Evaluation of Performance of a Bank Using Published Accounting Data - Case Study Example

Table of Content Introduction: 2 Background 3 Thesis ment 4 Main Body 4 Conclusion 6 Limitations 7 Recommendations 7 Bibliography 8 Evaluation of Performance of a Bank Using Published Accounting Data Introduction: Banks are the global industrial powerhouses1 and they have introduced very complex and risky products and services. During its operation, every bank is exposed to credit risk, liquidity problems, interest risk, market risk, operational and management risk.2 The collapse of banking industry severely influences the world financial system, which means that it is very important to evaluate the performance of the banks. There are different parameters based on which performance of a bank can be evaluated such as financial management, operational management, products and services of the bank and customer services. To evaluate all these parameters, different sort of information is required. Performance of a bank is evaluated because of various reasons. The banks evaluate their performance to find out the outcomes of previous decisions of management. The bank regulators evaluate the performance of the banks to identify the banks, which are facing severe problems. Evaluation using the published data is also needed by shareholders to make decisions such as whether to buy or sell share of banks. Furthermore, investment analysts advise their prospective investors regarding the selection of banks for making investments after performance evaluations of banks. There are different ways, which have been used to evaluate the performance of the banks. When the performance is analysed through available published accounting data then profit ratios, risk ratios and other such measures are calculated that will be discussed in detail. All information available in financial statements is accurate and reliable because it is usually audited and published by the company itself. Standards have been introduced based on which the financial statements are developed. According to Robert Beale and Howard Davey, “… All recognised items of financial performance should be reported in the primary financial statements in a way that clearly reflects they are part of financial performance.” Therefore, when it comes to evaluate the performance of the banks, a great focus is given towards using the information from published accounting data. Background Banks are the financial institutions and they can be grouped into various categories based on the products and services they are offering and other factors.3 Therefore, not every bank can be evaluated by following the same evaluating standard however, a set of tools are being used by different banks all over the world to evaluate their performance. A specific but suitable criterion can be selected to analyse the performance of bank. Since there are various factors, which can be used for the evaluation of performance of a bank; therefore, a brief overview is important to get an idea about them. The Swedish savings banks are less profit oriented and more service efficient therefore, they use different criteria to evaluate the performance of the bank.4Therefore, the evaluation criteria of a ‘service efficiency’ bank may differ from profit-for bank. The Islamic banking system is also growing rapidly in various countries of the world, however, different criteria is used to evaluate the performance of Islamic banks. “Each aspect of performance of Islamic banks is measured differently than in conventional banks. For example investigating profitability and bank spreads in conventional banks is measured based on the rates charged on loans in relation to the rates paid on deposits. In Islamic banks, where interest is prohibited in principle, profitability can only be measured based on the rates of returns on non interest transactions and direct investments (Badreldin, 2009).” Although financial ratios are widely used for analysing the performance of the bank however, new tools have been introduced to measure the overall performance of the banks. One of the adequate tools is CAMEL however; the relative importance of factors of CAMEL needs to be understood before using it. For example, Dr. Muhammad Tanko found that the best ratio of CAMEL is the ratio of total shareholder’s fund to total risk weighted assets.5 Kosmidou and Zopounidis evaluated the performance of banks in Greece based on their main accounts, selected financial ratios and multi-criteria Promethee method.6 Chien-Ta and Yun-Shan analysed the performance of three banks in Australia through Grey Relation Analysis (GRA), which is an evaluation method that is being commonly used in Industry and Commerce. Through GRA, only a few financial indicators were used from financial statement analysis to evaluate the performance of banks.7 The evaluation criterion that was used to analyse the performance of a sample of Greek banks was the financial ratios such as liquidity, profitability, capital structure, investment activity and development ratios (Zopounidis, 2002). Thesis Statement The aim of this paper is to discuss, “How would you evaluate the performance of a bank using published accounting data? What other data would use in this evaluation?” Main Body The performance of a bank can be evaluated by a number of ways such as checking the rating agencies and listings, going through customers reviews, independent analysis based on published accounting data, instructional guides and FDIC bank statistics and research.8 The most common method that is used to evaluate the individual performance of the bank is through its financial statements. The published accounting information that is usually given in the form of financial statements include Statement of financial position (Balance sheet), Statement of earnings (Income statement), and Cash flow statement and Statement of activities (Kenneth, 1996). The financial ratios can be determined based on the information collected form these statements. To analyse the profitability of the bank, profit ratios can be used which include Rate of return on equity (ROE = net income after taxes/total equity), Rate of return on Assets (ROA = net income after taxes/total assets) and Net Interest Margin (Total interest income - Total interest expense)/ (Total assets). Just quoting the value of ratios can never predict the performance of a bank and a proper interpretation is required. For example, Return on assets (ROA) is a good measure to reveal the performance of the bank however; it does not point