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Defining Key Ratios:


Net interest margin (NIM) Operating profit margin (OPM) Cost to income ratio Other income to total income ratio

Net interest margin (NIM): Just as we calculate and measure performances of non-financial companies on the basis of their operating performance (EBITDA margins), the performance of banks is largely dependent on the NIM for the year. The difference between interest income and interest expense is known as net interest income. It is the income, which the bank earns from its core business of lending. As such, NIM is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call. As such it is calculated as, NIM = (Interest income - interest expenses) / average earnings assets Operating profit margin (OPM): A bank's operating profit is calculated after deducting operating expenses from the net interest income. Operating expenses for a bank would mainly be more of administrative expenses. The main expense heads would include salaries, marketing and advertising and rent, amongst others. Operating margins are profits earned by the bank on its total interest income. As such, OPM = (Net interest income (NII) - operating expenses) / total interest income Cost to income ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its return on equity. Salaries, branch rationalisation and technology upgradation account for a major part of operating expenses for new generation banks. Even though these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based income). Cost to income ratio = Operating expenses / (NII + non-interest income) Other income to total income: Fee based income accounts for a major portion of a bank's other income. A bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenue is not depended on the bank's capital adequacy and consequently, the potential to generate the income is immense. The higher ratio

indicates increasing proportion of fee-based income. The ratio is also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.

Key financial ratios

Some of the key financial ratios are:

Return on equity (ROE) Return on capital employed (ROCE) Return on invested capital (ROIC) Return on total assets (ROA) Asset Turnover Debt to equity ratio (D/E) Interest coverage ratio

Return on equity (ROE) - ROE is probably the most important ratio in the investing world. It helps in measuring the efficiency with which a company utilises the equity capital. ROE reflects the efficiency with which the management has utilized the shareholders funds. It is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the company. The result of this calculation should be multiplied into 100. Return on equity = profit after tax / shareholders funds * 100 One could also take the average equity capital i.e. the average equity of a particular financial year and its preceding financial year. The ratio is also known as the return on net worth (RONW). It is important to note that this ratio should be compared within companies of a particular industry or intra-industry rather than inter-industry. This exercise helps in knowing which companies have better operating efficiencies and consequently, which managements have been utilising their shareholders' funds more efficiently. An inter-industry comparison does not really make sense as characteristics of different industries vary. Return on capital employed (ROCE) - Capital employed in simple terms is the value of all assets employed in a business. It can be calculated in two ways -from the 'Application of funds' side and the 'Sources of funds' side of the balance sheet. In case of the former, capital employed would the total assets minus the current liabilities. For the latter, one can simply add the shareholders funds and the loan funds. ROCE is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed. As such,

ROCE = EBIT / Capital employed * 100 This ratio helps in assessing the returns that a company realises from the capital employed by it. In other words, it represents the efficiency with which capital is being utilized to generate revenue. Return on invested capital (ROIC) - ROIC shows the returns that a company earns on the capital that is actually invested in the business. It is an important tool which helps in determining how well a company's management is able to allocate capital into its operations for future growth. It is calculated as: ROIC = (EBIT)*(1 - effective tax rate) / (Capital employed - cash in hand) * 100 As we can see form the above ratio, after reducing the tax from the earnings before interest and tax figure (EBIT), we divide the result by the capital employed (net of the idle cash on hand). The reason we take the EBIT figure is because it includes the PAT and depreciation (which is a non-cash expense). Surplus cash is subtracted from the total capital employed is because it is not actually employed in the business. Return on total assets (ROA) - ROA is another ratio which helps in indicating the management efficiency. This ratio gives an idea as to how efficiently a company's management is using its assets to earn the profits it is generation. It is calculated by dividing the profit after tax by the total assets as at the end of that year/period. As such, ROA = Profit after tax / total assets * 100 It measures how profitably the assets of the company have been utilised. Companies with high asset base in capital-intensive industry such as fertilisers and steel tend to have a lower ROA than companies selling branded products such as toothpaste and soaps, which may have a lower asset base. As such, it is important for one to compare the ROAs of companies involved in similar businesses/ industries. Asset turnover - The asset turnover ratio indicates how well the company is sweating its assets. In other words, it shows how much many rupees a company generates with every rupee invested in assets. This ratio is a measure of how efficiently the company has been in generating sales from the assets at its disposal. It is calculated by dividing the sales by the total assets. Asset turnover = Sales / Assets Let us take up an example to understand this well. Suppose company 'A' has assets worth Rs 10 bn on its books. At the end of the year, the company recorded a topline of Rs 25 bn. That means the company has an asset turnover of 2.5. This indirectly gives an indication that the company would be able to increase its revenues by Rs 2.5 with every rupee invested in as assets. Naturally, the higher the assets turnover, the better it is for a company. However, it largely depends on the strategy a company is following. It is likely that a company with lower margins and higher

