Chapter 12 – Commercial Banks’ Financial Statements and Analysis 6th Edition
1. Financial Statement Analysis Using A Return on Equity Framework
Time series and cross sectional ratio analysis can be useful to identify strengths and
weaknesses of banks. The FFIEC or the FDIC websites can be used to generate average
data for comparison.
Ratio analysis is very useful for identifying trends over time and for highlighting
differences from peer group competitors. Identifying the proper peer group may be
challenging.
a. Return on Equity and Its Components
Chart of ratios illustrating the sources of a bank’s ROE, all insured banks, FDIC Banking
Statistics
2013 Full Year Interest Expense 7.04%
Data Operating Income
Profit Margin
Net Income
Operating Income PLL 4.28%
21.60% Operating Income
ROA
Net Income Noninterest expense 57.89%
Total Assets Operating Income
1.06%
ROE Income Taxes 9.72%
Net Income Operating Income
Total Equity Capital
9.57% Asset Utilization Interest Income 3.21%
Operating Income Total Assets
Total Assets
Equity Multiplier 4.93% Noninterest income 1.72%
Total Assets Total Assets
Total Equity Capital
8.99x
Numbers are calculated from the FDIC webpage using yearend 2013 data for all federally
insured commercial banks. Operating income is interest income plus noninterest income,
i.e. this is gross, not net operating income.1 All profit measures have been dramatically
reduced due to the crisis and higher loan losses.
ROE measures the profits per dollar of investor’s equity. Generally, higher numbers
are better.
ROA measures the profits per dollar invested in assets. Note the low ROA of banks.
Higher numbers typically indicate better performance.
The equity multiplier is equal to 1 + Debt/Equity ratio. This implies that the average
1 This is potentially confusing as most bank income statements have a line titled
operating income or net operating income, but the text definition is not the same as in that
line.
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Chapter 12 – Commercial Banks’ Financial Statements and Analysis 6th Edition
debt to asset ratio of banks is 89%. The high percentage of debt is required to offset
the low ROA in order to offer a respectable ROE. Debt magnifies changes in ROE as
conditions change and increases insolvency risk.
b. Return on Assets and Its Components
ROA is the product of the profit margin and asset utilization ratios.
The profit margin measures how effectively the bank turns a dollar of revenue into a
dollar of bottom line profits. Generally, the higher this ratio the better. If this ratio
appears to be too low look for problems in the following ratios in the chart. The
analyst should ascertain whether the PLL is too high. The PLL to Operating Income
ratio fell for banks in 2003 and 2004, improving profitability, but the ratio increased
in 2006 and 2007 due to the mortgage market problems and remained high in 2008
and 2009 before beginning to fall in 2010 and continuing to improve since. Salaries
are a major component of noninterest expense and may be the problem if noninterest
expense to operating income is too high. Additional breakdowns for each component
of these categories may be desirable.
The asset utilization ratio measures how effectively the bank converts its assets into
gross operating revenues. Generally, the higher the better. Excessively high ratios
may indicate that the bank is investing in highly risky loans and/or investments. If
this ratio appears to be too low look for problems in the following two ratios in the
chart. The bank may also have too many nonearning assets.
Problems here may be
indicative of too few loans/excess liquidity, low interest income or a lower amount of
fee based services than peer groups.
c. Other Ratios
Net interest margin (NIM)
LeasesandLoansNetSecuritiesInvestment
ExpenseInterestIncomeInterest
AssetsEarning
IncomeInterestNet
NIM
For 2013 the average NIM = 3.25%. Higher NIM ratios generate a higher bank rate
of return on investments, ceteris paribus. As always, higher returns may come at the
expense of higher risk.
The Spread
The estimated spread was 3.14% for 2013. The spread measures the average yield on
earning assets less the average interest cost of interest bearing liabilities.
Overhead Efficiency
This ratio is seldom greater than 1; the average for 2013 was 60.51%.
