CB Income Statements Financial Statement Analysis

Financial Markets and Institutions: Lecture 7

Anurag Singh

Instituto Tecnológico Autónomo de México (ITAM)

Spring 2021

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 0 / 18

CB Income Statements Financial Statement Analysis

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Managing Risk

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 1 / 18

CB Income Statements Financial Statement Analysis

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Depository Institutions

Finance Companies

Securities Firms and Investment Banks

Mutual Funds and Hedge Fund Companies

Insurance Companies

Risk: Types of Risk and Measuring the Risk

Managing Risk

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 1 / 18

CB Income Statements Financial Statement Analysis

Topics to be Covered Today

Financial Intermediation & Financial Institutions: An Overview

Commercial Banks (CB)

Size, Structure and Composition of Commercial Banking Industry
Financial Statement Analysis of Commercial Banks
Balance Sheet
Off-Balance-Sheet (OBS) Assets and Liabilities
Income Statements
Financial Statement Analysis Using A Return on Equity Framework

Regulation
Industry Performance

Savings Institutions (SI)

Credit Unions (CU)
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 2 / 18
CB Income Statements Financial Statement Analysis

Recap of Commercial Bank Balance Sheet

Summary: Assets

We saw how individual entries on the balance sheet look like for small
as well big banks. What about aggregate trends?

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 3 / 18

CB Income Statements Financial Statement Analysis

Recap of Commercial Bank Balance Sheet

Summary: Liabilities

CBs have two major sources of funds other than the equity provided
by owners: deposits and borrowed or other liability funds
CBs had an average ratio of equity to assets of 11.26% in 2015. How
much was debt?
This implies that 88.74% of their assets were funded by debt, either
deposits or borrowed funds
Deposits, not the borrowings, constitute the biggest part of the debt
Liability structure of bank balance sheets tends to reflect a shorter
maturity structure than does the asset portfolio
Relatively more liquid instruments, such as deposits and interbank
borrowings, used to fund less liquid assets such as loans
Maturity mismatch or interest rate risk and liquidity risk exposures

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 4 / 18

CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Broadly speaking, income statement identifies the (1) interest

income, (2) interest expenses, (3) non-interest income, and (4)
non-interest expenses for the banks earned from the on- and
off-balance-sheet activities

The combination of FI’s assets and liabilities, along with the interest
rates earned or paid on them, determines the interest income and
expenses in the income statement

There seem to be a relationship between income statement and the

balance sheet (both on- and off-)

Availability:
Concise: Yahoo Finance
Detailed: Market Watch

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 5 / 18

CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Bird’s Eye View

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 6 / 18

CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Interest Income

Lists interest and fees on loans and leases as well as interest income on
investment securities (with subcategories of each in detail)
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 7 / 18
CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Interest Income

As expected, interest and fees on loans and leases is largest income

producing category1

Interest income is recorded on accrued basis2

Loans on which interest payments are past due can still be recorded
as generating income for a bank

1
We discussed that investment in securities is generally for maintaining liquidity and the loans and leases are higher return
generating assets
2
To illustrate how the accrual principle works, consider a retailer who is selling a customer goods on credit, in the month of
September. According to the accrual principle, the transaction is to be immediately recorded in the accounts receivable account.
The transaction will also be labeled as income for September, although technically no payment was received for the transaction.
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 8 / 18
CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Interest Expense

Items listed here come directly from the liability section of the balance sheet
Interest paid on deposit accounts and borrowings
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 9 / 18
CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Interest Expense

Net interest income = Total interest income - Total interest expense

Provision for loan losses: Current period’s allocation to the allowance for
loan losses listed on the balance sheet

Represents the bank management’s prediction of loans at risk of

default for the period

Bank of America increased its loan loss reserve (recording a provision

for loan losses) by $13.4 billion in the second quarter of 2009

Bank of America’s earnings per share fell 54 percent

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 10 / 18

CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Non-Interest Income

Includes all other income received by the bank as a result of its on- and
off-balance-sheet activities
Becoming increasingly important

