Analyse Earnings and Profitability of Commercial Banks
As part of series of “Analyse Performance of Commercial Banks“, this article focus on the fourth area of FACE: Earnings and Profitability.
FACE stands for:
Why does analysing earnings and profitability of commercial banks so important?
We must assess recurring earnings power of a bank to find out how efficiently a bank is using its assets and manage provisions. We must also assess profitability of a bank to understand management’s ability to control the cost base.
The core metric, operating profit/risk-weighted assets, has the greatest explanatory power for the earnings and profitability factor score because it captures the bank’s ability to generate recurring profits relative to the risks it assumes.
Click to view examples of analysis commercial banks: Malayan Banking Berhad (MAYBANK) and Public Bank Berhad (PBBANK). Want to test your knowledge of earnings ratios of banks, click here to take a test.
Core Metric: Operating Profit/Risk-Weighted Assets (%)
[Operating Profit Before Impairment Charges]/[Risk Weighted Assets] ×100%
The numerator is pre-tax profit less non-operating items. Non-operating items always include the change of accounting fair value of a bank’s own debt and goodwill impairment. Profit/loss of an associated company reported at equity is also usually excluded from operating profit, unless the company is an integral and consistent part of the business.
The denominator is the same as the one in the core capital and leverage metric. It is a period-end number rather than an average.
What does Operating Profit/Risk-Weighted Assets (%) tell us?
This ratio is also called recurring earnings power ratio. This ratio provides further indication of how efficiently a bank is using its assets, removing provisions and taxes which can fluctuate considerably year-on-year. The ratio provides some cross-border peer comparability, as taxes vary in different companies and countries.
The higher this ratio is the better. Observing the trend of ratios and doing peer comparison is very important.
To improve this ratio, a bank can price risk better and cut costs. However, the bank can improving lending margins for higher risk lending to flatter pre-impairment profits.
Complementary Metric: Net Interest Margin (NIM)
[Net Interest Income]/[Average Interest Earning Assets] ×100%
The numerator is total interest revenue plus dividends received less total interest expense. The numerator does not include interest or coupon paid on preference shares or hybrid capital reported in equity. The denominator is an average and is equal to total assets less cash, foreclosed assets, fixed assets, intangibles, tax assets, prepayments made and other non-earning assets. The denominator is not so straight-forward, but can be quite difficult to calculate at times. Thus, we can take the NIM figures provided in a bank’s financial report.
What does Net Interest Margin (NIM) tell us?
NIM tells us what earnings the bank is making from the difference between interest earned on interest-bearing assets and interest paid on financing those assets (liabilities and capital). Provided the bank provides the breakdown of interest bearing assets, NIM might tell us about business mix (the balance between high and riskier interest-bearing assets, and low risk / low return mortgage loans). NIM might also provide insight into management’s strategy on pricing.
Significance of interest income ratio tells us about the diversification of business mix. For example, a pure mortgage bank will have a very high ratio, while a universal bank will have a lower ratio. If this ratio trends down, management strategy is to diversify its income streams. To diversify its income streams, the bank will boost
- Its fee and commission business from wealth management and insurance businesses
- Its trading and brokerage business, but trading income is very volatile.
There are other ways to improve the ratio:
- Increase consumer deposits and reduce market funds to lower funding costs (organic way)
- Increase higher risk lending
- Forex translation in net interest income.
This ratio can be distorted by the following:
- The bank has a broad asset base, where profits are made from trading, for example as opposed to interest earning
- Inclusion of dividends in net interest income
- Classification of earning assets
- Will vary dependent on riskiness of loans
The higher this ratio is the better. Observing the trend of ratios and doing peer comparison is very important.
Complementary Metric: Cost/Income (%)
[Operating Expense]/[Operating Profit Before Impairment Charges] ×100%
The numerator is staff costs plus other administrative expenses. The denominator comprises net interest income (as in the metric above) plus all other operating revenue (for example, fees and commissions, net trading profit). Profit/loss of an associated company reported at‐equity is not included in the denominator or in numerator. As banks will provide this ratio in their financial reports, thus we can skip the calculation by taking the figure they provide.
What does Cost/Income (%) tell us?
This ratio tells us about management’s ability to control the cost base of the Bank. It measures the effectiveness of the institution’s use of its cost base to generate revenue (ignoring impairment charges). However, it may be influenced by structural issues such as high levels of unionisation or strong labour laws. If the ratio is low and flat; management is controlling costs well. It can of course be affected by higher or lower revenues.
Business strategies of bank will also be attributed to this ratio. Banks with the following characteristics tend to have lower cost structure:
- Put higher focus on retail banking
- Less branches and offices, and functions in most branches are generally simple.
