Measuring-Bank-Performance.docx

8/18/2019 Measuring-Bank-Performance.docx

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Measuring Bank Performance

What is performance?

How adequately a financial firm meets the needs of its stockholders, employees,

depositors and other creditors and borrowing customers

Keep regulators satisfied that operating policies, loans and investments are sound

Must be directed towards specific objectives

To understand how well a bank is doing, we need to start by looking at a bank’s income

statement, the description of the sources of income and epenses that affect the bank’s

profitability!

Evaluating Performance

"erformance must be directed toward specific objectives

# 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

# key objective is to maimi$e the value of the firm


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What is Profitability?

is a bank’s first line of defense against unepected losses, as it strengthens its capital position and

improves future profitability through the investment of retained earnings!

Why Profitability based performance measurement?

Traditionally, a common metric used to measure performance has been %et &ncome! However, it does not

totally serve the purpose of measuring how effectively a bank is functioning in relation to its si$e and

does not truly reflect its asset efficiency! %et &nterest Margin captures the spread between the interest

costs and earnings 'anking "rofitability and "erformance Management on banks liabilities and assets and

indicates how well the bank manages its assets and liabilities! 'ut it fails to measure the operational

efficiency of a bank! "rofitability based measurement on the other hand can serve as a more robust and

inclusive means to measure the performance by gauging the etent of operational efficiency as well as

capturing the nuances of banks diversifying earnings through non(interest income activities and

management of their costs

Operating Income )perating income is the income that comes from a bank’s ongoing operations! Most of a bank’s operating

income is generated by interest on its assets, particularly loans! &nterest income fluctuates with the level

of interest rates, and so its percentage of operating income is highest when interest rates are at peak

levels!

For eample, a retailer*s main operating activities are the buying and selling of merchandise or

goods!

!oninterest income

%oninterest income is generated partly by service charges on deposit accounts, but the bulk of it comesfrom the off(balance(sheet activities, which generate fees or trading profits for the bank! The importance

of these off(balance(sheet activities to bank profits has been growing in recent years!

Operating Epenses


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)perating epenses are the epenses incurred in conducting the bank’s ongoing operations! #n important

component of a bank’s operating epenses is the interest payments that it must make on its liabilities,

particularly on its deposits! +ust as interest income varies with the level of interest rates, so do interest

epenses!

!oninterest epenses

%oninterest income include the costs of running a banking business salaries for tellers and officers, rent

on bank buildings, purchases of equipment such as desks and vaults, and servicing costs of equipment

such as computers!

Operating epenses include

• #dvertising

• office epenses

• supplies

• legal fees

• utilities, such as telephone

Provisions for loan losses

-hen a bank has a bad debt or anticipates that a loan might become a bad debt in the future, it can write

up the loss as a current epense in its income statement under the .provision for loan losses/ heading!

"rovisions for loan losses are directly related to loan loss reserves

"chieving superior profitability for a financial institution depends upon

several crucial factors

0areful use of financial leverage 1or the proportion of assets financed by debt as opposed

to equity capital2

0areful use of operating leverage from fied assets 1or the proportion of fied(cost inputs

used to boost operating earnings as output grows2

0areful control of operating epenses so that more dollars of sales revenue become net

income

0areful management of the asset portfolio to meet liquidity needs while seeking the

highest returns from any assets acquired

0areful control of eposure to risk so that losses don’t overwhelm income and equity

capital

#raditional bank performance analysis carries three basic fla$s


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3! &t ignores the wide diversity in strategies pursued by different institutions

4! # bank’s total assets no longer serve as a meaningful yardstick when banks engage in off(

balance sheet activities

5! The analysis provides no direct information concerning how or which of the bank’sactivities contribute to the creation of shareholder value

Let’s use an abridged balance sheet for the Doobie Company to see how these ratios are

calculated and used:

Doobie CompanyBalance Sheet

For the year ending December 31, 200x

Assets

Current Assets $ 65,000

Fixed Assets 115,000

Total Assets 180,000

Liabilities

Current Liabilities 40,000

Long-term Liabilities 100,000

Oner!s "#uit 40,000

Total Liabilities and Assets 180,000


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Doobie CompanyCommon Size Income Statement

for the period ending December 31, 200x

%ales$

&00,000100

'

Cost o( goods sold 1)0,000 65'

*ross +rot 0,000 )5'

O.erating ex.enses

%elling ex.enses &&,000 11'

*eneral ex.enses 10,000 5'

Administrati/eex.enses 4,000 &'

Total o.eratingex.enses )6,000 18'

O.erating inome )4,000 1'

Oter inome &,500 1'

Total inome )6,500 18'

2nterest ex.ense 500 0'

2nome be(oretaxes )6,000 18'

2nome taxes 1,800 1'

Net income 34,200 17%


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Proftability ratios

Interpreting the key profitability ratios

6eturn on 7quity

16)72

• Measure of rate of return flowing to shareholders• #pproimates the net benefit that the stockholders have received

from investing their capital in the financial firm

6eturn on #ssets16)#2

• Managerial efficiency• How capable management has been in converting assets into net

earnings


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%et &nterest Margin • How large a spread between interest revenues and interest costs

management has been able to achieve

%eturn On E&uity

et!rn on a""et" # $et income before taxe"%&otal a""et" x 100

'3(,000%1)0,000* x 100 # 20+

This ratio is useful when you compare the figure for the most recent period with results from earlier periods in your company’s history. It can also be very informative when you compare your company’s return on assets with the returns generated by other businesses in your industry.

If your company’s return on assets ratio is lower than those of other companies this may indicatethat your competitors have found ways to operate more efficiently. If your company’s current returnon assets is lower than it was a year ago you should loo! at what has changed in the way your company is using its resources.

%eturn on Investment

et!rn on ine"tment # $et profit before &ax%$et -orth

"eturn on Investment for the Doobie Company:

3(,000%.0,000 # /0

Doobie Company return on investment # $%&.


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"eturn on investment is considered by many e'ecutives to be the most important profitability ratio. Itmeasures the return on the owner’s investment (or owners’ if there are more than one.) *or you asa small business owner the return on investment figure can help you decide whether all of your hardwor! has been worth it. If the return you are receiving on the money invested in your company doesnot at least e+ual the return you would receive from a ris!,free investment (such as a ban! CD) thiscould be a red flag.

!et Interest Margin

!et interest Margin 8 !et interest income' total "ssets

()*++',-++++. +/0+0 x ,++

Doobie Company -et Interest argin# /%./0 &

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