Bank administration--ratios

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Bank Administration

Ratio Analysis


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Frequently used measures ofrate ofreturn 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)

Retainedearnings

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 weuse?

The answer is yes, because ROA and ROE reveal

different information about a bank or other

financial institution.

ROA is a measure ofefficiency. It conveys

information on how well the institutions

resources are being used in order to generate

income.


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ROE is a moredirect measure ofreturns tothe shareholders. Since thereward to the

owners are a key goal for the wholeorganization, ROE is generally superior toROA as a measure of profitability.

One point should be obvious here: ROE is

strongly influenced by the capital structure ofa financial institution, in particular, how muchuse it makes ofequity financing.


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Management may be able to boost ROE simply

by greateruse of financial leverage- that is,

increasing theratio ofdebt to equity capital.

This can be seen clearly if we note that

ROE = ROA x (total assets/total equity capital)

orequivalently,ROE=ROA x ((total equity+total debt) / total

equity)


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Theelements which makeup 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 institutions ROE is lower or falling.

Forexample, if the profit margin is falling, this implies

that less net income is being recovered from each dollarof operating revenue.


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The causes of this problem would bedue to:

lack of adequateexpense control

below-par tax management practices

inappropriate pricing of services

ineffective marketing strategies

However, if ROE, is low ordeclining due to a decreasing

asset utilization ratio, we need to review the institutionsasset management policies-particularly the yield and mix ofits loans and security investment and the size of its cash orliquidity.


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Finally, theequity multiplier sheds light on the

financing mix of the institution -- what

proportion of assets are supported by owners

equity (particularly stock andretained

earnings) as opposed to debt capital.


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Theelements which makeup 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 takeremedial action.


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Bank Administration

Alternative measures of a financial institutions rate

ofreturn

Facing with increasing tax rates, many financial institutionshavedeveloped great proficiency at reducing their tax

liabilities through theuse of allowable tax shelters, such as:

investment in tax-exempt municipal bonds

leasing anddepreciation of capital assets

development of foreign sources of income which results in domestictax credit

accelerateddepreciation 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 institutions net earnings that truly

reflects theefficiency of the institution ingenerating revenues and in controlling

expenses, independent of tax considerations.

Two possibleearnings 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 securitiesgains or losses + provision for possible loan

losses -(losses charged to loan allowance-recoveries on charged-off loans credited toloan 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 bededucted from any gains on securities as an offset

to earnings from regular operations.

Forexample, a bankexperiencing rapid growth

in income from loans can frequently reduce itsexposure to taxes by selling at loss bonds held in

its investment portfolio.


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Anotherearnings measure which gives us some

indication of theefficiency of operations and

which nets out other tax- management effects isthe net operating margin (NOM).

NOM = [(total operating income- total operating

expenses) / TA]

NOM is a measure of operating efficiency - how wellmanagement controls expenses so that morerevenues

flow through to net income.


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Some analysts also see it as a reflection of the

effectiveness of a financial institutions

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 manyanalysts is the Revenue- to - Incomeratio:

RTO = (Total operating income / Net Income)

This ratio gives us a further index of theeffectiveness of the institutions cost-controlprogram.

It reflects how well management is able to squeeznet earnings out ofeach dollar ofrevenuereceived 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 thespread between the yield on averageearning

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 averageearning assets -

- Percent cost on interest-earning sources of funds)


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The next ratio is Net IncomeMargin (NIM)

which is basically thedifference 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, averageearning 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:

Therate ofreturn earned by a financial institution is

affected by numerous factors. The key external factors

affecting earnings are as follows:

changes in the technology of servicedelivery

competition from bank and nonbank institutions

laws andregulations

government economic and monetary policies


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Management can not control theseexternal factors.

The most it can do is to anticipate future changes in

these outside influence and to try to position theinstitution to take advantage ofexpected

developments.

While the management of a bank may havedifficulty

in responding to external pressure on the institutionsnet 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 ofresources

productivity of human and otherresources

income-earning power of assets

character of service technology

size of organization

Control ofexpenses

interest costs on deposits

cost of nondeposit borrowing

employee costs

overhead and otherexpenses


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Tax management policies

timing of income and losses

tax-exempt investments

depreciation of assets

Liquidity position

composition of assets

composition ofdeposits and other funds sources

Risk position

use of financial leverage

composition andquality of assets

losses on loans and other assets


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Ratios on efficiency in use ofresources

In general, greaterefficiency is indicated by how well expenses arecontrolledrelative to revenues and how productiveeach employees

is in terms ofrevenues and income generated, assets managed, andaccounts handled.

Improvements in efficiency can be achieved by:

installing new labor-saving machinery

expanding the overall size of the organization to take advantage ofany economies of scale.

Among the most popular indicators of how efficient a bank or otherfinancial institution is in using human and otherresources are levelsand trends in the following ratios:


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Ratios on efficiency in use ofresources:

(Total operating expenses / Total operating revenue)

(Total assets / Number of full-timeemployees) (Total deposits / Number of full-timeemployees)

(Total revenue / Number of full-timeemployees)

Net income / Number of full-timeemployees)

(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 / Totaloperating expenses

(Other operating expenses / Total operating expenses)


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Tax management policies:

Tax shelters areextremely important to many financial

institutions today as aids in achieving annual earningstargets.

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 linkeddirectly to earnings.

Assets held to meet liquidity need generally carry the lowest

yields. Thus,

The maintenance of high levels of liquidity usually reducesearnings. An institution can often maximize its rate ofreturn

by minimizing holdings of liquid assets, but only by accepting

a greaterrisk of a cash out, which can beexpensive to make

up.


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Bank Administration 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 demanddeposits / Total time and savingsdeposits)

(Large negotiable CDs / 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 suitablerisk position:

One area of critical concern to the management of any

financial institution is risk. Bank can reducerisk to someextent 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 ofrisk 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)

Bank administration--ratios

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