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Key ratios associated with banks' P&L statements - Views on News from Equitymaster
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  • Jan 5, 2010

    Key ratios associated with banks' P&L statements

    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. Below, we have displayed HDFC Bank's FY09 profit and loss account. We shall calculate the above mentioned ratios for the bank.

    Source: HDFC Bank's FY09 annual report.

    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 Rs 163 bn. The interest expended during the year was Rs 89 bn. Therefore the net interest income is Rs 74 bn (Rs 163 - Rs 89 bn).

    Average earnings assets for the bank for the year stood at Rs 1,753 bn. It is calculated by adding the cash and balances with Reserve Bank of India (Rs 135 bn), balances with banks and money at call and short notice (Rs 40 bn), investments (Rs 587 bn) and advances (Rs 990 bn).

    Therefore the NIM for the year FY09 was 4.2% (Rs 74 bn / Rs 1,753 bn)

    Now moving on to the OPM for HDFC Bank - Net interest income for the year stood at Rs 74 bn. The operating expenses for the year were about Rs 56 bn. Total interest income for the year was Rs 163 bn. Therefore, the OPM for the year stood at,

    OPM = (Net interest income (NII) - operating expenses) / total interest income

    = Rs 74 bn - Rs 56 bn / Rs 163 bn. 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 Rs 56 bn. Non-interest income, which is basically the other income, stood at Rs 36 bn. NII, as calculated above, was Rs 74 bn. Putting all this together, we get the following:

    = Rs 56 bn / (Rs 74 bn + 36 bn)

    = 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 Rs 34 bn. The total income for the year was about Rs 198 bn. 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.

    Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article



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