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sLiabilitieBearingInterest
ExpenseInterest
AssetsEarning
IncomeInterest
Spread
ExpenseerestintNon
IncomeerestintNon
EfficiencyOverhead
Chapter 12 – Commercial Banks’ Financial Statements and Analysis 6th Edition
Teaching Tip: You may be more familiar with a similar measure, the net noninterest
margin (Noninterest income – noninterest expense) / earning assets. The net
noninterest margin is sometimes called the noninterest burden because it is usually
negative. This ratio was -1.29% in 2013 for the industry.
1.1.1.1
1.1.1.2 Comparison of HBT and BOA
HBT = Heartland Bank and Trust
BOA = Bank of America
Interest Expense HBT = 4.62%
BOA = 3.74%
Operating Income
Profit Margin
Net Income
Operating Income PLL HBT = -1.82%
HBT = 44.51% Operating Income BOA = 7.22%
ROA BOA = 26.41%
Net Income Noninterest expense HBT = 52.01%
Total Assets Operating Income BOA = 49.24%
HBT = 2.31%
ROE BOA = 1.51% Income Taxes HBT = 0.68%
Net Income Operating Income BOA = 13.39%
Total Equity Capital
HBT = 22.86% Asset Utilization Interest Income HBT = 3.99%
BOA = 12.21% Operating Income Total Assets BOA = 3.01%
Total Assets
Equity Multiplier HBT = 5.18% Noninterest income HBT = 1.19%
Total Assets BOA = 5.71% Total Assets BOA = 2.69%
Total Equity Capital
HBT = 9.92
BOA = 8.10
More detailed comparisons are available in the text.
Analysis:
HBT has a substantially higher ROE.
HBT has a higher ROA and is more highly leveraged (larger equity multiplier)
HBT has a higher ROA.
oHBT’s higher ROA is driven by its substantially higher profit margin (PM)
ratios.
oEven though the interest income to assets ratio is higher at HBT, the AU
ratio is lower at HBT because of the substantially lower level of
noninterest income to total assets ratio as compared to BOA.
Operating Income – (Interest expense + PLL + Noninterest expense + Income Taxes) =
Net Income. Hence, the top four ratios in the fourth column comprise the cost
components of the profit margin. The substantially lower values for tax and loan loss
ratios indicate that on net HBT translated more dollars of operating income into net
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Chapter 12 – Commercial Banks’ Financial Statements and Analysis 6th Edition
income.
As a percent of income, BOA incurs far less interest expense than HBT. A further
breakdown of this component reveals that HBT pays a substantially higher percent of
operating income than BOA on MMDAs and wholesale CDs and has higher salary
expenditures as a percent. HBT also uses more wholesale and retail CD funding at higher
rates than BOA.
HBT’s higher profit margin is driven by a very low (even negative) PLL to OI ratio and
much lower tax to OI ratio. A low PLL indicates high loan quality (or unrealistic
management) and fits with the concentration in real estate loans.
Salaries and spending on fixed assets are much lower percentages of operating income at
BOA.
Asset Utilization
BOA generates more operating income per dollar invested in assets. This is in spite of
HBT’s greater percentage investment in loans than BOA.2 BOA has 53.4% of assets in
net loans and leases and HBT has 56.6%. HBT also has a lower percent of nonearning
assets than BOA which should lead to an improved AU.
BOA generates lower interest income per dollar of assets; HBT has substantially higher
asset yields on C&I and real estate loans and on municipals. BOA has higher yields on
the other loans category on leases and on some of their investments.
BOA’s advantage in asset utilization stems in part from the much higher amount of
noninterest income generated per dollar invested in assets. This is because BOA offers
many more off-balance-sheet and fee related services than HBT.
Other ratios:
The NIM for BOA is 4.46%, substantially higher than HBT’s 3.49%. BOA’s advantage
occurs because they have higher earning consumer loans, lower interest costs on deposits
and other funds sources.
HBT has a spread of 4.44%, compared to BOA’s spread of 3.48% indicating that HBT
has a substantial advantage in net interest yields.
The overhead efficiency ratio is substantially higher for BOA. BOA has an overhead
efficiency ratio of 95.88% while HBT’s ratio is only 44.19%. BOA has lower noninterest
expense ratios for salaries and premises, and BOA generates much more noninterest
income than HBT’s, making the efficiency ratio significantly higher for BOA.
