FRA Flashcards
CAMELS
best known of systematically scrutinizing a bank’s level of systematic risk
Capital adequacy Asset quality Management capability Earnings sufficiency Liquidity position Sensitivity to market risk
Capital adequacy
whether a bank’s level of capital is sufficient for its financial position to weather potential losses
Risk-weighted asset (RWA)
Under Basel III, tier 1 capital = common equity (less intangibles and deferred tax asset) + subordinated instruments with no specified maturity and no contractual interest/dividend
Tier ii capital = subordinated instruments with maturity exceeding five years
Minimum CS tier1 of 4.5% of RWA
Total tier 1 of 6% RAW
Total capital (tier 1 and 2) of 8% RWA
stable funding - 1 year
Asset quality
considers liquidity and credit quality of the securities and loans, and how diversified these assets are.
off-balance sheet items including guarantees, unused lines of credit, and letter of credit should also be evaluated
loans (amortized cost = amortized cost- allowances for loan losses)
Management capabilities
effective mgmt involves successfully identifying and exploiting appropriate profit opportunities while simultaneously managing risk credit risk market risk operating risk legal risk
Earnings
sufficient earnings are required to provide adequate ROC
high quality earnings are :
unbiased accounting estimate
sustainable earnings
fair value are used to measure financial assets
- level i inputs are quoted prices for identical financial a/l in active market
- level 2 inputs are observable but are not the quoted prices for identical financial instruments
level 3 in puts are unobservable
Liquidity
Liquidity coverage ratio (LCR)
= HIGH LIQUID assets/
banks expected cash outflow (anticipated 1-month liquidity needs in a stress scenario)
highly liquid asset = easily convertible into cash
Minimum liquity - 30 days
# of days of stress volume of cash outflows:
30* LCR
Sensitivity to market risk
considers the extent to which a bank’s financial position and earnings could be negatively impacted by shifts in the markets.
other factors in analyzing a bank
off-balance sheet liability support by gov't risks disclosed competitive environment corporate culture segmental data fx exposure mission of the bank
factors to consider in analyzing an insurance company
capitalization ,liquidity, business profile, characteristics of earnings, and returns on investments
life and health (roa, roe, growth and vol of capital, bvps)
-long term contract
-claims are straightforward to predict
higher returns offered by riskier investments
Property and casualty -short term, only 1 year or so -claims are more difficult to foresee require high degree of liquidity lower & stable return/risk
revenues com from
1) premiums collected from the purchasers of insurance
2) investment returns earned on funds collected as premiums and held to pay out as benefits
capital adequacy formula
capital/risk-weighted assets
RAW= $asset * risk adjusted weight
Common equity tier 1 capital
common stock Issuance surplus related to cs retained earnings accumulated other comprehensive income adjustments: - intangible assets & - DTA
Liquidity coverage ratio (LCR)
= HIGH LIQUID assets/
bank’s expected cash OUTFLOW
Net stable funding ratio (NSFR)
Available stable funding
/ banks’ required stable funding
set a target minimum of greater than 100%
P&C distribution
- direct writing
have their own sales and marketing staff - agency writing
use independent agents, exclusive agents, and insurance brokers to sell policies
loss and loss adjustment expense ratio
(loss expense + loss adjustment expense)
/ net premiums earned
the lower the better
=claims paid +change loss reserves/net premium earned
indicator of the quality of a company’s underwriting activities - the degree of success an underwriter has achieved in estimating the risks insured
underwriting expense ratio
underwriting expense including commissions
/net premiums written
indicator of the efficiency of money spent on obtaining new premiums
combined ratio
loss and loss adj expense ratio
+ underwriting expense ratio
= total insurance expense / net premium earned > 100%
implies underwriting loss
if low implies, hard mkt
if high implies, soft market
a measure of the overall underwriting profitability and efficiency of an underwriting operation.
dividends to policy holders ratio
dividends to policyholders/net premium earned
combined ratio after dividends
combined ratio - dividends to policyholders ratio
target minimum capital adequacy ratio
amount of qualifying capital/
amount of RWA required
high quality reporting
GAAP compliant and decision-useful
high quality earnings
persistence and sustainability
relevant and faithfully represent the economic reality of the company’s activities
adequate: high quality earnings covers the company’s cost of capital
sustainable: high quality tend to persist in the future
potential problems that affect the quality of financial reports can result from
1 measurement and timing issue
2. classification issues
GAAP compliance is necessary, but not sufficient, condition for high-quality financial reporting
earnings are
accrual + cash
aggregated accruals= accrual-based earnings - cash earnings
B/S approach to decompose earning
net operating assets = operating assets - operating liabilities
NOA = (total asset- cash)- (total liabilities - total debt)
accrual ratio = (NOAt- NOAt-1)/average(NOAt+NOAt-1)
CF approach to decompose earning
preferred because it generates a cleaner measure which is free from the effects of non-cash acquisitions and foreign currency translation adjustment effects
earnings= NIt- (CFOt+CFIt)
Accrual ratio = (NIt- (CFOt+CFIt))/ avg (NOAt+NOAt-1)
the higher the accrual ratio
the lower the earning quality
net interest margin ratio
[int. received(long term( - interest paid (short term)]
/ avg asset
loss reserve
est. value of unpaid claims
if downgrade implies conservative in est. their loss
upgrade implies aggressive profit booking, warning sign for analyst
Bemeish model
mean=0, std=1
limitation: rely on accounting data, may not reflect economic reality
prob of manipulation (M-Score) probit model
if m-score increase, prob of earnings manipulation increase
cut off=3.8%
M> -1.78
DSR days sales receivable index
> 1 implies revenue inflation
=receivable / sales t
/ (rec/sales t-1)
GMI gross margin index
> 1 deteriorate likely to manipulate earnings
=gross margin t-1/
gross margin t
AQI Asset quality index
increase mean excess capitalizing expense
=(1-pp&e+ca)/TA
/(1-pp&e+ca/ta)t-1
SGI sales growth index
manipulate sales and earnings
= salest/sales t-1
DEPI depre. index
depr rate t-1 /
depr rate t
>1 implies asset are depre. slower to manipulate earnings
depr rate= dep(dep+pp&e)
if decrease implies understated depr rate
SGAI (sg&a expense index)
SGA/sales over prioer period
Sales growth index of more than 1 simply implies that the growth in sales is positive.
