Question

What are some of the advantages and disadvantages of using ratio analysis to examine the financial performance of a bank?

Answer 1

Ratio analysis is a useful tool for users of financial statement of a Bank. It has following advantages:

Profitability Performance: Profitability ratios are generally considered to be the basic bank financial ratio in order to evaluate how well bank is performing in terms of profit. For the most part, if a profitability ratio is relatively higher as compared to the competitors, industry averages, guidelines, or previous years’ same ratios, then it is taken as indicator of better performance of the bank.

Return on Assets (ROA) = net profit/total assets: Generally, a higher ratio means better managerial performance and efficient utilization of the assets of the firm and lower ratio is the indicator of inefficient use of assets. ROA can be increased by Banks either by increasing profit margins or asset turnover but they can’t do it simultaneously because of competition and trade-off between turnover and margin. So bank maintain higher ROA will make more the profit.

Return on Equity (ROE) = net profit/ total equity: It measures how much the firm is earning after tax for each unit of amount invested in the Bank. In other words, ROE is net earnings per dollar equity capital. It is also an indicator of measuring managerial efficiency. Higher ROE means better managerial performance; however, a higher return on equity may be due to debt (financial leverage) or higher return on assets.

Cost to Income Ratio (C/I) = The ration help us to know that how expensive it is for the bank to produce a unit of output. In managerial aspects its show how much a manager can efficiently operate the bank activity as much as lower cost against income generate from operation. The lower the Cost to Income Ratio ratio, the better the performance of the bank.

Net Loans to total asset ratio = Net loans/total assets: Net Loans to total asset ratio measures the percentage of assets that is tied up in loans. Net loan to total assets ratio is also another important ratio that measures the liquidity condition of the bank. Whereas Loan to Deposits is a ratio in which liquidity of the bank is measured in terms of its deposits, Net Loans to total asset ratio measures liquidity of the bank in terms of its total assets.

Nonperforming Loans to Total Loan (NPLTL) = Nonperforming Loans /Total loans. This ratio indicates the proportion of the total loans that has been set aside but not charged off. It is percentage of total loan that has been either in default or close to being in default. Once a loan is nonperforming, the odds that it will be repaid in full are considered to be substantially lower. If the debtor starts making payments again on a nonperforming loan, it becomes a reperforming loan, even if the debtor has not caught up on all the missed payments.

Disadvantages:

Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:

Business conditions: Each bank has different business conditions and the operation models changes accordingly. So comparing the ratio numbers may not give a true comparison.

Historical Information: Financial statements provide historical information. They do not reflect current conditions. Hence, it is not useful in predicting the future.

Different Accounting Policies: Different accounting policies regarding valuation of inventories, charging depreciation etc. make the accounting data and accounting ratios of two firms non-comparable.

Window-Dressing: The term ‘window-dressing’ means presenting the financial statements in such a way to show a better position than what it actually is. If, for instance, low rate of depreciation is charged, an item of revenue expense is treated as capital expenditure etc. the position of the concern may be made to appear in the balance sheet much better than what it is. Ratios computed from such balance sheet cannot be used for scanning the financial position of the business.

Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies, which impairs comparability and hence ratio analysis is less useful in such situations.

Ratio analysis explains relationships between past information while users are more concerned about current and future information.