Financial Ratios

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, SL, 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 (Cashshort-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-(CashFixed AssetsNon-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 IncomeLoss
  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 borrowers 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.

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• 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
  customers 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 Bests 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 RatioLoss RatioExpense Ratio-Dividend
  Ratio
• Combined Ratio after Dividends Loss
  RatioExpense 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
  EarningsDepreciationDiffered 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 companys
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 dont
change much because they have few assets to
depreciate or write down.
19
Cash Flow StatementIllustration 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 Fleets ratios?
• Question Explain the changes in Fleets 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.

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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.