In the >previous article of this series , we initiated our discussion on the financial statements of banks. We discussed how different is a profit and loss statement of a financial company as against that of a non-financial company. In this article, we shall discuss some of the key ratios related to a bank's profit and loss statement.
As a bank's accounts are very different from that of a manufacturing firm, it would be necessary for an investor to understand some of the key performance ratios. As you must be aware, analysis of a bank's accounts differs significantly from any other company due to their structure and operating systems. Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank. Some of these key ratios are:
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.
Let's take up an example to understand this well. Above, we have displayed HDFC Bank's FY09 profit and loss account. We shall calculate the above mentioned ratios for the bank.
We will first calculate HDFC Bank's NIM for the year FY09. As mentioned above, for calculating NIM, one needs to divide the net interest income by the average earning assets.
Or, NIM = (Interest income - interest expenses) / average earnings assets
The interest income during FY09 stood at ₹163 billion. The interest expended during the year was ₹89 billion. Therefore the net interest income is ₹74 billion (₹163 - ₹89 billion).
Average earnings assets for the bank for the year stood at ₹1,753 billion. It is calculated by adding the cash and balances with Reserve Bank of India (₹135 billion), balances with banks and money at call and short notice (₹40 billion), investments (₹587 billion) and advances (₹990 billion).
Therefore the NIM for the year FY09 was 4.2% (₹74 billion / ₹1,753 billion)
Now moving on to the OPM for HDFC Bank - Net interest income for the year stood at ₹74 billion. The operating expenses for the year were about ₹56 billion. Total interest income for the year was ₹163 billion. Therefore, the OPM for the year stood at,
OPM = (Net interest income (NII) - operating expenses) / total interest income
= ₹74 billion - Rs 56 billion / ₹163 billion. This is equal to about 11%.
Moving on the cost to income ratio for HDFC Bank - As mentioned above, it is calculated by operating expenses by the total of the net interest income and the non-interest income.
Or, Cost to income ratio = Operating expenses / (NII + non-interest income)
Operating expenses for the bank during the year stood at ₹56 billion. Non-interest income, which is basically the other income, stood at ₹36 billion. NII, as calculated above, was ₹74 billion. Putting all this together, we get the following:
= ₹56 billion / (₹74 billion + 36 billion)
= 50.9%. The cost to income ratio stood at almost 51% for the year FY09.
The last ratio is the other income to total income ratio. It is a very straight forward ratio. The other income for the year FY09 stood at ₹34 billion. The total income for the year was about ₹198 billion. Therefore HDFC Bank's other income to total income ratio for the year FY09 was about 17%.
In the next article of this series, we shall continue our discussion on the financial statements of banks.
This article is authored by >Equitymaster.com , India’s leading independent equity research initiative
Disclaimer: The opinions expressed by Equitymaster are theirs alone and do not reflect the opinions of The Hindu Business Line or any employee thereof. The Hindu Business Line is not responsible for the accuracy of any of the information within the article.