Hope you are doing well.
If you have been investing in stocks, it's very likely that at some point of time you must have had a banking stock like - HDFC Bank, ICICI, SBI, etc. in you portfolio.
However, before investing in any banking stock, an investor should look at certain key
performance ratios. But, unlike any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per the banking regulation). The analysis of a bank’s accounts differs significantly from any other company due to their structure and operating systems.
Therefore, in this mail, we have attempted to throw light on some of the key ratios, which are unique for banks and determine the financial stability of a bank.
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Important ratios for evaluating performance and financial stability of banks
Net Interest Margin (NIM) - For banks, interest expense is their main cost (similar to cost of raw materials for companies) and interest income is their main revenue source. The difference between interest income and expense is known as net interest income. It is the income which the bank earns from its core business of lending.
Net interest margin is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call.
Net interest margin (NIM) is an indicator of the ability of a bank to generate returns. Higher the NIM, higher the profit a bank can earn from a given pool of funds.
Non Performing Assets (NPA) - When a customer defaults on a loan (interest is outstanding for more than 90 days), the bank moves the loan to the Non-Performing Asset (NPA) basket. There are 2 forms of NPAs:
Gross NPA (GNPA) - The amount outstanding against the borrowers account (with the outstanding interest)
Net NPA (NNPA) - Gross NPA – (Provisions made on the loan + Recoveries made on the loan + other adjustments)
NPAs are a reflection of the healthiness of a bank’s loan portfolio book. Higher ratio reflects rising bad quality of loans.
Provision Coverage Ratio (PCR) - When a bank does not expect a customer to repay the loan, it sets aside a certain sum of money for the expected loss. This is known as a provision.
The key relationship in analysing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to Gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip).
CASA ratio – This is the ratio of current account and savings account deposits to the total deposit base of the bank.
The bank pays out much lower interest rates on savings accounts and current accounts than other types of deposits such as fixed deposits. Raising money this way is also cheaper than loans from other sources like RBI, money market or other banks. Hence for a given sum of money, higher the ratio more profitable is the bank.
Capital adequacy ratio (CAR) – Capital adequacy ratios are a measure of the amount of a bank's capital expressed as a percentage of its risky loans. It is a measure of how well capitalized a bank is, i.e. how easily it can withstand losses.
Applying minimum capital adequacy ratios serves to protect depositors and improve the stability and efficiency of the financial system. The RBI specifies the minimum capital adequacy ratios that all banks have to maintain. As investors, we have to expect more than just the minimum.
Credit to Deposit ratio (CD ratio) – This ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through deposits. Higher ratio reflects ability of the bank to make optimal use of the available resources.
The regulator does not stipulate a minimum or maximum level for the ratio. But, a very low ratio indicates banks are not making full use of their resources. And if the ratio is above a certain level, it indicates pressure on resources.
Return on Assets (ROA) – Return on asset ratio is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (return on equity) indicates returns earned by the bank on its total net worth (shareholder’s funds).
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