Professional Documents
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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.
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 bottomline 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.
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 = (Cash+short-term securities)/Assets Loans to Deposits = Loans/Deposits Deposits Times Capital = Deposits/Equity A mixture of profit potential and risk measures.
MANAGEMENT EFFICIENCY
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
FINANCIAL RISK Loan Loss Coverage = (Pretax Income+Loss 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.).
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.
When a loan is made, the bank earns interest above the riskfree 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
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.
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.
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.
Insurance Ratios
MANAGEMENT EFFICIENCY
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
Other issues in financial analysis of Insurance Companies Look for significant differences between fair value of investments and their costs or amortized costs.
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?
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.
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.
Issue Securities
Obtain Loan
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 banks and thrifts, both of these are are available at www.fdic.gov. Handout Financial Statement and Notes or use Web.