Topic 3 - Financial Statement Analysis Flashcards
INTEREST MARGIN Ratio
Net interest revenue / Earning assets
Earning assets
Equals securities andloans
Canalsobecalculatedastotalassetsminus
cash&duefromother institutionsandfixed&otherassets
Net Profit Margain Ratio
Net profit after tax / Revenue
Net Profit Margain
This ratio measures the profitability of the ADI as a percentage of revenue earned
It represents what is left out of each dollar of revenue after all costs have been deducted
This ratio could be improved by increasing the interest margin and non-interest revenue, or by controlling non-interest expenses such as overheads
ASSET UTILISATION
This ratio reflects how effectively management has invested in earning assets by calculating the yield generated by the ADI’s assets.
This measure is strongly affected by the proportion of assets that are invested in earning assets (i.e. the extent to which the ADI can minimise cash and fixed assets), and how much revenue those earning assets are able to generate
ASSET UTILISATION Ratio
Revenue / Assets
RETURN ON ASSETS (ROA)
This ratio reflects management’s ability to use financial and real resources to generate net revenue
ROA is often seen as the best measure of an ADI’s efficiency
ROA depends on how much revenue is generated by the ADI’s assets, and how much profit is obtained from that revenue
ROA Ratio
Net profit after tax / Assets
LEVERAGE MULTIPLIER
Leverage means the use of debt to “lever up” returns to ordinary shareholders The leverage multiplier measures the degree of leverage The more debt that is used to acquire assets, the greater the proportion of assets to equity
LEVERAGE MULTIPLIER Ratio
Total assets / Equity
RETURN ON EQUITY (ROE)
This is considered to be the most important measure of profitability, because it combines all other measures of profitability into a single measure It indicates how competitive the ADI is able to be in raising private sources of capital in a market economy
The return from financial assets is generally lower than the return from real assets such as factories, and hence ROA is lower for financial intermediaries than for general companies However, financial intermediaries have far more in the way of assets and liabilities, compared to equity, because they take on significant liabilities to acquire assets, increasing leverage ROE is therefore comparable to other business with whom they have to compete for capital
RETURN ON EQUITY (ROE) Ratio
Net profit after tax / Equity
The four main types of risk faced by an ADI are:
- 4.1Liquidity risk
- 4.2Interest rate risk
- 4.3Credit risk
- 4.4Capital risk
LIQUIDITY RISK
A simple measure of liquidity risk is sources of liquidity divided by the need for liquidity The actual values used can vary, as long as the ratio is calculated in a consistent way
The higher the ratio, the lower the risk
LIQUIDITY RISK Ratio
Sources of liquidity / Need for liquidity
INTEREST RATE RISK
Interest rate risk can be estimated by isolating assets and liabilities that are sensitive to interest rate changes –where revenue and costs will change if interest rates change
INTEREST RATE RISK Ratio
Interest rate-sensitive assets / Interest rate-sensitive liabilities
An ADI with a interest rate risk ratio:
Greater than 1.0 will benefit if interest rates increase Less than 1.0 will benefit if interest rates decrease Equal to 1.0 has the lowest level of risk
The latter can be difficult to achieve, because it often means increasing short-term securities, which offer less return than long-term securities
Management might seek a ratio other than 1.0 if they think they can predict interest rate changes
CREDIT RISK
Credit risk is the risk that borrowers will default
“Loan quality” refers to the creditworthiness of the borrower, so the lower the quality of loans the more credit risk faced by the ADI
The higher the ratio, the more credit risk
Credit Risk Ratio
Medium quality loans / Assets
CAPITAL RISK
As previously discussed, leverage increases returns to ordinary shareholders, but the more debt, the more risk–interest payments represent fixed, contractual obligations, so the more there are, the more variable (i.e. risky) are shareholder returns
This capital risk ratio is the reciprocal of the leverage multiplier
In this case the higher the ratio, the lower the level of capital risk
Capital Risk Ratio
Equity / Assets
BENCHMARKS FOR COMPARISON
The ratios we have looked at give us a snapshot of the level of return and risk, but they don’t tell us much in isolation –we need benchmarks to determine whether the return and risk are high or low, getting better or worse
Typical benchmarks we might use include:
Past performance
Comparison with similar institutions or peer groups Assessment against targets or objectives Consideration of share price
THE RISK-RETURN TRADE-OFF for
Liquidity Risk
Liquidity risk
This can be reduced by investing in more shortterm, liquid assets, but these generally have less return than long-term asset
THE RISK-RETURN TRADE-OFF for
IR Risk
Interest rate risk
Most liabilities are interest rate sensitive, so achieving a ratio of 1.0 usually involves acquiring more interest rate sensitive assets, which usually provide a lower return
THE RISK-RETURN TRADE-OFF for
Credit Risk
Credit risk
This can be reduced by improving loan quality, but higher quality loans have a lower interest rate than lower quality loans
THE RISK-RETURN TRADE-OFF for
Capital Risk
Capital risk
This can be reduced by increasing equity and/or decreasing debt, but this reduces the leverage multiplier, which in turn reduces returns to ordinary shareholders