out poor performance. If ROA of bank is less than average ROA of the banking industry (which is usually set as a benchmark), then it may be the sign of bank’s inefficiencies such as excessive interest rate. The real thing is that how creatively the analyst interprets the ratios of the bank. For example, when interpreting the ROA of a bank, the analyst should know that a bank usually knows the deposit rate at which the despositors can be attracted therefore, the chances of paying excessive interest are very low. On the other hand, if the bank has to follow a market-determined rate then it may face high interest rate. An analyst should know that a low ROA than benchmark ROA rate can be as a result of low interest rate on loans and securities because it was locked into fixed rates before the increase in market interest rates was seen. Moreover, it can be also argued that a low ROA was a result of inadequate noninterest income. The risk ratios are also considered very important in evaluating the performance of a bank. The first group of risk ratios is capitalization which include Leverage ratio (Total equity/Total assets) and total Capital ratio ((Total equity + Long-term debt + Reserve for loan losses)/Total assets). The risk ratio that is used to check the Asset quality of banks include Loan ratio (Net loans/Total assets), loss ratio (Net charge-offs on loans (gross charge-offs excluding recoveries)/Total loans and leases), non-performing ratio (Nonperforming assets (nonaccrual loans and restructured loans)/Total loans and leases), provision for loan loss ratio (provision for loan losses/total loans and leases) and reserve ratio (Reserve for loan losses (Previous year reserve for loan losses minus gross charge-offs plus PLL and recoveries)/Total loans and leases). To evaluate the operational efficiency or cost control of the bank two ratios of Fixed occupancy expenses/Total expenses and Wages and salaries/Total expenses are calculated. The temporary investment ratio and volatility-liability dependency ratios are calculated to measure the liquidity of the bank. The idea of measuring these ratios is to determine the extent to which the bank has used ‘hot’ money to fund its riskiest assets. Apart from that, the other financial ratios that can be used to evaluate the performance of the bank may include tax rate (total taxes paid/Net income before taxes) and Dollar gap ratio (Interest rate sensitive assets – Interest rate sensitive liabilities)/Total assets). The other data that is usually used to evaluate internal performance of banks is bank planning or policy formulation, bank technology and personnel development (Madura, 2008). The bank planning typicall includes its goals, budgets and strategic planning. Since all these policy formulation tools have a strong impact on the overall performance of the bank, therefore, analysing the policy formulation strategy of the bank is an important step in this regard.9 Technology always contributes towards the efficiency of operations of the banks therefore, evaluating the systems used in the banks, communications and payments systems are evaluated. No doubt, another important factor, which can be considered to evaluate the performance of the bank, is the personnel development. It may also include the personal selling, geographical expansion, training and compensations of bank. The external performance of the bank is evaluated based on different factors. The three main indicators include market share, regulatory compliance and public confidence. The regulatory compliance is analysed in terms of capital, lending and securities of the bank whereas, the public confidence can be analysed through deposit insurance and public image. Conclusion From the above discussion, it may be concluded that published accounting data is commonly used to analyse the performance of banks. The different performance measures used by the banks for evaluating their performance are same. The financial ratios, major accounting heads, and CAMEL are the major tools, which can be used to evaluate the performance of a bank. Limitations There are various limitations when performance of a bank is evaluated based on its accounting data. For example, if financial ratios are used then different analysts may interpret the ratios with different reasons and arguments. It may result in inconsistency among the interpretations of different analysts. Secondly, different banks have different kinds of operations therefore, a single standard cannot be predicted to measure and compare the performance of all banks. Third, the use of different accounting standards10 also hinders the practice of standardising the accounting information, which is another major limitation. Recommendations In consideration to the analysis of this report and limitations mentioned-above, I am of the view that published accounting data provides the most reliable, economical and easiest way to evaluate the performance of bank. However, in order to make the comparisons of banks’ performance easier, there is a need to standardize financial reporting. Bibliography (n.d.). Retrieved October 21, 2009, from Wehner.Tamu: wehner.tamu.edu/finc.www/finc-kolari/Banking/bank3.ppt Badreldin, M. A. (2009). Measuring the Performance of Islamic Banks by Adapting Conventional Ratios. German University in Cairo. Banking and The Banking Industry . (n.d.). Retrieved October 19, 2009, from Economywatch : http://www.economywatch.com/banking/ Beale, R., & Davey, H. (2001). A single statement of financial performance: its time has come. Blackwell Publishers Ltd. Bergendahl, G., & Lindbloma, T. (2006, October 27). Evaluating the performance of Swedish savings banks according to service efficiency. Retrieved October 20, 2009, from Science Direct: http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VCT-4M6RYX9-1&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&_docanchor=&view=c&_searchStrId=1059500197&_rerunOrigin=google&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=2fa212c6c3e161d630 Berry, A. (n.d.). How to evaluate your banks performance. Retrieved October 21, 2009, from Examiner : http://www.examiner.com/x-5476-DC-Managing-Your-Money-Examiner~y2009m3d22-How-to-evaluate-your-banks-performance Financial Accounting Standards . (n.d.). Retrieved October 22, 2009, from Quick MBA : http://www.quickmba.com/accounting/fin/standards/ Ho, C.-T., & Wu, Y.-S. (2006). Benchmarking performance indicators for banks. Emerald Group Publishing Limited. K. KOSMIDOU, C. Z. (2008). 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