Financial Statements for Banks

Permitted to accept deposits and provide loans

A bank is a financial entity that is permitted to accept deposits and provide loans. Banks can also offer financial services, including wealth management, currency exchange, and safe deposit lockers. 

Banks are classified into three types: retail banks, commercial banks, or corporate and investment banks. Banks are governed by the national government or central bank in the majority of nations.

Banks' reported financial statements differ from the majority of companies studied by investors. Anyone can not determine if revenue is decreasing or increasing since receivables and inventory aren't present.

A distinguishing feature of bank financial statements is the layout of the balance sheet and income statement.

Once investors understand how banks generate revenue and how to analyze what drives that revenue, they will still be able to interpret bank financial statements.

Deposits can be made by individuals or businesses. Banks accept deposits from people and invest them in securities or lend them money. 

Because they earn or receive interest on their loans, this is a contributing factor to a bank's profit. The spread between the rates they charge for deposits and the rates they earn or receive from borrowers.

As another way to earn interest, banks invest their cash into short-term securities, such as US Treasury bills.

Banks also earn revenue from fees associated with their product and services and checking account fees. These fees also include overdraft fees, ATM fees, credit card fees, and interest.

Its role is to manage the spread between the rates it pays on deposits and the rates it receives on loans. The interest rate generates income for a bank when it earns more interest on loans than it pays on deposits.

A bank's profit is influenced by the size of the spread, the Federal Reserve's monetary policy, US Treasury yields, and other factors. 

Bank Profitability

Banks accept deposits from individuals and corporations and offer interest on selected accounts. In turn, banks accept deposits and either invest in securities or lend to businesses and individuals. 

Banks enjoy the disparity in the rate they pay for deposits and the rate they earn or receive from borrowers because they earn or get interested in their loans. US Treasury bills are short-term assets that generate interest for banks.

It is the bank's responsibility to manage the spread between deposits and loans. When the interest rate spread is higher than the deposit rate. A bank earns money by earning more interest on loans than it pays on deposits.

A bank's earnings are influenced by the spread it receives. Even though we do not wish to go into detail about how interest rates are set in the market, they will acknowledge that various factors influence rates, including the Federal Reserve Banks.

In the following example, we will consider an interest rate spread for a major bank.

For example, someone may have a savings account with a 1.5 percent annual percentage interest (APY). There is a simple explanation for low-interest bank rates: security. 

The (FDIC) insures the funds in your savings account are up to $250,000. This security, together with the ease with which you may access your funds. Explains the modest interest rates that banks give on most accounts.

The bank can use the funds in your savings account to create higher-interest loans. For example, vehicle loans at 3%, mortgages at 5%, student loans at 10%, and credit cards at 18%.

The interest rate differential may be large. That explains why the banking system benefits from interest alone.

Learn more about how banks make money

How to Analyze Financial Statements for Banks

When analyzing bank stocks, someone should be aware of the following metrics:

  • Since banks make up a large part of the stock market in India, banks are likely to be included in equity investors' investment portfolios.

  • Whether investing through mutual funds or stocks, it is difficult for an investor to avoid banks or financial firms. 

  • With credit penetration in India still low, financial institutions have a long runway for growth in the coming years. It translates into increased interest in banking and financial stocks.

  • But, evaluating banks differs from analyzing an FMCG. For example, an automobile company.

  • Bank financial statements can be a black hole of information. Having a lot of numbers can cause more confusion than clarity.

  • Banks use different metrics, unlike non-financial firms, which consider metrics.

To analyze a bank's financial statements, one must first understand these metrics. We've gone over some of the most important metrics to look for when researching a banking firm in this article.

The capital adequacy ratio (CAR) is the ratio of a bank's available capital to the risk of its loans. CAR protects depositors while also promoting financial system stability and efficiency.

It aids in determining a financial institution's financial strength-the ability to meet its obligations through the use of assets and capital. The CAR indicates how well-capitalized a bank is.

According to RBI guidelines, scheduled commercial banks in India must maintain a CAR of 9%, while public-sector banks must maintain a CAR of 12%.

Assume the CAR for an XYZ Bank was -2.8 percent during a particular quarter. This demonstrates that XYZ Bank had no capital to absorb losses on bad loans.

Non-Performing assets, both gross and net non-performing assets (NPAs), are a measure of how much of a bank's loan portfolio is at risk of default. If a loan is not paid for 90 days, it becomes non-performing.

Gross and net NPAs are two types of non-performing assets. The net NPA is calculated by subtracting the bank's provisions from the gross NPA. Gross NPA includes both the principal and interest aspects of the loan.

Bad loan issues have plagued public-sector banks in recent years. As of FY18, the State Bank of India, the country's largest public sector bank, had NPA (gross) on 11% of its outstanding loans.