accruals
(income before extraordinary items
-cash from operations)
/ total assets
are less persistent than cash component
revert to mean more quickly
LEVI (leverage index)
leverage t/leverage t-1
leverage =debt/assets
Account receivable turover
365/DSO
Earnings t+1
a +b1*earnings t +error
= a+ b1(cash flow)t + b2(accruals)4 + error
b1>b2
Altman Z score model
probability for bankruptcy
the higher the better, the less the more likely to go bankrupt
limitation: single period static model, does not capture change in days over time
net working capital/total asset RE/total asset operational profit/total asset maket value of equity/bv of liability sales/total assets all positively related to Z-score
flag of accruals
positive net income, but negative operating cash flow
higher growth rate of rec. relative to growth rate of revenue
higher sales outstanding (DSO) overtime, poor revenue quality
rec. turnover = sales/avg rec
rev. recognition issues, aggressive revenue recognition
channel-stuffing
bill & hold
missclassification
revenue a/r reclassify inventory as LT asets reclassifying non-core revenue as rev. from core continuing operations reclassifying exp as operating treat CFI (sale of LT asset) as CFO
Dupont analysis
adj. b/s, i/s for investment in associate
ROE (5)
NI/EBT* EBT/EBIT* EBIT/SALES * SALES/AVG ASSETS * Assets/Equity)
Tax burden * int. burden * EBIT margin * TATO * financial leverage
ROE (3)
net profit margin * asset turnover * leverage
adj asset base
total asset - investment in associates
adj NI
NI- NI of associates
adj tax burden
(NI-Equity income)/EBIT
adj TATO
Rev /
(beg total asset-beg equity invesmtnt) + (end ta-end equity invesment)/2
determining future capital allocation
capital expense/total asset
=1 allocation of capital expense
>1 growing the segment & low EBIT implies over-allocate resources
<1 lesser proportion
EST CF
EBIT+DEPR/AMORTIZATION
CGO cash generated from operations
EBIT + non-cash changes - increase in working capital
= OCF+ cash paid for interest + cash taxes paid
adj total asset b/s
asset + lease - depr on lease
value of opeartion
ending lease * liability
= bb lease + int. - rent
total equity = equity + +rent pmt - depr-int pmt
adj I/S
EBIT \+ rent exp =EBIT excluding cost of op. leases -depr of operating leases =adj EBIT
Mean reversion in earnings
tendency of earnins at extreme levels to revert back to normal levels overtime, implies that earnings at very high levels are not sustainable
high financial reporting quality
completeness (existence of off-balance sheet liabilities)
unbiased measurement
clarity of presentation
income from continuing operations
includes all revenues and expenses except discontinued operations and extraordinary items
capitalizing a lease enhances earnings quality. An operating lease lowers earnings quality.
capitalizing a lease enhances earnings quality. An operating lease lowers earnings quality.
Revenue quality issues may be indicated by
large increases in accounts receivable or large decreases in unearned revenue
an increase in the volatility of the ratio of revenue to cash collections
and by lessor use of capital leases.
Operating leases
are a form of off-balance sheet financing that result in an UNDERstatement of an entity’s liabilities.
Double-declining balance (DDB) depreciation
is a more conservative method of depreciation than straight-line because more depreciation expense is reported in the early years under DDB.
Number of days of stress
=30* Liquidity coverage ratio (LCR)
Liquidity coverage ratio (LCR)
= high liquid asset/net out flow
Systemic risk refers to
the risk that impairment in one part of the financial system could spread throughout other parts of the financial system, and then negatively affect the entire economy.
tax burden ratio
1 - the effective tax rate
the higher the cash flow based accruals ratios
the lower the earnings quality
the highest the M-score
the higher the prob of manipulation
banks is systemic important, role of bank
- serve as intermediaries
- accepting deposits from capital providers
- providing capital via loans to borrowers
minimum capital requirement
minimum % of its rwa that a bank must fund with equity capital
it prevents a bank from assuming so much financial leverage that it’s unable to withstand loan losses
minimum liquidity
bank must hold enough high-quality liquid assets to cover its liquidity needs in a 30-day liquidity stress scenario
stable funding
minimum amount of stable funding relative to bank’s liquidity needs over a one-year horizon
Is off-balance asset require capital funding and be risk weighted?
yes
conversion price
par / conversion ratio
