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Financial Ratios

FOUR BASIC TYPES - most commonly used for each - can be used for some financial companies. LIQUIDITY Current ratio = Current Assets / Current Liabilities Not so relevant for financial firms - most assets liquid. MANAGEMENT SKILL Total Asset Turnover = Sales / Total Assets Again, not so relevant because traditional sales are typically not very large. Interest and investment income is more relevant.

PROFITABILITY Operating profit margin = Operating Profit/Sales Return on Revenues = Net Income (or EBIT)/Tot. Assets Return on Assets = Net Income (or EBIT)/Total Assets Return on Equity = Net Income/Equity These are measures of top-line profitability and bottomline profitability, respectively. Similar for financial firms. FINANCIAL RISK Debt Ratio = Debt / Assets Times Interest Earned = Net Operating Income / Interest Expense Leverage and interest-paying ability - used for financials.

Depository Institutions Banks, S&L, Credit Unions


Financial Statements

National-charter banks must submit uniform accounting statements to the Comptroller of the Currency.
State charter banks submit accounting statements to their state regulator.

LIQUIDITY RISK - different than typical liquidity ratios Liquidity ratio = (Cash+short-term securities)/Assets Loans to Deposits = Loans/Deposits Deposits Times Capital = Deposits/Equity A mixture of profit potential and risk measures.

MANAGEMENT EFFICIENCY

Earning Assets to Total Assets = Assets-(Cash+Fixed Assets+Non-earning Deposits) / Total Assets


Burden = (Noninterest Exp.-Nonint. Inc.)/Tot. Assets Efficiency = Nonint. Exp./(Nonint. Inc. + Net Int. Inc.) Asset Utilization = Total Operating Income / Total Assets

PROFITABILITY Interest Margin to Earning Assets = (Interest Income-Interest Expense)/Earning Assets Profit Margin = Net Income/Total Operating Income Return on Earning Assets = Net Income/Earning Assets Return on Equity = Net Income/Equity

FINANCIAL RISK Loan Loss Coverage = (Pretax Income+Loss Provisions) /Net Charge-offs Provisions to Charge-offs = Loss Provisions/Net Charg. Loss Allowance to Loans = Loss Allow./Loans Equity to Assets = Equity / Total Assets Other issues important to financial analysis of banks Examine assets for risky asset types (LDC debt, related party loans, allowance for loan loss etc.).

Examine shareholder equity for unrealized gains/losses.

Loan Loss Reserves (part of the common equity account) should be sufficient to meet actual and potential losses. Review footnotes and management discussion for disclosure of non-performing assets- observe trend. Review footnotes for data on Off-Balance Sheet Activities which can add risk and profits. Review trend in demand and time deposits - these are low-cost sources of funds. Examine Other Income typically from services - this income is more stable and desirable than interest income.

Making Loans and Reserving for Losses Versus Guarantees


Financial firms, particularly banks, can make risky loans or provide loan guarantees and both are conceptually the same. Risky loan value = risk-free value + loan guarantee value

When a loan is made, the bank earns interest above the riskfree rate. The premium above the risk-free rate is a premium for bearing risk as well as compensation for analyzing the and monitoring the borrowers financial condition.
Loan rate = risk-free rate + risk premium and compensation

Effect of Loans vs. Guarantees on Financial Statements


1. The effects of loans - transparent. The loan appears as an asset on the balance sheet.

A loan loss reserve appears as a contra-asset that reduces the loan value by an amount to cover the expected loss on the loan - a risk measure.
Interest is collected periodically and appears on the balance sheet. 2. The effects of loan guarantees - opaque Off-balance sheet intangible liability - no contingent liability is booked. Footnote should provide some info. Large up-front fee may appear immediately on income statement or periodic fee shows up over time.

3. The cash payment for the guarantee goes to the cash account and a portion of the payment appears as a reserve for default and the rest goes to equity. The size of the reserve is supposed to be commensurate with risk of the borrower. 4. Problems with guarantees Guarantor may reserve too little when loan is not on balance sheet. If reserve is set properly, competitor lenders are able to see the value you place on particular customers creditworthiness.

Note: Earned premiums are premiums paid on policies with time elapsed - unearned premiums are paid but no time elapsed. PROFITABILITY Investment Return =Net Investment Income/Premiums Earned Operating Ratio = Combined Ratio After Dividends Investment Return Overall Profitability = 100 - Operating Ratio Return on Revenues = Net Income / Revenues Return on Equity = Net Income / Equity

Other issues in financial analysis of Insurance Companies Look for significant differences between fair value of investments and their costs or amortized costs.

Check the equity section for unrealized gains (losses).


Check for a deferred policy acquisition cost buildup. Check that loss reserves grow adequately with insurance in force.

Issues for Investment Companies - Mutual Fund Managers Examine Expense Ratio = Expenses / Operating revenues, or Expense Ratio = Expenses / Assets Under Management Marketing Ratio = Marketing Exp. / Operating Revenues.

Management Fee Ratio = Management Fees / Assets Under Management


Many of the traditional ratios apply also.

Issues for Finance Companies Examine Expense Ratio = Expenses / Operating revenues Loans to Equity = Loans / Equity Return on Revenues = Net Income / Revenues Can be treated similar to banks in many ways because they provide loans, otherwise, use traditional ratios.

Dupont Analysis - ROE


ROE = (Net Income/Total Assets) x (Total Assets/Equity) = ROA x (Equity Multiplier) = (Net Inc./Total Operating Income) x (Total Operating Income/Tot. Assets) x (Total Assets/Equity) = (Profit Margin) x (Asset Utilization) x (Equity Mult.) This says that ROE is determined by; (1) how profitable a companys products are; (2) how well it uses its assets and; (3) how much leverage it has. Net Income components to consider are Interest and Noninterest Income and Expenses, Taxes and Loan Loss Provisions. Financial firms tax rates dont change much because they have few assets to depreciate or write down.

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