Unlike other sectors, Banking sector companies have a different way to analyze it and why not? Most of the sectors have inventories to sell. For ex- Tyre industries sell numerous kinds of tyres to generate revenue, automobiles companies sell cars, trucks, bikes etc. but for the banking sector, they have nothing to sell as a tangible product.
They take deposits from you, put some necessary amount aside (18.25% as SLR and 3% as CRR) and try to lend the rest of the money to the borrowers so that they can charge them interest (more than they give interest to its depositors) and make some profits.
So, here is the list of 10 useful tools to analyze a bank in less than 10 minutes:
I will take the example of Kotak Mahindra Bank (2019 Annual Report)
1. Net Interest Income
Net Interest Income (NII) is simply the difference between interest earned from a bank’s lending activities to its customers and the interest paid to account holders. If the spread between interest earned and interest expenses rises, it will help NII to rise and vice versa.
Net Interest Income = Interest Earned — Interest Expended
No doubt, NII must be increasing every year. A bank can earn more interest from its assets than it pays out on its liabilities, but that does not necessarily mean the bank is profitable. Banks, like other businesses, have additional expenses such as rent, utilities, employee wages, and management salaries. After subtracting these expenses from net interest income, the bottom line could be negative. For Kotak Mahindra Bank Net Interest Income has been increasing with a whopping CAGR of 23%. Which is impressive
2. Total Advances (Bank Loan)
The extension of money from a bank to another party with the agreement that the money will be repaid.
The banks primary earning comes from advances. Advances are loans given out to customers and hence it is considered as assets in the business. The rise in assets and the rate of rising will tell us how the bank is growing its business. Nearly all bank loans are made at interest, meaning borrowers pay a certain percentage of the principal amount to the lender as compensation for borrowing. Total Advances must be increasing every year.
For Kotak Mahindra Bank Total Advances has been increasing with a CAGR of 29%. Which is again evoking.\
3. Total Deposits
If you deposit 100 Rs in the bank then the bank is only allowed to lend 78.75 Rs. (After deducting 18.25% as SLR and 3% as CRR). So, is very important for the banks to grow their deposits. This not only increases the confidence of its customers but it also provides more funds for the bank to lend and increase the advances. Banks accept deposits in the form of term deposits, savings and current account.
Total deposits must be increasing significantly every year.
For Kotak Mahindra Bank During FY 2019, average SA increased to ` 70,990.1 crore compared to 51,394.9 crore in FY 2018 and average CA increased to 28,741.5 crore from 24,009.9 crore in FY 2018.
4. CASA Ratio
CASA stands for Current and Savings Account. Different kinds of deposits like current account, savings account, and term deposits form the major source of funds for banks. A higher CASA ratio means a higher portion of the deposits of the bank has come from current and savings deposit, which is generally a cheaper source of fund. Many banks don’t pay interest on the current account deposits and money lying in the savings accounts attracts a limited interest rate.
Hence, the higher the CASA ratio means better the net interest margin, which means better operating efficiency of the bank. Now you must have realized why banks become shy increasing the savings account interest rate.
For Kotak Mahindra Bank, CASA Ratio is 52.5% means a higher portion of the funds is generally coming from a cheaper source of funds.
5. Net Interest Margin
From now onwards, things may become a bit complex.
Net interest margin is a profitability metric that compares its net interest income to its average earning assets. Net interest margin can be calculated by subtracting interest expenses from interest income, then dividing that figure by the average earning assets.
Let’s understand with an example: For Kotak Mahindra bank,
Net interest income = 14,748
Average earning assets = Cash and Balances with Reserve Bank of India + Balances with Banks and Money at Call and Short Notice + Investment + Advances (In the balance sheet of Kotak bank below)
= 3,782,133 Cr.
So, Net Interest Margin = 14,748 / 3,782,133 = 4% Approx
Simply put: a positive net
interest margin suggests that an entity operates profitably, while a negative
figure implies investment inefficiency.
If it is negative then Bank either needs to increase the lending rate or decrease the deposit rate or maybe both.
6. Cost to Income Ratio
The cost-to-income ratio is calculated by dividing the operating expenses by the operating income generated i.e.net interest income plus the other income. This ratio is important for determining the profitability of a bank.
A lower ratio indicates higher profitability. If the ratio is rising over the years, it means costs are rising at a higher rate than income.