Balance Sheet Basics

Assets are equal to liabilities plus the company's equity and are one of the basic accounting principles. These are things that both banks and non-financial entities have in common, but they start to diverge after that.

Besides that, banks are subject to a slew of regulatory requirements, which alter the Reserve requirements.

The amount of reserve requirements is determined by the Federal Reserve. Banks with deposits exceeding $182.9 million ($127.5 million in 2020) must maintain a 10% reserve. 

As of 2021, banks with reserves of between $21.1 million ($16.9 million in 2020) and $182.9 million ($127.5 million in 2020) must maintain a 3% reserve.

Following the 2008 financial crisis, the Basel Committee enacted the Basel III accords. To protect banks from economic shocks, certain regulatory capital requirements were updated.

The accords specify the least amount, leverage, and liquidity requirements that banks must meet. With these items, a simplified bank's balance sheet might look like this:

Bank Balance Sheet

The table below illustrates how to earn assets and interest-bearing deposits. Also, provide a yield to the bank's balance sheet and income statement.

The majority of banks use this sort of table in their yearly reports. The table below depicts the same bank as in the preceding examples:

Assets and liabilities

Liabilities depreciate the worth of your organization and reduce its equity, whereas assets raise their value and equity. The greater the difference between your assets and liabilities, the better your company's financial health

However, if your obligations exceed your assets, you may be on the verge of going out of business.

Assets are frequently classified according to their liquidity or how fast they may be converted into cash. Cash is the most liquid asset on your balance sheet since it may be utilized to settle a debt right away. 

An illiquid asset, such as a factory, is the polar opposite because the selling procedure (changing the property to cash) is likely to be lengthy.

Current assets are the most liquid assets. Cash, marketable securities, inventories, and accounts receivable are examples of assets that may be converted to cash in less than a year. These assets bring in money for your business.

Fixed assets are non-liquid assets that are all bundled together. Real estate, automobiles, and machinery are examples of these. 

Fixed assets are assets that belong to your organization and contribute to revenue, but they are not consumed in the income generation process and are not kept for cash conversion. 

Fixed assets are tangible goods that often require a large capital investment and last for a long time. Debts to clients are left over after all expenses because they are the primary way a bank earns money. 

Often, these companies take deposits from customers and pay a small interest rate on those deposits. Then they lend a part of those deposits to other customers as loans at a higher interest rate.  

The spread on interest rates is where a bank makes money. Customer deposits are not owned by banks and must be paid out to customers upon request under liabilities.

Bought securities are the securities that banks get through their trading operations. These securities are assets that are expected to increase in value; if they decrease in value, they may become trading liabilities.

The central bank deposits line item shows how much money banks keep in reserve funds. The capital is required by law for reserve requirements. These deposits are the bank's property.

Income Statement

The income statement is one of three primary financial statements used to reflect a company's financial performance during a certain accounting period. The balance sheet and the statement of cash flows are the other two.

The income statement, also known as the profit and loss statement or the statement of revenue and expense, focuses on the company's earnings and costs during a specific period.

The income statement of a bank is divided into two categories:

1) Interest income 

Interest income is the money earned from lending out customer deposits and the interest earned on financing.

2) Non-interest income

Non-interest income encompasses all a bank's other business activities. 

The bank may earn non-interest income from:

  • credit card fees, 

  • underwriting fees, 

  • overdraft fees, 

  • transaction fees, 

  • and other sources.

Interest expense, the cost of storing customer deposits, will be deducted from interest-related revenue on a bank's income statement. 

The "provisions" line item on a bank's income statement is also significant. Provisions are for loans that have gone into default and will not be paid back. This will appear on the income statement as a "loan loss provision."

Banks' Risks

Every business must deal with risks in its operations. Risks will differ for each company depending on the type of business, industry, and economic environment. Interest rate and credit risk are two of the most important risks a bank must manage.

Risk of Interest Rates

As before stated, banks earn interest on deposits that they lend out as loans. The amount of revenue a bank earns is determined by the amount of interest it can charge. 

Depending on the current economic climate, the interest rate environment can benefit or hinder a bank's profits. Banks earn more on their loans in high-interest rate environments while they earn less in low-interest rate environments.

The interest rate environment can also influence non-interest earning sections of a bank's operations. Consumers may be hesitant to acquire houses in a high-interest rate environment since they will be paying higher interest rates on their mortgages. 

As a result, mortgage demand will fall, as would any non-interest revenue, such as mortgage-related fees.

Credit Danger

When a bank offers a loan to an individual or firm, credit risk occurs. The danger is that the borrower will default and will be unable to repay the loan. 

Banks do extensive credit risk assessments on borrowers before providing a loan, yet surprising defaults still occur. A bank incurs losses as a result of a default. However, reserves are set aside to cover these losses.

