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Understanding the profit & loss statement of banks/ financial institutions - Views on News from Equitymaster
 
 
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  • Dec 24, 2009

    Understanding the profit & loss statement of banks/ financial institutions

    In the previous article of this series, we had discussed some of the key ratios relating to the cash flow statement. With that, we concluded our discussion on financial statements. However, we have till now discussed the financial statement for non-financial companies. Non-financial companies include firms involved in manufacturing and providing services.

    However, financial statements of financial firms such as banks are very different. In the next few articles, we will talk about the financial statements for such firms. On the back of banking regulations, banks' accounts are presented in a different manner. As such, one needs to analyze the same in a different manner.

    Before we get into a detailed discussion, we think it would be better to start right at the basics. For this, we will see the difference between the financial statements of a financial organization and a non-financial organization.

    Profit and Loss account

    Let's start with the profit and loss account. A non-financial company, say a manufacturing company, derives revenues from product sales. The expenses for the company would include that of raw materials, labour, power and fuel, salaries and wages, administrative costs, amongst others.

    For a bank it is quite different. The basic function of a bank is to accept deposits and give out loans. On the loans that it gives out, it charges an interest rate. This interest earned is the key revenue source for a bank. This term is known as 'interest income'.

    Apart from interest income from loans advanced, it also earns interest from certain investments that it makes. In addition, a bank is also required to keep a certain amount of its cash reserves with the RBI. However, it must be noted that a bank's interest income from investments depends upon some key factors like monetary policies (Cash reserve ratio and statutory liquidity ratio limits) and credit demand.

    Cash reserve ratio (CRR) is a certain percentage of deposits which a bank is mandated to maintain with the RBI. Statutory liquidity ratio (SLR) is the second part of regulatory requirement, which requires banks to invest in G-Secs. The bank's revenues are basically derived from the interest it earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand is lower, the bank increases the quantum of investments.

    Apart from interest income being the key revenue source for a bank, it also earns income in the form of fees that it charges for the various services it provides. These services include processing fees for loans and forex transactions, amongst others. It is believed that banks derive nearly 50% of revenues from this stream in developed economies. In India, the story is very different. This stream of revenues contributes about 15% to the overall revenues.

    Now that we have covered the income part of the profit and loss account, we shall move on to the expenditure aspect of the same. The key expense of a bank is interest on deposits that are made with it. These could be in the form of term (fixed) or savings bank account deposits. The second biggest expense head for a bank would be its operating expenses. This head would include all operational costs, which even non-financial companies expend. Some of include employee costs, advertisement and publicity costs, administrative costs, rent, lighting and stationary.

    Under expenses, there is also an item called 'provisions and contingencies' that is included. In the simplest terms, these are liabilities that are of uncertain timing or amount. This includes provisions for unrecoverable assets. In accounting terms, such provisions are called as 'Provisions for Non-performing assets (NPAs)'. Apart from NPAs, these provisions also include provision for tax and also depreciation in the value of investments.

    After removing these heads from the income generated, we simply arrive at the profits figure. The process of appropriation thereafter is similar to that of non-financial companies.

    We shall take up an example to understand this. Displayed below is the profit and loss account of HDFC Bank.

    Source: HDFC Bank's FY09 annual report.

    The total income generated by the bank during FY09 was Rs 198 bn. Of this, interest income was Rs 163 bn. The balance was contributed by other income.

    Out of the Rs 163 bn of interest income, HDFC Bank earned about Rs 121 bn from interest on loans advanced/ bills. The income from investments during the year stood at Rs 40 bn, while interest from the balance with RBI and other inter-bank funds stood at Rs 2 bn.

    During FY09, HDFC Bank earned revenues of Rs 34 bn as other income. The largest contributor here was fee income (Commission, exchange and brokerage) to the tune of Rs 26 bn. This translates as 13% of the total income during the year. Other major contributors were profit on sale of investments and exchange transactions.

    Moving on to the bank's expense account. The total interest expended stood at Rs 89 bn. The interest on deposits stood at Rs 80 bn , while interest on borrowings from other sources such as the RBI and other bank borrowings stood at Rs 6 bn. Operating expenses during the year stood at Rs 56 bn. The major contributor to this head was employee costs (Rs 23 bn). Provision and contingencies amount stood at Rs 29 bn.

    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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    4 Responses to "Understanding the profit & loss statement of banks/ financial institutions"

    ips

    Jan 1, 2010

    Articles Useful and thought provoking.Please mail all the Articles from archieves to my mail.

    Like 

    devaredeva

    Dec 30, 2009

    The last line of the article has the link to the previous articles.

    Like 

    Turab Dedanwal

    Dec 29, 2009

    Dear Sir
    I am the new memeber of the Equity Master and would like to have all the previous issues of "Investing - Back to Basics". If possible the issues can be mailed to me at the above address

    Like 

    CA. K.RAVIKRISHNAN

    Dec 25, 2009

    As a C.A I find these articles very interesting , I would like to have the editions
    Investing : Back to basics I - X.Please let me have these

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