1. Financial Ratios
FOUR BASIC TYPES - most commonly used for each - can
be used for some financial companies.
LIQUIDITY
• Current ratio = Current Assets / Current Liabilities
Not so relevant for financial firms - most assets liquid.
MANAGEMENT SKILL
• Total Asset Turnover = Sales / Total Assets
Again, not so relevant because traditional sales are typically
not very large. Interest and investment income is more
relevant.
2. PROFITABILITY
• Operating profit margin = Operating Profit/Sales
• Return on Revenues = Net Income (or EBIT)/Tot. Assets
• Return on Assets = Net Income (or EBIT)/Total Assets
• Return on Equity = Net Income/Equity
These are measures of top-line profitability and bottom-
line profitability, respectively. Similar for financial firms.
FINANCIAL RISK
• Debt Ratio = Debt / Assets
• Times Interest Earned = Net Operating Income /
Interest Expense
Leverage and interest-paying ability - used for financials.
3. Depository Institutions -
Banks, S&L, Credit Unions
Financial Statements
• National-charter banks must submit uniform accounting
statements to the Comptroller of the Currency.
• State charter banks submit accounting statements to their
state regulator.
LIQUIDITY RISK - different than typical liquidity ratios
• Liquidity ratio = (Cash+short-term securities)/Assets
• Loans to Deposits = Loans/Deposits
• Deposits Times Capital = Deposits/Equity
A mixture of profit potential and risk measures.
4. MANAGEMENT EFFICIENCY
• Earning Assets to Total Assets = Assets-(Cash+Fixed
Assets+Non-earning Deposits) / Total Assets
• Burden = (Noninterest Exp.-Nonint. Inc.)/Tot. Assets
• Efficiency = Nonint. Exp./(Nonint. Inc. + Net Int. Inc.)
• Asset Utilization = Total Operating Income / Total Assets
PROFITABILITY
Interest Margin to Earning Assets =
(Interest Income-Interest Expense)/Earning Assets
• Profit Margin = Net Income/Total Operating Income
• Return on Earning Assets = Net Income/Earning Assets
• Return on Equity = Net Income/Equity
5. FINANCIAL RISK
• Loan Loss Coverage = (Pretax Income+Loss Provisions)
/Net Charge-offs
• Provisions to Charge-offs = Loss Provisions/Net Charg.
• Loss Allowance to Loans = Loss Allow./Loans
• Equity to Assets = Equity / Total Assets
Other issues important to financial analysis of banks
• Examine assets for risky asset types (LDC debt, related
party loans, allowance for loan loss etc.).
• Examine shareholder equity for unrealized gains/losses.
6. • Loan Loss Reserves (part of the common equity account)
should be sufficient to meet actual and potential losses.
• Review footnotes and management discussion for
disclosure of non-performing assets- observe trend.
• Review footnotes for data on Off-Balance Sheet
Activities which can add risk and profits.
• Review trend in demand and time deposits - these are
low-cost sources of funds.
• Examine “Other Income” typically from services - this
income is more stable and desirable than interest income.
7. Making Loans and Reserving
for Losses Versus Guarantees
• Financial firms, particularly banks, can make risky loans or
provide loan guarantees and both are conceptually the same.
Risky loan value = risk-free value + loan guarantee value
• When a loan is made, the bank earns interest above the risk-
free rate. The premium above the risk-free rate is a premium
for bearing risk as well as compensation for analyzing the
and monitoring the borrower’s financial condition.
Loan rate = risk-free rate + risk premium and compensation
8. Effect of Loans vs. Guarantees
on Financial Statements
1. The effects of loans - transparent.
• The loan appears as an asset on the balance sheet.
• A loan loss reserve appears as a contra-asset that
reduces the loan value by an amount to cover the
expected loss on the loan - a risk measure.
• Interest is collected periodically and appears on the
balance sheet.
2. The effects of loan guarantees - opaque
• Off-balance sheet “intangible” liability - no contingent
liability is booked. Footnote should provide some info.
• Large up-front fee may appear immediately on income
statement or periodic fee shows up over time.
9. 3. The cash payment for the guarantee goes to the cash
account and a portion of the payment appears as a reserve for
default and the rest goes to equity. The size of the reserve is
supposed to be commensurate with risk of the borrower.
4. Problems with guarantees
• Guarantor may reserve too little when loan is not on
balance sheet.
• If reserve is set properly, competitor lenders are able to
see the value you place on particular customer’s
creditworthiness.
10. Insurance Companies
FINANCIAL STATEMENTS
• State insurance regulators require annual reports based on
statutory accounting practices (SAP).
• Reports are similar across states and focus on the balance
sheet to help assure solvency for policyholders.
• A.M. Best provides “Best’s Insurance Reports” which rate
insurance company financial strength.
• Ratios used by best include operating, profitability,
leverage, liquidity ratios - specific to insurance type.
• Annual reports filed with the SEC follow GAAP.
11. Insurance Ratios
MANAGEMENT EFFICIENCY
• Loss Ratio = Incurred Losses/Premiums Earned
• Expense Ratio = (Sales + Service Expenses)/Premiums
Earned
• Dividend Ratio = Dividends/Premiums Earned
• Combined Ratio=Loss Ratio+Expense Ratio-Dividend
Ratio
• Combined Ratio after Dividends =Loss Ratio+Expense
Ratio
• If the Combined Ratio after Dividends exceeds 1, then the
company must rely on investment income for profit.