Liquidity Risk

The capacity of a bank to get funds to satisfy financing obligations are referred to as liquidity risk. Allowing clients to withdraw their deposits is one of the obligations. The inability to give funds to consumers on schedule might have a snowball effect. 

If the bank delays transferring cash to a few clients for a day, other depositors may rush to withdraw their funds as they lose faith in the bank. This reduces the bank's capacity to supply cash even further, resulting in a bank run.

Over-reliance on short-term sources of cash, a balance sheet concentration in illiquid assets, and customer loss of confidence in the bank are all reasons why banks experience liquidity challenges. 

Mismanagement of asset-liability duration can also lead to financial problems. This happens when a bank has a large number of short-term liabilities but not enough short-term assets.

Customer deposits or short-term guaranteed investment contracts (GICs) that the bank must pay out to consumers are examples of short-term obligations.

If a bank's assets are completely or mostly tied up in long-term loans or investments, the bank may face an asset-liability duration mismatch.

There are regulations in place to help with liquidity issues. They include a need for banks to keep enough liquid assets to exist for a period of time even if no outside funds are injected.

Key Financial Ratios to Analyze Retail Banks

Financial Ratios in Banking

Net interest margin, loan-to-assets ratio, and return-on-assets (ROA) ratio are among the important financial parameters used by investors and market analysts to analyze firms in the retail banking industry.

Bank and banking stock research have always been difficult since banks operate and create profit in such a fundamentally different way than most other firms.

While other companies develop or manufacture goods for sale, a bank's principal product is money.

Banks' financial statements are often significantly more intricate than those of nearly any other sort of company. Investors considering bank stocks utilize classic equity indices. 

In addition to looking at the price-to-book (P/B) ratio or the price-to-earnings (P/E) ratio, they also look at industry-specific indicators to more precisely analyze particular banks' investment prospects.

  • Banks and banking stocks are particularly difficult to analyze since they operate and produce profit in ways that most other firms do not.

  • Net interest margin is a key indicator in bank evaluation since it displays a bank's net profit on interest-earning assets such as loans or investment securities.

  • Banks with a greater loan-to-asset ratio earn more money from loans and investments.

  • Banks with lower loan-to-asset ratios obtain a higher proportion of their overall revenue from more diverse, non-interest-earning activities, such as asset management or trading.

  • The return-on-assets ratio is an essential profitability statistic that indicates the profit per dollar invested in a company's assets.

The Retail Banking Sector

The retail banking business encompasses banks that offer direct services to individual clients, such as checking accounts, savings accounts, and investment accounts, as well as lending services. 

However, most retail banks are commercial banks that serve both corporate and individual customers. 

Retail banks and commercial banks traditionally function independently of investment banks, while the repeal of the Glass-Steagall Act now permits institutions to provide both commercial banking and investment banking services. 

Loans and services generate revenue for the retail banking business, as they do for the banking industry as a whole.

The retail banking sector in the United States is separated into four large money center banks: Wells Fargo, JPMorgan Chase, Citigroup, and Bank of America, as well as regional banks and thrifts.

When examining retail banks, investors look at profitability metrics that give performance assessments most relevant to the banking business.

Margin of Interest

Because it displays a bank's net profit on interest-earning assets such as loans or investment securities, net interest margin is an extremely relevant indicator in evaluating banks. 

Because interest on such assets is a significant source of revenue for a bank, this statistic is a solid predictor of overall profitability, and greater margins usually imply a more profitable bank. 

A variety of factors, including interest rates charged by the bank and the source of the bank's assets, can have a substantial influence on the net interest margin. 

Net interest margin is computed by taking the sum of interest and investment returns less related expenditures and dividing it by the average total of earning assets.

The Asset-to-Loan Ratio

Banks with higher loan-to-assets ratios earn more from loans and investments, whereas banks with lower loan-to-assets ratios earn a bigger share of their overall revenue from more diverse, non-interest-earning sources, such as asset management or trading. 

When interest rates are low, or credit is scarce, banks with lower loan-to-asset ratios may do better. They may also do better during recessions.

The Return-on-Assets Ratio

The return-on-assets (ROA) ratio is applied to banks because the cash flow analysis is more difficult to construct. 

The ratio is considered an important profitability ratio and indicates the per-dollar profit a company earns on its assets. Since bank assets consist of money and bank loans, the per-dollar return is an important metric of bank management. 

The ROA ratio is a company's net after-tax income divided by its total assets. An important point to note is that since banks are leveraged, even a low ROA of 1 to 2% may represent large revenues and profit for a bank.

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Researched and authored by Fatemah Kamali | LinkedIn

Edited by Colt DiGiovanniLinkedIn

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