Key Parameters for Analysing Banking Stocks

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Unlike any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per banking regulations). The analysis of a bank account differs significantly from any other company. The key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank (like say operating margins). Cash is the raw material for a bank. The ability to grow in the long-term therefore, depends upon the capital with a bank (i.e. capital adequacy ratio).

Capital comes primarily from net worth. This is the reason why price to book value is important. As a result, price to book value is important while analyzing a banking stock rather than P/E. But deduct the net non-performing asset from net worth to get a true feel of the available capital for growth.

Let’s look at some of the key ratios that determine a bank’s performance.

Net interest margin (NIM):
For banks, interest expenses are their main costs (similar to manufacturing cost for companies) and interest income is their main revenue source. The difference between interest income and expense is known as net interest income. It is the income, which the bank earns from its core business of lending. Net interest margin is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the central bank and money at call.

NIM = (Interest income - Interest expenses) / Average earning assets

Operating profit margins (OPM):
Banks operating profit is calculated after deducting administrative expenses, which mainly include salary cost and network expansion cost. Operating margins are profits earned by the bank on its total interest income. For some private sector banks the ratio is negative on account of their large IT and network expansion spending.

OPM = (Net interest income - Operating expenses) / Total interest income

Cost to income ratio:
Controlling overheads are critical for enhancing the bank’s return on equity. Branch rationalization and technology upgrade 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 / (Net interest income + non interest income)

Other income to total income:
Fee based income account for a major portion of the bank’s other income. The bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenues is not depended on the bank’s capital adequacy and consequently, 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.

Credit to deposit ratio (CD ratio):
The ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through deposits. Higher ratio reflects ability of the bank to make optimal use of the available resources. The point to note here is that loans given by bank would also include its investments in debentures, bonds and commercial papers of the companies (these are generally included as a part of investments in the balance sheet).

Capital adequacy ratio (CAR):
A bank’s capital ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. For example, the central bank has set the minimum capital adequacy ratio at 10% for all banks. A ratio below the minimum defined by central bank indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the bank do not...
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