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EKRP311 > Chapter6 > Flashcards

Chapter6 Flashcards

1
Q

What does the word perform mean when it comes to banks and other financial firms?

A

Performance refers to how adequately a financial firm meets the needs of its stockholders (owners), employees, depositors and other creditors, and borrowing customers.

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2
Q

What is the first step in analyzing financial statements?

A

-Determine the objectives
-A fair evaluation of any financial firm’s performance should start by evaluating whether it has been able to achieve the objectives its management and stockholders have chosen.

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3
Q

What is the key objective for all financial service institutions?

A

Maximizing a corporation’s stock value

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4
Q

What will happen if the value of stock fails to meet shareholders’ expectations?

A

Current investors may seek to unload their shares and the financial institution will have difficulty raising new capital to support its future growth.

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5
Q

Unpack the value of stock formula.

A

-E(Dt) represents stockholder dividends expected to be paid in future periods, discounted by a minimum acceptable rate of return (r) tied to the financial firm’s perceived level of risk.
- r is minimum acceptable rate of return.

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6
Q

What does the value of stock formula assume?

A

Assumes that the stock may pay dividends of varying amounts over time.

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7
Q

What are the 2 main components of the rate of return ( cost of capital)?

A

( 1) the risk-free rate of interest
(2) the equity risk premium

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8
Q

How does the value of a bank’s stock rise?

A
  • Expected Dividends Increase (due to growth of the markets served, or profitable acquisitions )
  • Risk of the Bank Falls ( due to increase in equity capital, decrease in loan losses)
  • Market Interest Rates Decrease( reducing shareholders acceptable rates of return)
  • Combination of Expected Dividend Increase and Risk Decline
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9
Q

What are the the stock values of financial institutions sensitive to

A

Changes in:
-Market interest rates
-Currency exchange rates
-Strength or weakness of the economy

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10
Q

What do the two stock-price formulas assume?

A

That the financial firm will pay dividends indefinitely into the future.

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11
Q

Why is the value of stock not always effective to indicate the performance of a financial firm?

A

The indicator is often not available for smaller banks and other relatively small financial-service corporations because the stock issued by smaller institutions is frequently not actively traded in international or national markets.

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12
Q

List some of the most important ratio measures of profitability used today.

A

-Return on equity capital(ROE)
-Return on assets(ROA)
-Net interest margin
-Net noninterest margin
-Net operating margin
-Earnings per share (EPS)

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13
Q

What is the ROA and what is it used for?

A

An indicator of managerial efficiency; it indicates how capable
management has been in converting assets into net earnings

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14
Q

What is the ROE and what is it used for?

A

-a measure of the rate of return flowing to shareholders
-It approximates the net benefit that the stockholders have received from investing their capital in the financial firm

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15
Q

List the ratios used to measure efficiency and profitability ?

A

-net operating margin
-net interest margin
-net noninterest margin

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16
Q

What do the measures of efficiency indicate collectively?

A

Indicate how well management and staff have been able to keep the growth of revenues

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17
Q

What does the net interest margin measure?

A

how large a spread between interest revenues and interest costs management has been able to achieve by close control over earning assets and pursuit of the cheapest sources of funding.

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18
Q

What does the net non interest margin measure?

A

measures the amount of noninterest revenues stemming from service fees the financial firm has been able to collect
relative to the amount of noninterest costs incurred

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19
Q

Is the net non interest margin typically positive or negative?

A

Negative because non-interest costs generally outstrip fee income.

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20
Q

What is the traditional measure of earnings efficiency?

A

Earnings spread.

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21
Q

What does the earnings spread measure?

A

The effectiveness of a financial firm’s intermediation function in borrowing and lending money and also the intensity of competition in the firm’s market area.

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22
Q

What is the return to a financial firm’s shareholders sensitive to?

A

How its assets are financed, whether more debt or more owner’s capital is used.

23
Q

How can a financial institution with a low ROA achieve
a relatively high ROE?

A

Through heavy use of debt (leverage) and minimal use of owners’ capital.

24
Q

What does the relationship between ROE and ROA illustrate ?

A

The fundamental trade-off the managers of financial-service firms face between risk and return.