- Less ATM machines
Banks with the following characteristics tend to have higher cost structure:
- Universal banks – actively involve in every possible segment, such as retail, corporate, government, brokerage services, investment, asset management, insurance, etc…
- Very wide network of branches and offices. Also, most of the branches and offices offer various of services to customers.
- Very wide network of ATM machines.
To perform a meaningful peer comparison, investor should understand business strategies of banks. Then, compare banks with similar business strategies.
This ratio is a measure of efficiency and the lower this ratio is the better. Observing the trend of ratios and doing peer comparison is very important. It can be improved by managing down costs or letting them rise slower than revenues are increasing.
To improve this ratio, management can:
- Reduce expenses
- Increase revenue – higher margin business
- Establish more cost-effective distribution channels.
This ratio can be distorted by classification of expenses and use of finance leases.
Complementary Metric: Loans & Securities Impairment Charges/Pre-Impairment Operating Profit (%)
([Loans Impairment Charges]+[Securities Impairment Charges])/[Operating Profit Before Impairment Charges] ×100%
The numerator is total impairment charges from loans and securities. The denominator is operating profit (as in the core metric above) less the numerator.
What does Loans & Securities Impairment Charges/Pre-Impairment Operating Profit (%) tell us?
This metric measures how much of a bank’s earnings are consumed by impairment charges, or in other words, how much revenue is being lost through poor loans or securities.
The lower this ratio is the better. Observing the trend of ratios and doing peer comparison is very important.
To improve this ratio, a bank can improve its profitability, and credit procedures. This ratio can be distorted if the bank understated impairment charges.
Complementary Metric: Operating Profit/Average Total Assets (%)
[Operating Profit Before Impairment Charges]/[Average Total Assets] ×100%
This metric is similar to the core earnings and profitability metric, but in a cruder form. The numerator is the same. The denominator is average total assets, which in this context represents the total of capital and funding employed (they equate to total assets on the other side of the balance sheet). No adjustment is made to reflect how risky the deployment of capital and funding has been.
What does Operating Profit/Average Total Assets (%) tell us?
This ratio tell us how efficiently a bank is using its assets, (or put other ways: the bank’s ability to use its assets to create profits; or, the income producing value of assets). It might provide insight into management strategy on its business / product mix.
This ratio removed many accounting assumptions, such as weighting risks of assets (risk-weighted assets), taxation, and impairment charges. If Operating Profit/Risk-Weighted Assets (%) ratio is extremely good or bad, this ratio can be used to validate the finding.
The higher this ratio is the better. Observing the trend of ratios and doing peer comparison is very important.
In general, if compare to ROE, value of this ratio is lower, probably below 3%. Nature of bank business lack of innovation, so they need more assets to make more money. Thus, this ratio is low.
To improve this ratio, a bank can increase fee business and sell off low return assets. This ratio can be distorted by balance sheet low point at reporting date and IFRS gains on derivatives.
Complementary Metric: Return on Average Equity
[Net Income Available to Common Shareholders]/[Average Total Shareholders’ Equity] ×100%
This metric is usually called return on equity. It is similar to the ratio shareholders commonly employ to measure their return on investment. Net income and equity are as reported in financial statements without adjustment. The denominator is an average.
What does Return on Average Equity tell us?
This ratio provides the rate of investment return a bank earns on stockholder’s equity, or put another way, how profitably owners’ money is invested. It might provide insight into management strategy by, for example, demonstrating stability, which shareholders usually want; or it might reflect management’s success in achieving a target return, thus fostering shareholder confidence.
Banks will provide this ratio in their financial reports, so we can skip calculation of this ratio most of the time.
In general, the higher this ratio is the better. Observing the trend of ratios and doing peer comparison is very important.
To improve this ratio, a bank can improve its profitability, exercise shares buy back, and distribute high dividends. As a general critic to ROE, ROE can be distorted by manipulation of earnings.
Oher useful ratios and metrics that useful to deep dive into warning signals in earnings and profitability of banks
| Profitability | Ratio and Calculation | Meaning | Ways to Improve Ratio | Ratio Distortions |
|---|---|---|---|---|
| Earnings diversity | Non-interest income / Operating revenue | Degree of diversification of earnings away from pure lending | Change business mixIncrease fee incomeIncrease trading income | Classification of earningsFees in lieu of interest |
| Return on assets Return on tangible assets | ROAA = Net Income / Average Assets ROTA = Net Income / Average Tangible Assets | Internal measure of performance or profitability | Increase fee businessSell off low return assets | Balance sheet low point at reporting dateIFRS gains on derivatives |