Bank Performance Evaluation - Coursework Example

Introduction Banks are considered as one of the most important s in the financial system of any economy therefore their performance also plays a critical role in defining the overall soundness of the financial system. In order to evaluate the performance a bank, it is important that one must take into account a multi-dimensional approach must be undertaken to properly evaluate the bank performance. Such approach therefore will require that one must blend a combination of approaches such as financial ratio analysis, economic value model as well as balancing of risk versus return of the bank during analysis. (Srinivasan, 2009). Financial ratio analysis is considered as one of the most important tools that are being used to evaluate the performance of any bank. It is important to note that the financial ratios for a bank are slightly different as compared to the typical ratio analysis for any manufacturing firm. Due to this basic difference, there are some additional ratios that are being computed for evaluating the basic performance of a bank. These ratios include net profit margin, provision for loan losses, loans to assets, capital adequacy etc which are computed in order to provide a deeper insight into the overall financial performance of any bank. This paper will discuss as to how the performance of a bank is evaluated and what are some of the tools including financial ratio analysis which can be used to effectively evaluate the performance of the bank and the type of data required to make such an analysis. Financial Ratio Analysis- FRA Financial Ratio analysis is one of the leading tools that are being used to evaluate the performance of a bank. These are common sets of financial ratios that are used to compute various financial indicators and by making either trend analysis or industry comparison, the overall performance of the bank can be evaluated. These ratios are: Return on Assets Return on assets is computed by dividing the net income earned by the Bank with its total assets. This is an important ratio because it informs us about the overall efficiency of the bank’s assets i.e. how the total assets of the bank are used by the management in producing the desired results for its shareholders. Return on assets is also considered important ratio because it can be a better judge of the overall efficiency of the bank’s management i.e. if return on assets is low it can indicate that the overall management efficiency in utilizing the assets of the firm is not entirely up to the satisfaction and management shall improve its practices and internal control environment to improve upon the overall efficiency in managing the assets of the firm. Return on equity Return on equity is computed by dividing the net income earned by the bank with its total equity. ROE is an important ratio because it indicates as to how much has been earned for shareholders of the firm. This ratio can further be de-composed into different other ratios to gain further insight into what actually derive the value for the shareholders of the firm. (Isberg, 1998). Du-Pont Analysis is a technique which is used to further decompose this ratio into following ratios: ROE = Net Income/ Sales x Asset/Equity x Sales/ Asset This indicates that there are three major ratios which can explain the return on equity ratio therefore analysts can get a deeper insight into what are the major contributors for increase in return on equity. For example, among these three ratios, assets/equity can be a better indicators of the return on equity or net profit margin can further explain the improvement or decrease in the return on equity ratio. Du-Pont Analysis therefore increases the overall sophistication of the ratio analysis by providing different specific measures which can be highlighted as the main contributors of generating the returns for the shareholders of the firm. Net Interest Margin This ratio is computed by dividing the net interest income earned by the bank with the total earning assets of the firm. This ratio is considered as an important measure comparing the overall investment decisions of the bank as compared to its overall debt situation. (Goldman, 2009) This ratio is important because it defines the overall profitability of the operations of the firm i.e. how much interest income has been earned by the bank during the year. Net interest margin is also critical because of the fact that it indicates as to how the bank is performing in earning interest i.e. bank has two sources of income including interest income as well as non-interest income however, interest income is considered as the most important component of the total income of the bank because it is obtained from the core operations of the bank. Loans to Assets Loans to Assets ratio is computed by dividing the total outstanding loans with the total assets of the firm. Management of loans to assets ratio is important because it defines the overall strategy of the bank i.e. whether the bank is pursuing an aggressive strategy of lending or whether it has adapted a more conservative strategy. If this ratio is higher that means that most of the bank’s assets have been loaned and the bank may face strong liquidity crises. (Rojas-Suárez & Weisbrod, 1995) However, lower ratio can also be critical because it can