For Kotak Mahindra Bank, Cost to Income ratio approx 47.4% in 2019 as compared to 47.3% in 2018. This indicates that the company’s profitability is increasing at a higher pace than its expenses, which is good.
7. Credit to Deposits Ratio or Loan-to-Deposit Ratio
Credit to Deposits Ratio = Total Loans / Total Deposits
Bank’s liquidity can be measured by CDR. One can also measure the trust of the customers for the bank
More trust of customers > More deposits > More money for the bank to lend > Bigger loan size > Higher the profitability
Less trust of customers > Fewer Deposits > Banks need to borrow for lending requirements > Interest cost increases > Less profitability
Typically, the ideal loan-to-deposit ratio is 80% to 90%. A loan-to-deposit ratio of 100% means a bank loaned one dollar to customers for every dollar received in deposits it received. It also means a bank will not have significant reserves available for expected or unexpected contingencies.
For Kotak Mahindra Bank CDR is as follows. it seems like Kotak is not just using all the deposits for lending but using other funds as well to lend more.
On one hand, it can be risky as NPA may increase sharply, on the other hand, the bank seems quite confident in books and aims higher profitability.
8. Provision Coverage Ratio (PCR)
The ratio of provisioning to gross non-performing assets indicates the extent of funds a bank has kept aside to cover loan losses. Higher the PCR, lower is the unexposed part of the bad debts.
The provision coverage ratio (PCR) also gives an indication of the provision made against bad loans from the profit generated. A higher ratio means the bank can withstand future losses better, including unexpected losses beyond the loan loss provision.
Overall, by setting aside loan loss reserves and constantly updating estimates through loan loss provisions, banks can ensure they are presenting an accurate assessment of their overall financial position. This financial position is often released publicly through the bank’s quarterly financial statements.
For Kotak Mahindra Bank is around 72% which means the bank has already set aside sufficient funds for future losses and well prepared for uncertainty.
9. Gross NPAs and Net NPAs
A non-performing asset (NPA) is a loan for which the principal or interest payment remained overdue for a period of 90 days.
One of the main differences between Gross NPA and Net NPA arises from the meaning. Gross NPA refers to the total amount of the debts that an organization has failed to collect or the people owing the organization has failed to honor their contractual obligations of paying both the principal and interest amount.
On the other hand, Net NPA is the amount that results after deducting provision for doubtful and unpaid debts from the sum of the loans defaulted. It is the actual loss that the organization incurs after loan defaults.
For example: If Bank A has a total of 100 Cr Gross NPA and the bank kept aside 10 Cr as provisions then Net NPA would be 100–10 = 90 Cr.
For Kotak Mahindra Bank, Gross NPA and Net NPA both is the lessor and decreasing YoY.
10. Capital Adequacy Ratio (CAR)
The capital adequacy ratio (CAR) is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. CAR ensures that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent.
CAR = (Tier 1 Capital+Tier 2 Capital) / Risk-Weighted Assets
Now let’s understand what is Tier 1 and Tier 2 Capital.
Under the Basel Accord, a bank has to maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. Under Basel III, a bank’s tier 1 and tier 2 assets must be at least 10.5% of its risk-weighted assets.
Tier 1 Capital:
Tier 1 capital consists of shareholders’ equity and retained earnings — disclosed on their financial statements — and is a primary indicator to measure a bank’s financial health. These funds come into play when a bank must absorb losses without ceasing business operations. Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank’s tier 1 capital by its total risk-weighted assets (RWA).
For Kotak Mahindra Bank, Tier 1 Capital Ratio is 17% in 2019
Tier 2 Capital:
Tier-2 capital comprises unaudited retained earnings, unaudited reserves and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating. Tier-2 capital is the one that cushions losses in case the bank is winding up, so it provides a lesser degree of protection to depositors and creditors. It is used to absorb losses if a bank loses all its Tier-1 capital.
Risk-weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights are assigned by the banking regulator to each such asset.
As of 2019, under Basel III the minimum capital adequacy ratio should be 10.5%.
For Kotak Mahindra Bank it is 18.38% which is well above the threshold.
That’s it, now go and analyze HDFC Bank (Annual Report) on your own and see how much you have learned.
Apart from all these, you can also use Net Profit, Return on Assets (ROA), Return on Equity (ROE) and Net Interest Margins for better evaluation.
Hope it was informative.