Evaluation of Bank Performance - Case Study Example

EVALUATION OF BANK PERFORMANCE How would you evaluate the performance of a bank using published accounting data. What other data would you use in this evaluation? Introduction Banks are the most important institutions in a country’s financial system. They are the major conduits by which funds may be coursed from individual and corporate savers to fund users, mainly business and industry. Through the well-oiled machinery by which banks attract deposits and loan this out to borrowers, capital for production is generated in a manner and volume that could not be achieved by other financial institutions and intermediaries. The basis is the trust reposed by the public in the banking institution because of its highly regulated operations overseen by the government. And according to many industry experts, a new era of global banking is emerging (Kubris-Labiak, 2005). It is important to have a method of analysing banks’ performance, in order that problems could be threshed out early on and government intervention could protect the public’s savings and preserve the public trust in the safety of the banking system in general (Mishkin & Eakins, 2003). The basic function of a bank is to source funds from savers, and to deploy the funds into productive undertakings by producers. (Madura, 1992). The degree to which banks are capable of discharging this function is the measure of its performance. (Fraser & Ormiston, 2001) The Income Statement The fundamental source of data for measuring bank performance is the income statement. This is the financial report that describes the source of income and expenses that affect the bank’s profitability (Saunders & Millon Cornett, 2008). This paper will walk through a hypothetical bank’s financial statement, which is given here as ABC Bank, a typical commercial bank. A cursory inspection of the income statement above shows several important items. Operating income is the income that comes from a bank’s ongoing operations. It is comprised of the interest income and non-interest income. Most of a bank’s income is interest income, because the banking function is basically that of converting deposits to loans that earn income. In the above table, interest income is shown to account for 73.5% of ABC Bank’s operating income. Interest income fluctuates with the level of interest rates. Non-interest income, on the other hand, makes up about 26.5% of total income in the above example, and is generated partly by service charges on deposit accounts. Typically, however, the bulk of non-interest income comes from off-balance sheet activities, such as trading in financial instruments and generating income from fees and loan sales. The importance of these activities to banks’ income has been growing in recent years (Bernstein & Wild, 2000). Operating expenses are the expenses incurred in conducting the bank’s ongoing operations. Interest payments that the bank makes on its liabilities are the most important component of bank operations, in particular its deposits. Just as interest income varies with the level of interest rates, so too do interest expenses fluctuate with interest rates. In the example, interest expenses comprised 47.7% of total operating expenses. Non-interest expense, on the other hand, include the costs of running a banking business. These include salaries for tellers and officers, rent on bank buildings, purchases of equipment such as desks, and vaults, and servicing costs of equipment such as computers. The final item listed under operating expenses is provisions for loan losses. When a bank has a bad debt or anticipates that a loan might become a bad debt in the future, it can write up the loss as a current expense in its income statement under the “provision for loan losses” heading. Provisions for loan losses are directly related to loan loss reserves. (Mishkin & Eakins, 2003) The deduction of total operating expense from total operating income yields the net operating income, which in the example above amounts to $110.6 million. The net operating income is closely monitored by bank managers, shareholders and regulators because it is an indicator of the regular business of the bank – that is, the bank’s performance on an ongoing basis. In fact, the net operating income is more closely monitored than the net income which appears at the bottom (the “bottomline”). There are two items, which are the gains or losses on securities sold by banks (-$2.3 million) and net extraordinary items, which are events or transactions that are both unusual and infrequent (in this case, nil). These are added to the net operating income figure, in order to arrive at the net income before taxes. In