Bank-Sector Ratios, 13 Financial Ratios for Bank Stocks

Bank-Sector Ratios Meaning

The banking business has its own set of ratios, such as net interest margin (NIM), provision for credit losses (PCL), and efficiency ratio. Banks, like other businesses, use particular ratios to assess profitability and efficiency that are tailored to their individual company processes. Furthermore, because financial strength is particularly essential for banks, there are a number of ratios that may be used to assess solvency.

1. Gross Non-performing assets (NPAs)

According to RBI guidelines, gross NPAs are the total of all loan assets designated as non-performing assets. It reveals how much of a bank’s loan portfolio is at risk of default. Before investing in banks, this is one of the most crucial ratios to examine.

A loan becomes non-performing if interest is not received for 90 days. The amount of gross nonperforming assets (NPA) shows the quality of the bank’s loans. A high gross NPA Ratio indicates that the bank’s asset quality is in bad shape.

2. Net Non-Performing assets (NPA)

Net nonperforming assets (NPAs) are those for which the bank has deducted the provision for nonperforming assets.

(Net NPAs= Gross NPAs – Provisions )

Net NPA is a more accurate indication of a bank’s soundness. It demonstrates the bank’s true financial load.

A greater level of nonperforming assets (NPA) raises the amount of provision, reducing the bank’s profitability. It also has an effect on the bank’s net interest margin.

3. Current Account And Saving Account Ratio (CASA )

The acronym CASA stands for Current and Savings Account.

Deposits of various types, such as current accounts, savings accounts, and term deposits, are the primary source of funds for banks. If the CASA deposit is high, it is typically an inexpensive source of funds for banks. Because these deposits come with an interest payment, a higher CASA Ratio aids the bank in boosting its net interest margin.

The interest load on a current account is zero, while term deposits have a larger interest burden than savings account deposits. A low CASA Ratio indicates that a bank is inefficient, since it must pay higher rates on more expensive forms of deposits, reducing net interest margins. Before investing in banks, this ratio should be examined.

4. Credit To Deposit Ratio

The credit to deposit ratio is the amount of money a bank loans compared to the amount of money it holds in its account. It aids in the evaluation of a bank’s liquidity and health.

The ideal credit-to-deposit ratio is between 80% and 90%.

This indicates that the bank is lending this percentage of its total deposits. Because lending is the bank’s primary activity, this percentage should be high.

If the ratio is too low, it indicates that the bank is not making as much money as it should be. If the ratio is excessively high, the bank may not have adequate liquidity to handle any unexpected fund requirements, affecting capital adequacy and the asset-liability mismatch.

Before investing in banks, this ratio should be examined.

5. Net Interest Margin

Another measure to examine before investing in banks is the net interest margin. It is the difference between the interest revenue earned by the bank on loans and the interest paid out to their lenders on savings accounts and deposits, as a percentage of the bank’s interest producing assets.

Net Interest Margin= (Interest Income-Interest Expense)/Total Assets

The bank with more low-cost deposits (CASA) or high lending rates will have higher NIMs. If the bank’s non-performing assets (NPAs) increase, the interest earned decreases, and the NIM decreases. For a bank, having a low NIM and a high NPA is a poor combination.

6. Return On Assets

Return on Investment (ROI) The bank’s net profit divided by its total assets is known as the ratio. It is beneficial to understand how management uses its assets to create additional revenue.

The larger the percentage of average earning assets, the better the returns on total assets will be. A low or decreasing Return On Assets Ratio indicates that the bank is unable to effectively utilise its assets.

Check This Also:- Interest Coverage Ratio, Explained with Example In 2021.

7. Capital Adequacy Ratio

The Capital Adequacy Ratio compares a bank’s total capital (tier 1 + tier 2) to its risk-weighted assets. This is something to think about before investing in banks.

Central banks and bank regulators have agreed to prohibit commercial banks from taking on too much debt and going bankrupt as a result.

A bank’s tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets under Basel III. The minimum capital adequacy ratio is 10.5 percent (including the capital conservation buffer).

