Which financial ratios tell you best about the health of a bank


The banking sector truly reflects the health of the economy. A bank must maintain a balance between growth and risk. Analysis of banking stocks is not like analyzing stocks of any other business. Banks get funding through deposits or debt in order to have liquidity to extend as loans and to invest to generate treasury income.

Before jumping in to understand how to analyze bank stocks, one needs to understand the business model of banks and how they make money. Banks basically make money through a combination of spread income and fee income. One should always look at the core business of the bank, both retail and corporate banking. The proportions of these two in the bank’s total revenue should always be very healthy. A bank’s presence across the market should be also evenly balanced.

As banks have unique attributes, certain financial ratios provide useful insights, more so than the others. One needs to look at different parameters such as net interest income (NII), net interest margin (NIM), provisioning coverage ratio (PCR), capital adequacy ratio (CAR), Current Account-Savings Account (CASA) ratio, non-performing assets (NPA), gross non-performing asset (GNPA) and slippages.

A bank has to pay interest on the borrowed money, and earns interest on the money it has lent. So, investors should analyse the difference between the interest earned by the bank and interest paid, which gives the net interest income (NII). Investors should also minutely look at total deposits, total advances and net interest margin. A bank that maintains a low ADR (Advance-Deposit Ratio) is considered safe. Eventually, investors should analyze the capital adequacy ratio (CAR). Higher the capital adequacy ratio (CAR), the more the chances of the bank being on the safer side, meaning thereby, that the bank is strengthening its capital reserves and financial growth.

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Another important parameter is gross NPA and net NPA. Basically, non-performing assets (NPAs) are recorded on a bank’s balance sheet after a prolonged period of non-payment by the borrower. One should always look out for these numbers and how they change with time. In case of higher NPA, the borrowings get riskier and the bank would need to focus on recovery of the borrowing amounts. Normally, if a bank is into retail borrowing business, then probably the NPA may be lower, whereas, in corporate banking, the NPA levels are generally higher, because if any company defaults, the NPA number shoots up.

Another factor to watch is the provision coverage ratio (PCR), which indicates the extent to which a bank has provided for the weaker part of its loan portfolio. A high PCR suggests the bank may further provisions in the coming years would be relatively low, unless the GNPAs rise at a faster clip. Investors should also consider the slippage ratio, as a sharp rise in slippage can have a major impact on provisioning and net profit. Low slippage, or no slippage, reflects good quality of assets. Another important factor is the Casa ratio. It shows how much deposit a bank has in the form of the share of current and saving account deposits in total deposits. Investors should also look at the Casa ratio to understand a bank’s financial health. Higher the Casa ratio, better is its operating efficiency. NIM is yet another factor to look at, as it measures the effectiveness of a company’s investment decision. A positive net interest margin indicates that the bank is efficiently investing, whereas a negative net interest margin implies inefficient investing.

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Most importantly, a bank management’s forward guidance is an equally important event to watch before coming making an investment decision. Instead of looking at just the current numbers, ratios should also be compared with their historical numbers. This will give an understanding as to whether those numbers have improved or not. Moreover, these ratios should be compared with peer banks and the industry average to decide the position of a bank with respect to its competitors and whether one should invest in that particular banking stock or not.

(DK Aggarwal is the CMD of SMC Investment and Advisors)





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