Understanding Financial Statements ( 3): How to analyse and interpret Financial Statements

By  Enock YEBOAH-MENSAH

Financial statements are a summary of the financial records of an organisation that shows its financial performance over a given period and financial position as at a point in time. In my previous article (published on 25^th April 2024), we looked at why companies publish their financial statements.

The purposes for which companies publish their financial statements as identified were to facilitate capital allocation, mitigate agency conflicts, enhance market efficiency, fulfil stakeholder expectations, signal company performance, and meet legal and regulatory requirements. It was pointed out that these purposes could only be achieved if the users of financial statements understand what the statements are communicating.

This article is, therefore, aimed at providing basics to analysing and interpreting financial statements. Whereas our previous article(published on 10^th October 2024) focused on Common-Size Analysis, today’s article focuses on financial ratios (profitability and efficiency) analysis using the financial statements of banks.

CATEGORIES OF FINANCIAL RATIOS

There are several financial ratios that are used to assess various aspects of a business using its financial statements. Fundamentally, there are five (5) categories of financial ratios-profitability, efficiency, liquidity, solvency and investor ratios. In the previous article, we defined financial ratios as comparing different line items of the same financial statements to assess the financial health of the business. This article looks at the different categories of financial ratios used in assessing banks and how they can be improved.

PROFITABILITY RATIOS: This category of ratios assesses the ability of a bank to generate income relative to expenses, assets and equity. Ratios under this category include return on assets, return on equity, net interest margin and non-interest income to total income ratio.

Return on assets (ROA) (Net profit Before Interest & Tax/Total Assets)–This measures the bank’s ability to generate profit from its total assets. It reflects how management is competently using the bank’s assets to create income. A higher ROA means the bank is more effective in converting its assets into net income. A lower ROA may indicate inefficiency or lower profitability.

This ratio can be improved by expanding lending activities by offering competitive loan products to attract more borrowers whiles ensuring loan quality to minimize defaults. Other ROA improvement methods include the allocation of assets more efficiently by investing in high-return assets like loans and high-yielding securities, minimizing non-productive assets (e.g., excess cash or underutilized real estate) and streamlining operations, cutting unnecessary expenses and improving on efficiency through digital banking initiatives.

Return on equity (ROE) (Net Profit/Total Equity)–This measures the return that a bank generates on its shareholders’ equity. It shows how well the bank is using investors’ funds to generate profits. A higher ROE indicates strong profitability and efficient use of equity. A low ROE could imply poor capital utilization or insufficient profits.

This ratio can be improved by focusing on increasing revenue through loan portfolio growth, fee income, and cross-selling products to existing customers. Additionally, utilizing more debt (borrowed funds) relative to equity to finance growth whiles ensuring that the Capital Adequacy ratio remains strong to avoid solvency risks as well as buying back shares or reducing excess equity if the bank is over-capitalized are all measures that can be taken to improve ROE.

Net Interest Margin (NIM) (Net Interest Income/Average Earning Assets)– This measures the difference between interest income generated by the bank’s assets (loans, investments) and the interest paid on its liabilities (deposits, borrowings), relative to interest-earning assets. A higher NIM suggests that the bank is efficiently earning more interest from its assets than it pays out on its liabilities. A lower NIM indicates reduced profitability from interest-bearing activities.

This ratio can be improved by offering competitive loan products to boost lending activity whiles carefully managing credit risk. Other ratio improvement points include allocating more assets to higher-yielding investments and loans (e.g. corporate loans, SME loans) whiles managing risk exposure, accepting low-cost deposits (e.g. current and savings accounts) to reduce the cost of interest-bearing liabilities, adjusting interest rates on loans and deposits in response to market conditions to widen the spread between what is earned on loans and what is paid on deposits.

Non-Interest Income to Total Income Ratio (Non-Interest Income/Total Income)–This ratio measures the proportion of a bank’s total income that comes from non-interest sources such as fees, commissions, and trading activities. It reflects the Bank’s ability to diversify income streams. A higher ratio suggests greater diversification in income sources, reducing reliance on interest income. A lower ratio indicates dependence on interest income, which may expose the Bank to interest rate fluctuations.

To improve this ratio, a bank must introduce or enhance its services including but not limited to Wealth Management, Advisory, and Fee-based transactions (e.g. remittances). Encouraging existing customers to use additional services such as credit cards, insurance, and investment products, expanding trading desk operations or improving investment portfolio management to capture more trading income, charging fees for premium digital services (e.g. faster payments, higher withdrawal limits, account management services) are a few ways to achieve a higher Non-interest Income to Total Income ratio.

EFFICIENCY RATIOS: Efficiency ratios assess how effectively the Bank is managing its assets, liabilities and operations to generate revenue and control costs. These ratios are critical for evaluating how well the bank is utilizing its resources to achieve optimal performance. Ratios under this category include earning assets ratio, cost-to-income, assets turnover, loan-to-deposit and non-performing loans to total loans.

