money
Finance

6 Financial Ratios Used to Analyze Banks

Banks operate differently from other industries as they usually sell products or provide services; however, banks lend money. When analyzing banks, there are several important financial ratios unique to banks to compute when analyzing their solvency and financial strength. Banking financial model templates normally should include those. We will discuss some of these ratios below:

  1. Net Interest Margin. The net interest margin is the difference between the interest derived from loans and the interest expenses used to pay for customers’ deposits. The banks financed mostly its operation through the deposits, so the bulk of its costs incurred is for interest expenses. The majority of its income is derived from the interest income lend to companies and individuals. 
  1. Credit to Deposit Ratio (CD). A credit to deposit ratio is a financial ratio used to evaluate how much of the loans are coming from deposits. A higher CD indicates how efficient the bank is in turning the deposits into loan-assets. Bank deposits are derived from the savings account, current account, and even time deposits. 
  1. Return on Assets (ROA). Deposits make up most of the banks’ assets, with some percentage for the fixed assets needed to operate. The return on assets is computed by taking the net profit and divided by the total assets. ROA is considered a vital profitability ratio for a bank as it shows the capacity of assets to generate profit. The higher the percentage of the earning assets, the higher also the return on assets. Since banks are high leverage, even a one percent increase or decrease is a substantial gain or loss for banks.  
  1. Efficiency Ratio. The efficiency ratio computes the percentage of non-interest expenses over revenue. The interest expense is taken out since it’s a variable cost concerning the number of deposits. However, the non-interest expenses such as marketing and operational expenses are looked at to evaluate how efficient the bank is in handling expenses. Depending on the company’s budget for the non-interest expenses, it can be adjusted to achieve maximum profitability. Still, without compromising business operation—the lower the efficiency ratio, the better it is for the bank.
  1. Capital Adequacy Ratio. It is computed by dividing the qualifying capital to the weighted assets. The capital comprises Tier 1 and Tier 2: Tier 1 is the primary funding source, such as the shareholders’ equity and retained earnings. Tier 2 includes revaluation reserves, hybrid capital instruments, and undisclosed reserves. A lower capital adequacy ratio suggests that the business does not have enough capital to expand the operation.
  1. Leverage Ratio. The leverage ratio is the capacity of the bank to cover exposure by the Tier 1 capital. A high leverage ratio shows business solvency since the Tier 1 capital is very liquid and can cover the bank’s exposure.

Giving the banking industry’s unique operations it also uses different financial ratios unique to the industry. Some of them are presented above, which provide information to individuals and stakeholders of how banks assess its business operation. Financial model templates are specifically prepared for the banking industry available in eFinancialModels to understand better how the industry works. The banking industry financial model templates are created by industry experts for financial analysts and investors to help ease the financial models’ preparation.