volumes will have a higher asset turnover than a company involved in a low volume - high margin business. Debt/Equity ratio - This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. As mentioned in the earlier part of this series, a company can broadly have two sources for employing funds into its business - from the owners and from third parties, i.e. loan funds. As such, to get an idea as to how much of the funds employed into a business is in the form of loans, we use the debt to equity ratio. It is calculated by dividing the debt by the shareholders funds (or equity). As such, Debt to equity ratio = Debt on books / Shareholders funds (Equity) This ratio is probably one of the most observed ratios as it indicates the extent to which a company's management is willing to fund its operation with debt. Naturally, a high debt to equity ratio is considered bad for a company as it would have to pay the necessary interest on the borrowings. But that does not make companies that have a certain amount of debt a bad investment. If a company is easily able to cover its interest costs within a particular period, it could be a safe bet. For the same, one should also gauge at the interest coverage ratio. Interest coverage ratio - The interest coverage ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. As such, Interest coverage ratio = EBIT/ Interest expense

Ratios III : While the article related to the key 'profit and loss statement' ratios was more to do with the performance of a bank, the following ratios are more to do with the financial stability of a bank. In addition, we shall also compare the following ratios of India's largest banks. Some of these key ratios are:

Credit to deposit ratio Capital adequacy ratio Non-performing asset ratio Provision coverage ratio Return on assets ratio

Credit to deposit ratio (CD ratio): This ratio indicates how much of the advances lent by banks is done through deposits. It is the proportion of loan-assets created by banks from the deposits received. The higher the ratio, the higher the loan-assets created from deposits. Deposits would be in the form of current and saving account as well as term deposits. The outcome of this ratio reflects the ability of the bank to make optimal use of the available resources. Capital adequacy ratio (CAR): A bank's capital ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. The RBI has set the minimum capital adequacy ratio at 9% for all banks. A ratio below the minimum indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the bank do not expand their business without having adequate capital. CAR = Tier I capital + Tier II capital / Risk weighted assets It must be noted that it would be difficult for an investor to calculate this ratio as banks do not disclose the details required for calculating the denominator (risk weighted average) of this ratio in detail. As such, banks provide their CAR from time to time. Tier I Capital funds include paid-up equity capital, statutory and capital reserves, and perpetual debt instruments eligible for inclusion in Tier I capital. Tier II capital is the secondary bank capital which includes items such as undisclosed reserves, general loss reserves, subordinated term debt, amongst others. Non-performing asset (NPA) ratio: The net NPA to loans (advances) ratio is used as a measure of the overall quality of the bank's loan book. An NPA are those assets for which interest is overdue for more than 90 days (or 3 months). Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad quality of loans. NPA ratio = Net non-performing assets / Loans given

Provision coverage ratio: The key relationship in analysing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip). Provision coverage ratio = Cumulative provisions / Gross NPAs Return on assets (ROA): Returns on asset ratio is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned by the bank on its total net worth. ROA = Net profits / Avg. total assets


ratios generally fall into the following categories: Asset quality; Liquidity; Earnings; Capital adequacy; Market risk; and Funding risk.

Many other, more detailed ratios are ordinarily prepared by management to assist in the analysis of the condition and performance of the bank and its various categories of assets and liabilities, departments and market segments. a. Asset quality ratios: Loan losses to total loans Non-performing loans to total loans Loan loss provisions to non-performing loans Earnings coverage to loan losses Increase in loan loss provisions to gross income Size, credit risk concentration, provisioning b. Liquidity ratios: Cash and liquid securities (for example, those due within 30 days) to total assets Cash, liquid securities and highly marketable securities to total assets Inter-bank and money market deposit liabilities to total assets

c. Earnings ratios: Return on average total assets Return on average total equity Net interest margin as a percentage of average total assets and average earning assets Interest income as a percentage of average interest bearing assets Interest expense as a percentage of average interest bearing liabilities Non-interest income as a percentage of average commitments Non-interest income as a percentage of average total assets Non-interest expense as a percentage of average total assets Non-interest expense as a percentage of operating income d. Capital adequacy ratios: Equity as a percentage of total assets Tier 1 capital as a percentage of risk-weighted assets Total capital as a percentage of risk-weighted assets e. Market risk: Concentration of risk of particular industries or geographic areas Value at risk Gap and duration analysis (basically a maturity analysis and the effect of changes in interest rates on the banks earnings or own funds) Relative size of engagements and liabilities Effect of changes in interest rates on the banks earnings or own funds f. Funding risk: Clients funding to total funding (clients plus inter bank) Maturities Average borrowing rateT

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