25
What are the principles of return on equity?
- The net profit margin - The degree of assets utilization - The equity multiplier
26
What does the net profit margin reflect?
Effectiveness of expense management (cost control) and service pricing policies.
27
What does the degree of asset utilization reflect?
Portfolio management policies, especially the mix and yield on assets.
28
What does the equity multiplier reflect?
Leverage or financing policies: the sources chosen to fund the financial institution (debt or equity).
29
What management decisions do NPM and AU take?
* The mix of funds raised and invested * How big the institution should be * Control of operating expenses * The pricing of services * How to minimize the financial firm's tax liability
30
What management decisions regarding capital structure does the Equity multiplier address?
* What sources of funding should be used? *What dividends should be paid to stockholders?
31
Of the three ratios, which one is usually the largest?
Equity multiplier
32
What can cause a bank's asset utilization to decline?
Decline in market interest rate.
33
What is the variation of the ROE useful for?
For diagnosing problems in four different areas in the management of financial-service firms namely : ROE = Tax management efficiency x Expense control efficiency x Asset management efficiency x Funds management efficiency
34
What factors do the superior profitability for a financial institution depend on?
1. Careful use of financial leverage 2. Careful use of operating leverage from fixed assets 3. Careful control of operating expenses so that more dollars of sales revenue become net income. 4. Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired. 5. Careful control of exposure to risk so that losses don't overwhelm income and equity capital.
35
List the types of bank risks.
* Credit Risk * Liquidity Risk * Market Risk * Interest Rate Risk * Operational Risk * Legal and Compliance Risk * Reputation Risk * Strategic Risk * Capital Risk
36
What is credit risk?
The Probability that Some of the Financial Firm’s Assets Will Decline in Value and Perhaps Become Worthless.
37
List Credit risk measures.
* Nonperforming Loans/Total Loans * Net Charge-Offs/Total Loans * Provision for Loan Losses/Total Loans * Provision for Loan Losses/Equity Capital * Allowance for Loan Losses/Total Loans * Allowance for Loan Losses/Equity Capital * Nonperforming Loans/Equity Capital
38
Define Liquidity Risk.
Probability that the Financial Firm Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs.
39
List Liquidity Risk Measures
* Purchased Funds/Total Assets * Net Loans/Total Assets *Cash and Due from Banks/Total Assets *Cash and Government Securities/Total Assets
40
Define Market risk.
Probability of the Market Value of the Financial Firm’s Investment Portfolio Declining in Value Due to a Change in Interest Rates.
41
What are the 2 risks that fall under market risks?
- Price risk - interest rate risk
42
list the Market Risk Measures.
* Book-Value of Assets/ Market Value of Assets * Book-Value of Equity/ Market Value of Equity * Book-Value of Bonds/Market Value of Bonds * Market Value of Preferred Stock and Common Stock
43
Define interest rate risk.
The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income, the Value of its Assets or Equity.
44
List the Interest Rate Risk Measures.
* Interest Sensitive Assets/Interest Sensitive Liabilities * Uninsured Deposits/Total Deposits
45
Define Off-Balance-Sheet Risk.
The Volatility in Income and Market Value of Bank Equity that May Arise from Unanticipated Losses due to OBS Activities (activities that do not have a balance sheet reporting impact until a transaction is affected).
46
Define Operational Risk.
Uncertainty Regarding a Financial Firm’s Earnings Due to Failures in Computer Systems, Errors, Misconduct by Employees, Floods, Lightening Strikes and Similar Events or Risk of Loss Due to Unexpected Operating Expenses.
47
Define Legal and Compliance Risk.
Risk of Earnings Resulting from Actions Taken by the Legal System. This can Include Unenforceable Contracts, Lawsuits or Adverse Judgments. Compliance Risk Includes Violations of Rules and Regulations.
48
Define Reputation Risk.
This is Risk Due to Negative Publicity that can Dissuade Customers from Using the Services of the Financial Firm. It is the Risk Associated with Public Opinion.
49
Define Capital Risk.
Probability of the Value of the Bank’s Assets Declining Below the Level of its Total Liabilities. The Probability of the Bank’s Long Run Survival.
50
List the Capital Risk Measures.
* Stock Price/Earnings Per Share * Equity Capital/Total Assets * Purchased Funds/Total Liabilities * Equity Capital/Risk Assets
51
How do financial firms cater for the need for greater efficiency in their operations?
By reducing operating expenses and increasing the productivity of their employees through the use of automated equipment and improved employee training.
52
What are the ratios used for operating efficiency and employee productivity?
- Operating efficiency ratio - Employee productivity ratio
53
What does a rise in the value of the operating efficiency ratio mean?
Indicates an expense control problem or a falloff in revenues, perhaps due to declining market demand.
54
What does a rise in the value of the employee productivity ratio mean?
suggests management and staff are generating more operating revenue and/or reducing operating expenses per employee, helping to squeeze out more product with a given employee base.

EKRP311 (4 decks)

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