The minimum capital adequacy ratio guarantees that the bank has sufficient capital to withstand a fair level of losses before becoming insolvent and losing depositor funds. The bank is safe if the CAR is high.

These are the ratios that might assist you in determining which banks are weak and not worth investing in.

Although this is not a perfect approach, it is a quick way to assess the health of a bank.

8. Efficiency Ratio

By dividing non-interest expenditures by income, the efficiency ratio measures how efficient a bank’s operation is.

The efficiency ratio may be calculated using the following formula:

Efficiency Ratio= Non-Interest Expense/Revenue 

Interest expenditures are excluded from the efficiency ratio since they arise naturally as a bank’s deposits expand. The bank, on the other hand, may manage non-interest expenditures like as marketing and operations. A lower non-interest expenditure per dollar of sales indicates a lower efficiency ratio.

9. Operating Leverage Ratio

Another metric of efficiency is operating leverage. The increase of revenue is compared to the growth of non-interest costs.

The following is the formula for determining operating leverage:

Operating Leverage= Revenue Growth Rate – Non-Interest Expense Growth Rate 

A positive ratio indicates that income is outpacing costs. If the operating leverage ratio is negative, on the other hand, the bank is accruing expenditures faster than revenue. That would imply operational inefficiencies.

 10. Liquidity Coverage Ratio

The liquidity coverage ratio, as the name implies, gauges a bank’s liquidity. It assesses a bank’s capacity to satisfy short-term (less than 30 days) obligations without requiring recourse to external funds.

The liquidity coverage ratio is calculated using the following formula:

Liquidity Coverage Ratio = High-Quality Liquid Asset Amount/ Total Net Cash Flow Amount   

The 30-day term was chosen because it is thought to be the time it takes the government to intervene and assist a bank during a financial crisis. As a result, if a bank can fund cash withdrawals for 30 days, it will not decline in value.

11. Leverage Ratio

The leverage ratio analyzes a bank’s capacity to cover its risks with tier 1 capital. Tier 1 capital is extremely liquid because it is a bank’s main capital. Tier 1 capital may be quickly converted to cash in order to cover exposures and ensure the bank’s viability.

The leverage ratio is calculated using the following formula:

Tier 1 Capital / Total Assets Leverage Ratio (Exposure)

12. CET1 Ratio

The leverage ratio and the CET1 ratio are comparable. It evaluates a bank’s capacity to cover its risks. The CET1 ratio, on the other hand, is more rigorous since it only examines common equity tier 1 capital, which is lower than total tier 1 capital. The risk level of the exposure (asset) is also taken into account when calculating the ratio. A greater risk asset receives a higher risk weighting, lowering the CET1 ratio.

The CET1 ratio is calculated using the following formula:

CET1 Ratio = Common Equity Tier 1 Capital/ Risk-Weighted Assets

13.Provision For Credit Losses(PCL) Ratio

A bank’s provision for credit losses (PCL) is a sum set aside to cover loans that are unlikely to be collected. The bank is better safeguarded against insolvency by having such a large sum set aside. The provision for credit losses (PCL ratio) is calculated as a percentage of net loans and acceptances. Investors and regulators can use it to analyse the riskiness of the bank’s loans in comparison to their rivals. A greater PCL and, as a result, a higher PCL ratio are associated with risky loans.

The provision for credit losses ratio is calculated using the following formula:

Credit Loss Provision Ratio = Credit Loss Provision / Net Loans and Acceptances

Important Points to Remember

• Ratio analysis aids in determining performance and determining whether or not to invest in banks.
• According to RBI guidelines, gross NPAs are the total of all loan assets designated as non-performing assets.
• Net nonperforming assets (NPAs) are those for which the bank has deducted the provision for nonperforming assets.
• The credit to deposit ratio is the amount of money bank loans compared to the amount of money it holds in its account.
• Return on Investment (ROI) The bank’s net profit divided by its total assets is known as the ratio. It is beneficial to understand how management uses its assets to create additional revenue.