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 11 / 18

CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Non-Interest Income

Income from fiduciary activities3

Trading revenues: Gains [losses] and fees from trading marketable

instruments and OBS derivative instruments

Servicing fees: From mortgages, credit cards, and other assets

Other non-interest income: Fee income from OBS loan commitments and
letters of credit, ATM fees, money order, cashier’s check, and travelers’
check fees, data processing revenue, and revenue from one-time transactions
such as sales of real estate owned, loans, premises, and fixed assets

Total operating income or Total revenue = Total interest income +

Total non-interest income
3
Banks manage and administrate investment-related activities. They can register stocks, bonds and other securities and act
as trustees for them.
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 12 / 18
CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Non-Interest Expense

Consist mainly of personnel expenses and are generally large relative to

non-interest income

Other operating expenses: Deposit insurance premiums; expenses of

transactions such as losses on the sale of real estate, loans, and premises

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 13 / 18

CB Income Statements Financial Statement Analysis

Commercial Bank Income Statement

Income before Taxes and Extraordinary Items or Operating Profit =

Net interest income − Provisions for loan losses + non-interest income −
non-interest expenses

Extraordinary Items: includes such things as effects of changes in

accounting rules, corrections of accounting errors made in previous years,
and equity capital adjustments (losses from a major disaster such as an
earthquake in an area where earthquakes are not expected to occur in the
foreseeable future)

Net Income = Income before taxes and extraordinary items − income taxes
+/− extraordinary items

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 14 / 18

CB Income Statements Financial Statement Analysis

Balance Sheet and Income Statement: The Relationship

Items on the income statement are determined by the balance sheet

assets and liabilities along with the interest rates on each item
N
X M
X
NI = rn An − rm Lm − P + NII − NIE − T
n=1 m=1

where,
NI : Bank’s net income
An : Dollar value of the bank’s n’th asset; Lm : Dollar value of the
bank’s m’th liability; rn : Rate earned on the bank’s n’th asset; rm :
Rate earned on the bank’s m’th liability; N: Number of assets the bank
holds; M: Number of liabilities the bank holds
P: Provision for loan losses; NII : Noninterest income earned by the
bank (including income from OBS activities); NIE : Noninterest
expenses incurred by the bank; T : Bank’s taxes and extraordinary items

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 15 / 18

CB Income Statements Financial Statement Analysis

Example

What is the net income of a bank with,

$3m of assets yielding 6% per year interest rate, $1m of assets yielding
4.6% per year interest rate, $3m of liabilities costing 3.5% per year
interest rate, $1m of liabilities costing 4.75% per year interest rate

Provision for loan losses, Noninterest income earned by the bank,

Noninterest expenses incurred by the bank, and Bank’s taxes and
extraordinary items are all 0

What happens when the bank replaces $500,000 of assets currently

yielding 4.60 % with assets yielding 6 %?

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 16 / 18

CB Income Statements Financial Statement Analysis

Financial Statement Analysis

Financial Ratios

Performance and financial condition of companies can be studied

using the financial statements
These financial statements are often used as a way to identify
weaknesses and problem areas of financial institutions
Financial ratios that are computed from the financial statements have
become a cornerstone of Financial statement analysis
Investors/Managers use these ratios to evaluate current performance,
change in performance over time (time series analysis), or performance
relative to competitors (cross-sectional analysis) for various institutions
Lenders use these ratios to evaluate the repayment ability of
institutional borrowers
Owners use these ratios to evaluate shareholder earnings
Besides financial statements, financial press can be used to capture
other relevant information (e.g. market prices of securities) of
publicly-traded corporations
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 17 / 18
CB Income Statements Financial Statement Analysis

Financial Statement Analysis: Financial Ratios

Broad Categories

As there are many financial ratios, it is helpful to think about ratios in

terms of broad categories based on what aspects of performance a
ratio is intended to detect:
1 Liquidity ratios: Describe FI’s ability to fulfill its short-term,
immediate obligations
2 Profitability ratios: Describe ability of a FI to generate profits from
its resources (sales/assets)
3 Activity ratios: Measure how a FI performs day-to-day tasks, such as
the collection of receivables and/or management of inventory
4 Leverage ratios: Measure a FI’s ability to meet fixed financing
obligations
5 Shareholder ratios: Describe FI’s financial condition in terms of
amounts per share of stock
6 Return on investment ratios: Describe the amount of profit, relative
to the assets/equity employed to produce that profit

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 18 / 18