
losses (RIBSG) = {[Income before securities
gains or losses + provision for possible loan
losses -(losses charged to loan allowance -
recoveries on charged-off loans credited to
loan loss allowance)] / TA}
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• For banks securities gains are treated as ordinary
income (not capital gains) for tax purposes.
However, losses on securities trading may first be
deducted from any gains on securities as an offset
to earnings from regular operations.
• For example, a bank experiencing rapid growth in
income from loans can frequently reduce its
exposure to taxes by selling at loss bonds held in its
investment portfolio.
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• Another earnings measure which gives us some
indication of the efficiency of operations and
which nets out other tax- management effects is
the net operating margin (NOM).
– NOM = [(total operating income - total operating
expenses) / TA]
– NOM is a measure of operating efficiency - how well
management controls expenses so that more revenues
flow through to net income.
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• Some analysts also see it as a reflection of the
effectiveness of a financial institution’s
marketing program.
• Indirectly, it provides information relevant to
such questions as:
– Are we pricing our services correctly?
– Is our marketing program reaching the customers?
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• A related measure favored by many
analysts is the Revenue - to - Income ratio:
– RTO = (Total operating income / Net Income)
– This ratio gives us a further index of the
effectiveness of the institution’s cost-control
program.
– It reflects how well management is able to squeez
net earnings out of each dollar of revenue
received by the institution.
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• 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)
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• The next ratio is Net Income Margin (NIM) which
is basically the difference between revenue
generated by interest-bearing assets (loans and
investments) and the interest cost of borrowed
funds expressed as a percentage of either average
total assets, or as some analysts prefer, average
earning assets. Thus,
– NIM = [(Total income from interest-bearing loans and
investments -- Total interest cost on borrowed funds) / TA].
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• Internal and External factors affecting the
earnings of financial institutions:
– The rate of return earned by a financial institution is
affected by numerous factors. The key external factors
affecting earnings are as follows:
• changes in the technology of service delivery
• competition from bank and nonbank institutions
• laws and regulations
• government economic and monetary policies
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• Management can not control these external factors.
The most it can do is to anticipate future changes in
these outside influence and to try to position the
institution to take advantage of expected
developments.
• While the management of a bank may have difficulty
in responding to external pressure on the institution’s
net earnings, it can change many internal factors to
move the organization closer to its goals.
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• Internal factors affecting earnings:
– Efficiency in use of resources
• productivity of human and other resources
• income-earning power of assets
• character of service technology
• size of organization
– Control of expenses
• interest costs on deposits
• cost of nondeposit borrowing
• employee costs
• overhead and other expenses
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– Tax management policies
• timing of income and losses
• tax-exempt investments
• depreciation of assets
– Liquidity position
• composition of assets
• composition of deposits and other funds sources
– Risk position
• use of financial leverage
• composition and quality of assets
• losses on loans and other assets
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• Ratios on efficiency in use of resources
– In general, greater efficiency is indicated by how well expenses are
controlled relative to revenues and how productive each employees
is in terms of revenues and income generated, assets managed, and
accounts handled.
– Improvements in efficiency can be achieved by:
• installing new labor-saving machinery
• expanding the overall size of the organization to take advantage of
any economies of scale.
– Among the most popular indicators of how efficient a bank or other
financial institution is in using human and other resources are levels
and trends in the following ratios:
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• Ratios on efficiency in use of resources:
– (Total operating expenses / Total operating revenue)
– (Total assets / Number of full-time employees)
– (Total deposits / Number of full-time employees)
– (Total revenue / Number of full-time employees)
– Net income / Number of full-time employees)
– (Salaries and wages expenses / Number of full-time employees)
– (Interest and fees on loans / Total loans outstanding)
– (Income from security investment / Total security investment)
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• Ratios on controlling expenses
– Related to efficiency is how well management can keep
expenses under control in order to protect earnings.
– The greatest challenge in this area for the managers of
banks in recent years is control of the cost of funds--both
deposit and nondeposit borrowing and of salaries and
wages (including fringe benefits).
– Among the most important expense-control indicator
ratios are the following:
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– (Total interest expenses / Total earning assets)
– (Total interest expenses / Total time & savings deposits &
nondeposit borrowings)
– (Interest on deposits / Total operating expenses)
– (Interest on nondeposits borrowings / Total nondeposit
borrowings)
– (Payroll costs / Total operating expenses)
– (Net occupancy, furniture & equipment expenses / Total
operating expenses
– (Other operating expenses / Total operating expenses)
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• Tax management policies:
– Tax shelters are extremely important to many financial
institutions today as aids in achieving annual earnings
targets.
– Among the most widely used indicators of the effectiveness
of tax management policies are the following rations:
• (Investment in tax exempt assets / Total assets)
• (Earnings from tax-exempt assets / Total tax-exempt assets)
• (Total income tax payments / Income before taxes)
• (Total income tax payments / Total operating expenses)
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• Achieving a desirable liquidity position:
– One of the most pressing concerns for any financial institution
is the prospect of a cash out--not having sufficient cash
available when it is demanded.
– Liquidity policies are linked directly to earnings.
– Assets held to meet liquidity need generally carry the lowest
yields. Thus,
– The maintenance of high levels of liquidity usually reduces
earnings. An institution can often maximize its rate of return
by minimizing holdings of liquid assets, but only by accepting a
greater risk of a cash out, which can be expensive to make up.
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• Important measures of the liquidity position of a financial
institution include:
– (Cash & deposits due from other inst. / Total assets)
– (U.S. Govt. securities / Total assets)
– (Federal agency securities / Total assets)
– (Money market assets / money market liabilities)
– (Total demand deposits / Total time and savings
deposits)
– (Large negotiable CD’s / Total deposits)
– (Nondeposit borrowings / Total liabilities)
– (Total loans / Total assets)
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– (Business loans / Total assets)
– (Loans to individuals / Total loans)
– (Real estate loans / Total loans)
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• Establishing a suitable risk position:
– One area of critical concern to the management of any
financial institution is risk.
– Bank can reduce risk to some extent by such devices as:
• hiring competent management
• spreading their loans and security investments over a large
group of borrowers
• selling their services in a variety of markets with different
economic characteristics, and
• insuring against certain kinds of loss.
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• Among the more popular barometers of risk for banks and
other financial institutions are the following ratios:
– (Total equity capital / Total loans)
– (Total equity capital / Total deposits)
– (Total equity capital / Total assets)
– (Annual provisions for loan losses / Annual net loan losses)
– [(Income before taxes and securities + Annual provision for
loan losses) / Annual net loan losses)]
– (Net loan charge-offs / Total loans
– (Allowance for possible loan losses / Total loans)