Industry Report: Generally, it is very essential to find out the financial health of any institution and more particularly banking institution. One of the performance tools is LACE (Liquidity, Asset Quality, Capital, Earnings) Rating and hence its stability is to be observed. Downward trends in the financial ratings indicate deterioration in the organizations financial condition. Continuous changes in the financial ratings may be indicative of instability. Banking organizations having low ratings (C, D or E) are likely to have financial problems and for this reason the accompanying ratios should be carefully evaluated.
Liquidity in banking is very difficult to measure because a bank’s liquidity position changes daily. Thus by the time the bank’s financial data are processed, the ratios may not represent its current position. However, one must measure liquidity in the best possible way because it is the lack of liquidity which may bring about the closing of the bank if financial problems become known.
Two ratios are shown under the liquidity heading. The ratio of TI-VL/A.ASTS measures liquid assets minus volatile liabilities divided by average assets, which gives the net liquidity position relative to the bank’s size. The ratio will vary considerably by the size of bank, with smaller banks having higher ratios on the average than larger banks. The ratio of LNS/AST stands for total loans to average assets. Generally speaking, the more banks are loaned up, the less likely they are able meet unforeseen deposit withdrawals.
Banks generally fail because of bad loans. For this reason, the ratio of nonperforming assets to capital should be reviewed, especially in relation to the bank’s current and future earnings position. Banks having a nonperforming asset ratio to capital approaching 100 percent or greater and negative earnings are likely to be struggling for survival. When evaluating asset quality, one should
compare the ratio of CHARGEOFFS/ ASSETS to the ratio of LOSS RSRV/ASTS (loan-loss reserve ratio). Under normal conditions, the loan-loss reserve ratio should be around the 1.25 percent level. If the level of nonperforming assets or the level of charge-offs is above normal, the loan-loss reserve ratio should be higher to cover future losses.
In measuring capital, one should focus on the leverage ratio (basically equity capital-to- assets). This ratio should be six percent or higher for large banks and eight percent or higher for smaller banks. Important to a bank’s capital position is a strong and steady growth in earnings with a low dividend payout ratio. This allows earnings to be retained for capital.
The most important earnings ratios are those that represent the bottom-line of the income statement, mainly the ratios of income to assets or pretax income on a tax equivalent basis to assets. A return on capital ratio may be misleading because banks can increase the ratio through higher leveraging.
Analysis of bank earnings should begin with the net interest income ratio, which has been adjusted for tax equivalency. Higher this ratio the better, especially in relationship to other peer banks. The interest income, net interest income, and pretax income ratios should all be evaluated on a tax equivalent basis, which adds back to the income stream tax benefits. The no interest income ratio has become more important to banks in recent years because the deregulation of interest rates has narrowed net interest margins and has caused banks to rely more on fee income.
The overhead ratio should be looked at with caution because a bank’s cost will vary by its type of operation. Retail consumer-oriented banks with a large branch network should have higher overhead costs and higher margins than banks specializing in wholesale banking. The ratio of provisions to the loan-loss reserve should also be evaluated in relation to the bank’s margins. Higher provisions generally mean there are loan problems. However, further evaluation should be made by looking at the ratio of nonperforming loans to assets and at the bank’s net interest margins. Sometimes higher risks can be offset by higher returns, but careful analysis should be made before making such a deduction. The pretax income ratio (put on a tax equivalent basis) allows one to evaluate the bank’s overall earning strength without the effects of extraordinary items or tax credits.
From the aforesaid discussion, it is felt that the main purpose of using this tool is to examine the validity and the reliability of financial ratios in an international comparison. The relationship between international accounting practices and the comparability of financial ratios will be considered. The outcome is to find out which financial ratios are the most appropriate tools in the international context, i.e. when comparing companies operating in different countries.
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