Financial ratios for banks analysis

Using Ratio Analysis to Manage Not-for-Profit Organizations - The CPA  Journal

Bank stocks often find a place in everyone’s portfolio. They are lucrative given their day-to-day involvement in investors’ lives. While investing in stocks from the banking sector are an interesting investment option, analysing them requires a keen understanding of some of the key financial ratios that reflect a bank’s financial health. There are certain benchmark ratios for banks that can help you gauge their performance and decide whether to include them in your investment portfolio or not.

Some of the important financial ratios for banks are:

Gross non-performing assets: Non-performing assets are a bank’s loans that have a higher degree of risks of non-repayment; these are ascertained by following the Reserve Bank of India’s (RBI) guidelines. If a bank does not receive interest payment for its loan for three months in a row, the loan is categorised as a Non-Performing Asset (NPA). Gross non-performing assets show the condition of lending done by the bank. A poor NPA ratio indicates that the bank’s assets have a poor standing and there’s a high risk of the bank’s loan defaults inching towards bad debts.

Net non-performing assets: Banks start assuming the risks associated with bad loans through provisions. When the bad loans of banks spill through the provision, it is known as net non-performing assets. An increasing NPA indicates a further decrease in a bank’s loan quality and higher chances of default. This net NPA starts decreasing the bank’s profitability.

Current account savings account ratio: Banks receive fund inflows via current account, savings account, and term deposits. These inflows attract interest payments that go out to the customers or depositors of a bank. The outflow of interest payments is higher in term deposits than in savings accounts. There is no interest outflow in the case of current accounts. 

The Current Account Savings Account (CASA) ratio indicates how much of the bank’s total deposits are in current accounts and savings accounts. A higher CASA ratio is beneficial because it means that a higher portion of the bank’s deposits are in current and savings accounts as opposed to term deposit accounts and hence the bank’s fund inflows are coming at a lower cost. This is better for its overall profitability. 

Net interest ratio: Banks receive funds from customers in the form of deposits on which they have to pay interest to the customers. They then use these funds to give out loans and charge interest on the same. One of the main ways banks make a profit is through the difference between these interest rates. Net interest means the difference between interest earned and interest paid. A higher net interest ratio indicates a bank has earned more interest against the interest paid. Better the interest ratio, the better the banks’ earning capacity.

Credit deposit ratio: Banks source funds through deposits against interest and lend the same funds for a higher rate of interest. A bank whose credit ratio is higher indicates that it is lending a higher portion of the funds sourced. For instance, if a bank’s credit deposit ratio is 75%, this means that for every Rs. 100 deposited, the bank lends Rs. 75. A credit ratio of 80-90% is generally regarded as ideal for banking units. A ratio higher than that would indicate that the bank is stretching itself too thin and may not have sufficient reserves in the event of an unexpected contingency. 

Returns ratio: This ratio compares a bank’s earnings to its assets. This ratio indicates how well a bank has performed in utilising its assets to generate returns. This ratio helps in ascertaining how well its assets are deployed for income generation.

Capital adequacy ratio: This ratio helps in knowing if a bank is maintaining adequate capital to manage the risks associated with banking activities. A minimum capital adequacy ratio for banks is determined by RBI, which they have to maintain as per the regulations. Recent banking meltdowns have made regulators more stringent when it comes to bank capital adequacy norms.

Conclusion

These benchmark ratios for banks, among other financial information, are a good thing to research before you buy stocks. This is because these financial ratios for banks give you facts and figures that allow you to make sound investment decisions instead of simply investing based on how popular the bank is or what the market sentiment for it is.