the above example, the bank was assessed $37.8 million in income taxes, which after payment yields a net income after tax, or more commonly “net income,” of $70.4 million. This is the figure that tells the analyst most directly how well a bank is doing, since it is the amount that results from the bank’s year long activity that is added to the retained earnings, or at least that portion that is not paid out to stockholders as dividends. It represents the over-all return to the business for the risk it has assumed. (Anderson, Ghysels, & Juergens, 2009) Bank Performance Ratios Net income gives the analyst an idea of how the bank is performing; however, it suffers from the fact that it does not adjust for the bank’s size, therefore making it difficult to compare with other banks, or with its own past given a different level of capitalization. (Block & Hirt, 2006) A basic measure of bank profitability that corrects for the size of the bank is the return on assets (ROA). This is the result of dividing the net income of the bank by the amount of its assets. ROA is an indicator of how efficiently a bank’s assets are being utilized in order to generate profits. Assuming that ABC Bank has assets of $5915.9 million, the ROA is thus computed as: Net income 70.4 ROA = ----------------- = ----------- = 1.19% Assets 5915.9 While ROA provides useful information about bank profitability, it is not particularly of interest to bank owners (stockholders), who would be more interested in the amount of profit generated by each dollar of equity investment. This performance measure is best described by the return on equity (ROE), which is the results of dividing net income by equity capital. In the above example, assuming that bank capital amounts to $502.14, the ROE would be computed as: Net income 70.4 ROE = ----------------- = ----------- = 14.02% Capital 502.4 Another indicator that is of common interest to interested bank stakeholders is the net interest margin (NIM) which is the difference between interest income and interest expense expressed as a percentage of total assets. Interest income – Interest expense 427.5 – 224.4 NIM = -------------------------------------------- = --------------------- = 3.43% Assets 5915.9 The NIM is of special use to banks, and is not a financial ratio used for other industries. One of a bank’s primary intermediation functions is to issue liabilities and use the proceeds to purchase income-earning assets. A bank manager’s skill as far as asset and liability management will be evident in a favourable NIM, since the major portion of bank assets are in the form of loans that earn interest, and the major portion of bank liabilities are in the form of deposits for which interest payments are made. The spread between the two is precisely what the NIM measures. If the NIM is high, the bank is likely to be profitable in the main, recurring, operating activities it engages in. If the NIM is, however, low, then the opposite is true, that is, the bank is failing in its main or recurring operating activities (Mellman, 1994). Conclusion The measure of bank performance are derived from an understanding of the income statement of the bank, since the income statement reflects the components of the incomes and expenses of the bank. The total operating income is broken down into interest and non-interest income, while the total operating expense is comprised of the interest and non-interest expense. The net operating income is the difference between the two, and it describes the profitability of the ordinary and recurring business of the bank. The net income after tax is also important to show the overall performance of the bank over the year, since it includes even extraordinary income and expenses. The three ratios most important to describe bank performance expressed in common size are the return on assets, return on equity and the net interest margin (ROA, ROE and NIM, respectively). The first shows the bank’s performance in terms of its total assets, the second shows bank performance in relation to equity capital, and the third describes the spread by which the bank makes profit out of its main banking function. Recommendation and Limitations This study has been mainly a brief, cursory survey of the existing knowledge and theory concerning the evaluation of bank performance. It is hereby recommended that: 1. A study be made concerning the application of the principles learned her to real world data on commercial banks; 2. A comparison be drawn of the measures of bank performance described here and if the same are used in other countries; and 3. A cross-sectional industry study be conducted for major commercial banks and industry standards be drawn so as to form