Defining Key Ratios

Topics: Financial ratios, Generally Accepted Accounting Principles, Capital requirement Pages: 7 (2434 words) Published: December 16, 2012
Defining Key Ratios: * Net interest margin (NIM) 
* Operating profit margin (OPM) 
* Cost to income ratio 
* Other income to total income ratio
Net interest margin (NIM): Just as we calculate and measure performances of non-financial companies on the basis of their operating performance (EBITDA margins), the performance of banks is largely dependent on the NIM for the year. The difference between interest income and interest expense is known as net interest income. It is the income, which the bank earns from its core business of lending. As such, NIM is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call. As such it is calculated as, NIM = (Interest income - interest expenses) / average earnings assets Operating profit margin (OPM): A bank's operating profit is calculated after deducting operating expenses from the net interest income. Operating expenses for a bank would mainly be more of administrative expenses. The main expense heads would include salaries, marketing and advertising and rent, amongst others. Operating margins are profits earned by the bank on its total interest income. As such, OPM = (Net interest income (NII) - operating expenses) / total interest income Cost to income ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its return on equity. Salaries, branch rationalisation and technology upgradation account for a major part of operating expenses for new generation banks. Even though these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based income). Cost to income ratio = Operating expenses / (NII + non-interest income) Other income to total income: Fee based income accounts for a major portion of a bank's other income. A bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenue is not depended on the bank's capital adequacy and consequently, the potential to generate the income is immense. The higher ratio indicates increasing proportion of fee-based income. The ratio is also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.

Key financial ratios

Some of the key financial ratios are:
* Return on equity (ROE)
* Return on capital employed (ROCE)
* Return on invested capital (ROIC)
* Return on total assets (ROA)
* Asset Turnover
* Debt to equity ratio (D/E)
* Interest coverage ratio
Return on equity (ROE) - ROE is probably the most important ratio in the investing world. It helps in measuring the efficiency with which a company utilises the equity capital. ROE reflects the efficiency with which the management has utilized the shareholders funds. It is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the company. The result of this calculation should be multiplied into 100. Return on equity = profit after tax / shareholders funds * 100 One could also take the average equity capital i.e. the average equity of a particular financial year and its preceding financial year. The ratio is also known as the return on net worth (RONW). It is important to note that this ratio should be compared within companies of a particular industry or intra-industry rather than inter-industry. This exercise helps in knowing which companies have...
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