FINANCIAL ANALYSIS OF A BANK

Importance of Financial Analysis

-Measure past performance

-Determine starting point for planning

-Estimate future performance

-Determine Risk

-Predict Cash flows

Importance of Ratio Analysis

Financial ratios are used as guide lines for companies to know the areas that require more investigation and to determine possible weaknesses in a company and the order of priority in making further inquiry regarding the details of operations. It is also use to facilitate comparison and trends with results of previous years or with others in the same industry. Financial ratios are also useful in standardizing measurements and numbers. However, we should keep in mind that the analysis and interpretation of financial ratios is not conclusive.

CAMELS Rating System

CAMELS Rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It is used as an internal tool to measure risk and allocate resources for supervision purposes. It’s purpose is to provide an accurate and consistent assessment of a credit union’s financial condition in the following areas:

Capital adequacy -20%Asset quality – 20%Management – 25%

Earnings – 15%Liquidity – 10%

Sensitivity to market risk – 10%

The rating system have a scale from 1 to 5, with 1 being the strongest and 5 being weakest. Rating Composite Range Description Meaning1 1.00-1.49 Strong Basically sound in every aspect

Findings are of minor nature and can be handled routinely

Resistant to external economic and financial disturbances

2 1.5-2.49 Satisfactory Fundamentally sound Findings are of minor nature Stable and can withstand business fluctuations Supervisory concerns are limited to the extent that

findings are corrected3 2.50-3.49 Fair Financial, operational or compliance weaknesses

ranging from moderately severe to unsatisfactory Vulnerable to the onset of adverse business

conditions Easily deteriorate if actions are not effective in

correcting weaknesses Supervision concern and more than normal

supervision to address deficiencies4 3.50-4.49 Marginal Immoderate volume of serious financial weaknesses

Unsafe High potential for failure Close supervision surveillance and a definite plan for

correcting deficiencies5 4.50-5.00 Unsatisfactory High immediate or near term probability failure

Severity of weaknesses is so critical that urgent aid from stockholders or other financial resources is necessary

Without immediate corrective actions, will likely require liquidations, merger or acquisition.

ACCOUNT NAMES USED FOR FINANCIAL ANALYSIS OF BANKS

1. Assets Cash and Balances with Treasury Banks Advances Lending to Financial Institutions Balances with Other Banks Provision Against Advances Investments Fixed Assets

2. Liabilities

Bills Payables Borrowing from Financial Institutions Deposits and Other Accounts

3. Shareholder’s Equity Ordinary Share Capital or Head Office Account (in case of foreign bank) Reserves Un-appropriated Profit/Loss

4. Income Interest Earned Interest Expenses Non-interest Income (Fiduciary activities and service charges) Non-interest Expense (Personal Expense, Occupancy expense and other operating

expense) Profit/Loss Before Tax Profit or loss after Tax

CAPITAL ADEQUACY- It is a measurement of a bank to determine if solvency can be maintained due to risks that have

been incurred as a course of business. Capital allows a financial institution to grow, establish and maintain both public and regulatory confidence, and provide a cushion (reserves) to be able to absorb potential loan losses above and beyond identified problems. A bank must be able to generate capital internally, through earnings retention, as a test of capital strength. An increase in capital as a result of restatements due to accounting standard changes is not an actual increase in capital.

Ratios in Examining Capital Adequacy

1. Capital Adequacy Ratio -This ratio indicates the margin of protection available to both depositors and creditors against unanticipated losses that may be incurred by the bank.

-The calculation of this ratio involves weighing each category of assets for risks, deducting intangibles from assets, and adding contingent liabilities in risk weighted assets.-It is generally believed that commercial banks should maintain a minimum capital adequacy ratio of 8%

2. Earning Assets to Total Asset Ratio -It will reveal the extent to which bank's assets are put into productive use. Investment in equipment and buildings may not directly generate income but they are important for the bank's operations.