12. Note: Earned premiums are premiums paid on policies with
time elapsed - unearned premiums are paid but no time
elapsed.
PROFITABILITY
• Investment Return =Net Investment Income/Premiums
Earned
• Operating Ratio = Combined Ratio After Dividends -
Investment Return
• Overall Profitability = 100 - Operating Ratio
• Return on Revenues = Net Income / Revenues
• Return on Equity = Net Income / Equity
13. Other issues in financial analysis of Insurance Companies
• Look for significant differences between fair value of
investments and their costs or amortized costs.
• Check the equity section for unrealized gains (losses).
• Check for a deferred policy acquisition cost buildup.
• Check that loss reserves grow adequately with insurance
in force.
14. Other Financial Companies’
Ratios and Financial Issues
Other financial companies have more conventional
financial statements and one can use the conventional
ratios discussed at the beginning of this lecture.
Issues for Securities Companies and Investment Banks
• Look for excess leverage using Equity to Assets.
• Examine the degree of long or short positions relative to
total assets for extreme positions.
• Look at the list of securities held for large positions in
risky securities.
• Is income largely from fees (more stable) or trading?
15. Issues for Investment Companies - Mutual Fund Managers
Examine
• Expense Ratio = Expenses / Operating revenues, or
• Expense Ratio = Expenses / Assets Under Management
• Marketing Ratio = Marketing Exp. / Operating Revenues.
• Management Fee Ratio = Management Fees / Assets
Under Management
• Many of the traditional ratios apply also.
16. Issues for Finance Companies
Examine
• Expense Ratio = Expenses / Operating revenues
• Loans to Equity = Loans / Equity
• Return on Revenues = Net Income / Revenues
• Can be treated similar to banks in many ways because
they provide loans, otherwise, use traditional ratios.
17. Issues for Real Estate Companies
• Focus on funds from operations =
Earnings+Depreciation+Differed Taxes.
• Consider current value of real estate as market or
discounted future income value, not book value.
• Short-term or variable rate debt used to fund real estate
increases earnings risk.
18. Dupont Analysis - ROE
ROE = (Net Income/Total Assets) x (Total Assets/Equity)
= ROA x (Equity Multiplier)
= (Net Inc./Total Operating Income) x (Total Operating
Income/Tot. Assets) x (Total Assets/Equity)
= (Profit Margin) x (Asset Utilization) x (Equity Mult.)
This says that ROE is determined by; (1) how profitable a
company’s products are; (2) how well it uses its assets and;
(3) how much leverage it has.
Net Income components to consider are Interest and
Noninterest Income and Expenses, Taxes and Loan Loss
Provisions. Financial firms’ tax rates don’t change much
because they have few assets to depreciate or write down.
19. Cash Flow Statement
Illustration of Inflows and Outflows
Inflows Outflows
Operations Operations
Cash Revenues Payment for Supplies
Collection of A/R Wages, Rent, Tax, etc.
Investments Investments
Sell Securities, Assets Working Capital
From Subsidiaries Capital Investments
Financing Financing
Issue Securities Pay Interest & Dividends
Obtain Loan Repay Loans and Bonds
Retire Equity
• Handout Cash Flow Statement or show on web.
20. Ratio Analysis for Fleet Bank
For a ratio analysis,
• Analyze at least 3 years to look for trends (1999-1997).
• Compare to similar firms (average-$10 Billion Banks).
1999 1998 1997
% Fleet Comp. Fleet Comp. Fleet Comp.
Lns/Dep 129 97 104 91 95 89
Burden 1.06 0.97 1.15 1.39 1.30 1.34
Prov./Ch. 100 100 105 101 86 100
Int. Marg. 4.31 3.84 4.60 3.76 4.96 3.88
Eq/Asset 8.37 7.87 9.24 7.86 8.71 7.58
ROE 13.73 15.97 15.59 13.80 17.69 15.30
Question: Are there any trends in Fleet’s ratios?
Question: Explain the changes in Fleet’s ROE year-to-year.
21. •The data for this example was taken directly from
www.fdic.gov. It also has income statement, balance sheet,
ratio and common size statements for banks and thrifts.
Similar data can be found at www.ffiec.gov.
• Ratios and financial data may also be found in analyst
reports at www.investext.com.
• For other companies, use EDGAR-ONLINE and find the
10k statements for a company. Click on FDS to get
spreadsheets with raw income statement and balance sheet
data. Alternatively, use EDGAR at www.sec.gov. These sites
also have quarterly data from 10Qs which can be used for
more up-to-date analysis.
• For some Credit Union Data try www.ncua.gov.
22. Other Approaches to
Financial Analysis
1. Common Size Statements
• All income statement lines expressed as
percentages of total revenues.
• All balance sheet lines expressed as percentages of
total assets.
• Compare changes in percentages over time and in
comparison to industry (comparable group)
average.
For banks and thrifts, both of these are are available at
www.fdic.gov.
Handout Financial Statement and Notes or use Web.