Earning Assets Ratio (Earning Assets/Total Assets) – This ratio measures the proportion of a bank’s assets that are actively generating income. It is a key indicator of how efficiently the bank is using its asset base to produce revenue, specifically through interest-earning activities such as loans and investments.

A higher ratio is favorable as it indicates the bank is using a larger proportion of its assets to generate income, thus operating efficiently. A lower ratio suggests the bank holds too many non-earning or underperforming assets, potentially lowering profitability.

This ratio can be improved by expanding the Bank’s loan portfolio by offering competitive loan products to boost interest-earning assets. Other ratio improvement methods include strengthening credit risk management to minimize defaults, allocating more funds to income-generating investments such as government and corporate bonds, selling off or reducing non-productive assets like excess cash or unused real estate and reinvesting the proceeds in revenue-generating assets, optimizing the distribution of assets by prioritizing loans and other high-yielding income sources whiles maintaining liquidity requirements.

Cost-to-Income Ratio (Operating Expenses/Operating Income) – This ratio assesses a bank’s efficiency by comparing operating expenses to operating income. It reflects how well a bank is managing its operating costs relative to the income it generates. A lower cost-to-income ratio indicates higher efficiency, meaning the bank spends less of its income on operating costs. A higher ratio signals inefficiency and higher operating costs relative to income.

This ratio can be improved by reducing expenses through the optimization of operational processes, renegotiating supplier contracts, and eliminating non-essential expenditures. Investment in technology to automate manual processes, improvement in digital banking services, reduced labour-intensive tasks, diversifying income by offering new products (e.g. wealth management, insurance, or investment products) and increasing fee-based income from non-interest services as well as streamlining physical branch operations by closing underperforming branches and shifting towards online and mobile banking platforms are a few ways to improve upon the cost-to-income ratio.

Asset Turnover Ratio (Total Revenue/Total Assets) – This ratio measures the efficiency of the bank in using its total assets to generate revenue. It indicates how well the bank’s assets are utilized in generating income. A higher asset turnover ratio indicates better efficiency in using assets to generate revenue. A lower ratio may indicate underutilization of assets.

This ratio can be improved upon by focusing on boosting revenue through increased lending activities, expanding fee-based services, and improving cross-selling of banking products to existing customers. Selling of underutilized or non-earning assets (such as real estate) and reinvesting the proceeds into income-generating activities as well as optimizing the use of existing assets by improving portfolio management will yield a positive asset turnover ratio.

Loan-to-Deposit Ratio (LDR) (Total Loans/Total Deposit) – The loan-to-deposit ratio measures the proportion of customer deposits that have been given out as loans. It reflects the bank’s efficiency in utilizing deposits to fund income-generating loans. A higher LDR indicates that more deposits are being used for lending, which can improve profitability but may pose liquidity risks. A lower ratio suggests the bank is holding excessive liquidity, which could reduce interest income.

To improve this ratio, a bank must offer competitive loan products as well as make the needed marketing efforts to increase loan origination whiles managing credit risk. To further ensure improved loan-to-deposit ratio, banks must focus on acquiring more low-cost deposits (e.g. current and savings accounts) to support additional lending without significantly increasing the cost of funds, strengthen credit underwriting standards to minimize non-performing loans, allow for more sustainable loan growth in addition to reducing excessive liquidity holdings and allocate more of the deposits into productive revenue-generating loans.

Non-Performing Loans (NPL) to Total Loans Ratio (Non-performing Loans/Total Loans) – The NPL ratio measures the proportion of loans that are in default or close to being in default. It reflects the bank’s effectiveness in managing its loan portfolio and controlling credit risk. A lower NPL ratio indicates better asset quality and credit risk management. A higher ratio signals deteriorating loan quality, which could lead to future losses.

This ratio can be improved upon by implementing more stringent credit assessment procedures to ensure loans are granted to creditworthy customers. Setting up early warning systems to detect potential defaults, improved collection efforts on delinquent loans, reducing concentration risk by lending to a more diverse group of borrowers across different sectors and geographies, offering loan restructuring or refinancing options to struggling borrowers can help to reduce as well as prevent loan defaults. The above measures when implemented can improve the NPL ratio of banks.

In conclusion, profitability and efficiency ratios provide vital insights into a bank’s ability to generate income, manage costs, and utilize its assets effectively. By focusing on metrics such as return on assets, return on equity, net interest margin, and cost-to-income ratio, banks can assess their financial health and identify areas for improvement.

Enhancing these ratios through better asset allocation, cost management, and revenue diversification can significantly improve a bank’s operational performance. Understanding these financial ratios is essential for both internal management and external stakeholders to make informed decisions about a bank’s profitability and efficiency.

In the next article, we shall delve into liquidity, solvency, and investor ratios which further assess a bank’s ability to manage short-term obligations, maintain long-term financial stability and appeal to investors.

The author is an Mphil Finance graduate of the University of Ghana Business School and a member of the Institute of Chartered Accountants Ghana.

Email: [email protected]

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