3. Texas RatioDeliquent Loans+NonPerforming Assets

Capital+Loan Loss Reserves

If the ratio is 100% or higher, then the bank is in imminent danger. If it is between 50-100% then a capital infusion is necessary.

4. Loan Loss Provision to Total Loans RatioThis ratio will give useful insight into the quality of a bank's loan portfolio.

ASSET QUALITYIt evaluates risk (and there must be some risk to earn a return), controllability, adequacy of loan loss reserves, and acceptable earnings; and the effect of off-balance sheet earnings and loss. The quality of a bank's assets hinges on their ability to be collected during and at maturity.

Ratios in Examining Asset Quality

1. Loan Loss Provision to Total Loans RatioThis ratio will give useful insight into the quality of a bank's loan portfolio.

2. Overdue Loans to Total Loans Ration

Total Loans30−89DaysPast DueTotal Loans

- Indicates that either credit underwriting standards are inappropriate or collection procedures are inadequate

EARNINGS (PROFITABILITY)

Banks, like other business entities, need to make profit. At least, three main reasons can be identified for banks' profit motive: to provide an appropriate return to the shareholders; to give confidence to the depositors that the business in sound and competently managed; and to maintain and expand the bank's capital base, in order to satisfy prudential criteria and facilitate business growth in real terms. Above all, earnings are the first line of defense against the risks of losses in banking; as well as losses arising from credit risk, interest rate risk, liquidity risk or currency risk.

Ratios used in Examining Profitability

1. Return on Asset (ROA)It indicates the management’s ability to generate income and its ability to control expenses.

Historically, the benchmark is 1.00% or higher for the bank to be considered to be doing well.

2. Return on Equity (ROE)Profit after TaxTotal Equity

×100

In the long run, a return of around 15% to 17% is regarded as necessary to provide a proper dividend to shareholders and maintain necessary capital strengths

3. Interest SpreadSpread is the difference between the rate earned on income producing assets and the rate on interest bearing liabilities.

4. Average Collection of Interest (Days)This is a measurement of the number of days interest on earning assets remains uncollected and indicates that volume of overdue loans

is increasing or repayment terms are being extended to accommodate a borrower's inability to properly service debt.

Accrued Interest ReceivableInterest Income

×365

5. Efficiency RatioThis is a measure of productivity of the bank, and is targeted at the middle to low 50% range. This may seem like break-even but it is not; what this is saying is that for every dollar the bank is earning it gets to keep 50 cents and it has to spend 50 cents to earn that dollar. The ratio can be as low as the mid to low 40% range, which means that for every dollar the bank earns it gets to keep 60 cents and spends 40 cents, a very efficient bank. Ratios in excess of 75% mean the bank is very expensive to operate.

Totalnon−interest ExpensesTotal Net Interest Income

+Total Non−Interest Income

Efficiency improves as the ratio decreases, which is obtained by either increasing net interest income, increasing non-interest revenues and/or reducing operating expenses.

LIQUIDITY

Banks must be capable of meeting their obligations when they fall due. If the depositors or other lenders do not have confidence that the claims can be met, they will stop depositing or lending funds to the bank. The acquisition of deposits and other funds is a necessary condition for the expansion of loans and investments beyond the amount permitted by the use of equity only. Maintaining adequate liquidity is a key constraint on the bank's profit-making capacity.

Ratios in Examining Liquidity1. Loans to Deposit Ratios

This ratio is a measure of bank liquidity; the higher the ratio, the lower the liquidity.

2. Loans to Asset RatioA rise in this ratio would indicate lower liquidity and the need to evaluate other liquidity ratios.

3. Cash RatioThis ratio relates the sum of cash in hand and at banks including the Central Bank to total deposits.

4. Liquid Assets to Total Deposit RatioMeasures deposits matched to investments and whether they could be converted quickly to cover redemptions.

Liquid AssetsTotal Deposits