the basis of comparison for analyses of individual banks. Finally, since this is just a brief study of the three most important indicators of bank performance, a greater appreciation of the full complement of financial ratio analysis for banks could be gained from the example in the appendix, where the key financial ratios for an actual bank are indicated. The numeric data is not as important as a listing of the financial ratios for the banking industry that give a full-blown picture of the bank’s condition, performance, efficiency, profitability, debt coverage, and valuation. APPENDIX Bottom of Form Bottom of Form Key Financial Ratios   Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Investment Valuation Ratios         Face Value 10.00 10.00 10.00 10.00 10.00 Dividend Per Share 8.50 8.50 10.00 11.00 11.00 Operating Profit Per Share (Rs) 36.37 36.75 42.19 51.29 48.60 Net Operating Profit Per Share (Rs) 160.69 196.87 316.45 354.71 343.77 Free Reserves Per Share (Rs) 110.70 193.24 199.52 346.21 351.22 Bonus in Equity Capital -- -- -- -- -- Profitability Ratios         Interest Spread 3.56 2.67 3.43 3.51 3.66 Adjusted Cash Margin(%) 21.14 17.55 12.3 11.81 11.45 Net Profit Margin 16.32 14.12 10.81 10.51 9.74 Return on Long Term Fund(%) 70.54 56.24 82.46 62.34 56.72 Return on Net Worth(%) 18.86 14.33 13.17 8.94 7.58 Adjusted Return on Net Worth(%) 15.99 11.4 12.31 8.8 7.55 Return on Assets Excluding Revaluations 1.2 1.01 0.9 1.04 0.99 Return on Assets Including Revaluations 1.2 1.01 0.9 1.04 0.99 Management Efficiency Ratios         Interest Income / Total Funds 8.08 8.36 9.55 10.6 9.82 Net Interest Income / Total Funds 3.6 3.78 4.06 4.29 3.99 Non Interest Income / Total Funds 0.31 0.22 0.1 0.02 0.08 Interest Expended / Total Funds 4.49 4.58 5.49 6.31 5.83 Operating Expense / Total Funds 1.77 2.22 2.79 2.76 2.6 Profit Before Provisions / Total Funds 1.73 1.49 1.19 1.4 1.3 Net Profit / Total Funds 1.37 1.21 1.04 1.12 0.96 Loans Turnover 0.16 0.15 0.17 0.2 0.18 Total Income / Capital Employed(%) 8.39 8.58 9.65 10.62 9.9 Interest Expended / Capital Employed(%) 4.49 4.58 5.49 6.31 5.83 Total Assets Turnover Ratios 0.08 0.08 0.1 0.11 0.1 Asset Turnover Ratio 2.14 2.94 4.52 5.61 5.14 Profit And Loss Account Ratios         Interest Expended / Interest Earned 69.83 69.62 71.14 76.28 73.09 Other Income / Total Income 3.65 2.59 1.07 0.17 0.86 Operating Expense / Total Income 21.06 25.86 28.87 26 26.22 Selling Distribution Cost Composition 5.08 4.8 6.12 4.43 1.74 Balance Sheet Ratios         Capital Adequacy Ratio 11.78 13.35 11.69 13.97 15.53 Advances / Loans Funds(%) 76.65 84.89 77.72 72.67 69.86 Debt Coverage Ratios         Credit Deposit Ratio 89.17 87.59 83.83 84.99 91.44 Investment Deposit Ratio 55.52 46.07 41.15 42.68 46.35 Cash Deposit Ratio 7 5.77 6.99 10.12 10.14 Total Debt to Owners Fund 7.98 7.45 9.5 5.27 4.42 Financial Charges Coverage Ratio 1.48 1.39 1.25 1.25 1.25 Financial Charges Coverage Ratio Post Tax 1.4 1.33 1.22 1.2 1.2 Leverage Ratios         Current Ratio 0.09 0.08 0.09 0.11 0.13 Quick Ratio 4.98 6.64 6.04 6.42 5.94 Cash Flow Indicator Ratios         Dividend Payout Ratio Net Profit 36.05 34.08 33.89 33.12 36.6 Dividend Payout Ratio Cash Profit 27.85 27.36 28.84 29.08 31 Earning Retention Ratio 63.98 65.82 64.8 66.35 63.23 Cash Earning Retention Ratio 72.17 72.58 70.22 70.51 68.87 AdjustedCash Flow Times 38.43 52.3 65.12 52.34 49.41   Earnings Per Share 27.22 28.55 34.59 37.37 33.78 Book Value 170.35 249.55 270.37 417.64 445.17 Source: http://www.moneycontrol.com/stocks/company_info/print_main.php REFERENCES Anderson, Evan W.; Ghysels, Eric; Juergens, Jennifer L. (2009) The impact of risk and uncertainty on expected returns.. Journal of Financial Economics, Nov2009, Vol. 94 Issue 2, p233-263 Bernstein, Leopold & Wild, John. (2000) Analysis of Financial Statements, McGraw-Hill. Block, Stanley B. and Hirt, Geoffrey A. (2006) Foundations of Financial Management. Eleventh Edition. McGraw-Hill International Edition. Fraser, L. M. & Ormiston, A. (2001) Understanding Financial Statement, Sixth Edition, Prentice Hall. Kubis-Labiak, Barbara. (2005) The Top 10 Global Retail Banks: Growth Strategies and Best Practices of the Leading Players. Business Insights Ltd. Madura, Jeff. (1992) Financial Markets and Institutions. Second Edition. West Publishing Company. Mellman, Martin. (1994) Accounting for Effective Decision Making . Irwin Professional Press. Mishkin, Frederic S. and Eakins, Stanley G. (2003) Financial Markets and Institutions. Fourth Edition. Addison Wesley International Edition. Saunders, Anthony and Millon Cornett, Marcia (2008), Financial Institutions Management: A Risk Management Approach, 6th Edition, McGraw International Edition. Read More