potentially undermine the true potential of the bank’s assets to earn. Thus the management of this ratio plays a critical role in the management of overall liquidity position of bank as well as defines its lending strategy. Bank’s management has to strike a balance in maintain a healthy and balanced ratio so that adverse impacts of the market can be easily discounted. Balanced loans to asset ratio also allow banks to perform better during bad times because it will not allow banks to further lend during such periods but also a balanced ratio provides a cushion against potential losses that may be incurred during bad economic situation. (http://www.calculatedriskblog.com, 2009). Provisions for Loans Losses Provisions for loans losses are other important indicators of measuring and assessing the performance of a bank. It reflects the overall reserves as well as charge offs created against the total assets of the firm in order to accommodate the natural accretion of non-performing assets of the bank. Higher the provision, greater is the probability that the overall assets of the bank are not performing as well as profitability of the bank will reduce. Provisions for loans losses are often analyzed by computing two ratios i.e. reserves/total assets & charge off/ total assets. Higher the ratio of charge-off/total assets, the greater will be the total provisions and lesser will be the profitability of the bank. (Joyce, 2001). Capital Adequacy Capital Adequacy is one of the important indicators of the overall riskiness of the firm i.e. capital adequacy ratio defines the extent to which the capital of the bank is covered through the risk weighted assets of the bank. This ratio is calculated by dividing the capital of the firm with the total risk weighted assets of the firm. (McKiernan & Salmon, 2008) The above ratios are considered as the most important fundamental indicators of the bank performance however, there are other more important and critical methods of evaluating the performance of the bank such as economic value analysis which provides a more comprehensive indication of the overall performance of the bank. The above financial ratios can be integrated into the economic value analysis so as to provide a more comprehensive set of data to perform further analysis. The above ratios can also be used to perform the fundamental analysis of the bank for assessing the fair market value of the firm for the purpose of purchasing or selling the stocks of the particular bank. Conclusion The above discussion indicates that in order to evaluate the performance of a bank, it is important that a multiple tools shall be used to evaluate such performance. Financial ratios such as loans to assets, loans losses provision as well as capital adequacy are some of the ratios which can provide a deeper insight into the overall riskiness of the bank whereas ratios like return on equity, return on assets as well as net profit margin are better indicators of the overall profitability as well as performance of the bank. It is critical to note that other analysis models such as economic value analysis can also provide a better understanding of the true performance of a bank as well as its correct intrinsic value. Though financial ratios can provide a better insight into a company’s performance however, ratio analysis is retrospective in nature therefore past performance of the firm cannot be taken as an indicator of the future performance of the firm. (http://www.financialmodelingguide.com, 2009). Apart from that, financial ratios do not account for the activities which are off-balance sheet therefore to consider financial ratio analysis as a comprehensive tool for assessing the performance of the firm may not be entirely true as it did not provide complete insight into the performance. Bibliography 1. Goldman, D. (2009, Feburary 09). Net Interest Margin: the key to bank recovery. Retrieved October 31, 2009, from Asia Times: http://blog.atimes.net/?p=569 2. http://www.calculatedriskblog.com. (2009, September 26). Banks: Troubled Asset Ratio . Retrieved November 02, 2009, from http://www.calculatedriskblog.com: http://www.calculatedriskblog.com/2009/09/banks-troubled-asset-ratio.html 3. http://www.financialmodelingguide.com. (2009). Limitations of Financial Ratio Analysis. Retrieved October 31, 2009, from http://www.financialmodelingguide.com: http://www.financialmodelingguide.com/financial-ratios/financial-ratio-limitations/ 4. Isberg, S. C. (1998). Financial analysis with the DuPont ratio: A useful compass. Retrieved October 31, 2009, from findarticles.com: http://findarticles.com/p/articles/mi_qa3857/is_199804/ai_n8799612/ 5. Joyce, W. B. (2001). A signaling approach to the provision for loan losses. Retrieved October 30, 2009, from findarticles.com: http://findarticles.com/p/articles/mi_qa3682/is_200101/ai_n8943648/ 6. McKiernan, S., & Salmon, J. (2008). Basel II: an introduction to the new Capital Adequacy Rules. Retrieved November 02, 2009, from out-law.com: http://www.out-law.com/page-7096 7. Rojas-Suárez, L., & Weisbrod, S. R. (1995). Financial fragilities in Latin America: the 1980s and 1990s. New York: International Monetary Fund. 8. Srinivasan, D. (2009, September). Performance measurement of Banks -NPA analysis & credentials of Parameters. 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