Teaching Tip:
Using the average data from the FDIC, HBT is above the norm in leverage (EM) and
2 Loans are typically the highest earning asset category.
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Chapter 12 – Commercial Banks’ Financial Statements and Analysis 6th Edition
beneath the norm in AU measures.3 HBT’s PM is well above the norm. Their PLL / OI
measure is very low, reflecting the low risk nature of their lending. Noininterest expense
to OI is about the same as the industry norm but their average tax rate is lower. HBT
earns lower amounts of noninterest income in relation to total assets than the typical
bank. BOA is well above the average for ROE, ROA and PM. BOA is under the norm in
terms of use of leverage (EM) and is slightly beneath the norm for AU. BOA’s PLL/OI
ratio is much lower than the norm, indicating better credit quality, and their tax rate is
above average. Their interest income to total asset ratio is below the norm.
2. Impact of Market Niche and Bank Size on Financial Statement Analysis
a. Impact of a Bank’s Market Niche
If a bank can find a profitable niche in which to specialize, they can potentially generate
higher rates of return than more diversified institutions at times. Specialization in credit
analysis for one loan type for example builds expertise in credit evaluation and generates
time and cost economies. If the specialty chosen falls on hard times however, a
diversified institution may fare better. Heartland generated higher profit rates than BOA
by specializing in real estate lending funded with core deposits. BOA had a more
diversified portfolio and used more purchased funds and fewer core deposits. This may
make them more sensitive to interest rate changes unless they are well hedged.
b. Impact of Size on Financial Statement Analysis
Some major comparisons
Large banks have greater access to purchased funds and usually maintain more liquid
assets.
Large banks also typically carry lower amounts of equity. At times the ROA of large
banks has been less than for small banks because the large banks operate in more
competitive markets.
Large banks have higher salary expense (%) and typically have higher % costs for
premises.
Large banks certainly have more noninterest income than smaller banks, but they may
also have higher noninterest expense as indicated above. BOA had much more
noninterest income per dollar of assets than HBT due to BOA’s much higher
involvement in off-balance-sheet activities.
1.1.1.3
1.1.1.4 VI. Web Links
http://www.federalreserve.gov/ Website of the Board of Governors of the Federal
Reserve
www.chicagofed.org Website of the Chicago Federal Reserve Bank, call
reports for banks are available from this site.
3 Some of these differences are due to using numbers from different time periods so be
careful using these comparisons.
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Chapter 12 – Commercial Banks’ Financial Statements and Analysis 6th Edition
http://www.americanbanker.com The publication of the banker’s trade association.
http://www.wsj.com/ Website of the Wall Street Journal Interactive edition. The
web version of the well known financial newspaper can be
personalized to meet your own needs. Instructors can also
receive via e-mail current events cases keyed to financial
market news complete with discussion questions.
http://www.fdic.gov/ The Federal Deposit Insurance Corporation’s website. New
regulations and current and historical banking statistics are
available on this site.
http://www.ffiec.gov/ Federal Financial Institutions Examination Council will
shortly provide peer group average data for banks. The
website also includes forms needed to fill out call reports
and contains the Uniform Bank Performance Report.
http://www.bankofamerica.com/ Bank of America Corp.’s website
http://www.hbtbank.com/ Heartland Bank and Trust Company website
http://www.ginniemae.gov/ The Government National Mortgage Association
http://www.fanniemae.com/ The Federal National Mortgage Association
http://www.freddiemac.com/ The Federal Home Loan Mortgage Corporation
1.1.1.4.1.1
1.1.1.4.1.2
1.1.1.4.1.3 VII. Student Learning Activities
1. Go to http://www.bankofamerica.com/ and learn about current career opportunities
with the corporation. Make an oral report to the class about different job openings
and requirements.
2. Go to http://www.ffiec.gov/ and obtain summary ratios for Bank of America. Using
the most recent quarterly data available compare Bank of America with its peer group
averages for the following ratios:
ROE
ROA
PLL/Average Assets
Explain why these ratios vary from the peer average.
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