Topic 3 - Financial Statement Analysis

Question 1

INTEREST MARGIN Ratio

Answer 1

Net interest revenue / Earning assets

Question 2

Earning assets

Answer 2

Equals securities andloans

Canalsobecalculatedastotalassetsminus
cash&duefromother institutionsandfixed&otherassets

Question 3

Net Profit Margain Ratio

Answer 3

Net profit after tax / Revenue

Question 4

Net Profit Margain

Answer 4

This ratio measures the profitability of the ADI as a percentage of revenue earned
It represents what is left out of each dollar of revenue after all costs have been deducted
This ratio could be improved by increasing the interest margin and non-interest revenue, or by controlling non-interest expenses such as overheads

Question 5

ASSET UTILISATION

Answer 5

This ratio reflects how effectively management has invested in earning assets by calculating the yield generated by the ADI’s assets.

This measure is strongly affected by the proportion of assets that are invested in earning assets (i.e. the extent to which the ADI can minimise cash and fixed assets), and how much revenue those earning assets are able to generate

Question 6

ASSET UTILISATION Ratio

Answer 6

Revenue / Assets

Question 7

RETURN ON ASSETS (ROA)

Answer 7

This ratio reflects management’s ability to use financial and real resources to generate net revenue
ROA is often seen as the best measure of an ADI’s efficiency
ROA depends on how much revenue is generated by the ADI’s assets, and how much profit is obtained from that revenue

Question 8

ROA Ratio

Answer 8

Net profit after tax / Assets

Question 9

LEVERAGE MULTIPLIER

Answer 9

Leverage means the use of debt to “lever up” returns to ordinary shareholders The leverage multiplier measures the degree of leverage The more debt that is used to acquire assets, the greater the proportion of assets to equity

Question 10

LEVERAGE MULTIPLIER Ratio

Answer 10

Total assets / Equity

Question 11

RETURN ON EQUITY (ROE)

Answer 11

This is considered to be the most important measure of profitability, because it combines all other measures of profitability into a single measure It indicates how competitive the ADI is able to be in raising private sources of capital in a market economy

The return from financial assets is generally lower than the return from real assets such as factories, and hence ROA is lower for financial intermediaries than for general companies However, financial intermediaries have far more in the way of assets and liabilities, compared to equity, because they take on significant liabilities to acquire assets, increasing leverage ROE is therefore comparable to other business with whom they have to compete for capital

Question 12

RETURN ON EQUITY (ROE) Ratio

Answer 12

Net profit after tax / Equity

Question 13

The four main types of risk faced by an ADI are:

Answer 13

3. 4.1Liquidity risk
4. 4.2Interest rate risk
5. 4.3Credit risk
6. 4.4Capital risk

Question 14

LIQUIDITY RISK

Answer 14

A simple measure of liquidity risk is sources of liquidity divided by the need for liquidity The actual values used can vary, as long as the ratio is calculated in a consistent way

The higher the ratio, the lower the risk

Question 15

LIQUIDITY RISK Ratio

Answer 15

Sources of liquidity / Need for liquidity

Question 16

INTEREST RATE RISK

Answer 16

Interest rate risk can be estimated by isolating assets and liabilities that are sensitive to interest rate changes –where revenue and costs will change if interest rates change

Question 17

INTEREST RATE RISK Ratio

Answer 17

Interest rate-sensitive assets / Interest rate-sensitive liabilities

Question 18

An ADI with a interest rate risk ratio:

Answer 18

Greater than 1.0 will benefit if interest rates increase Less than 1.0 will benefit if interest rates decrease Equal to 1.0 has the lowest level of risk

The latter can be difficult to achieve, because it often means increasing short-term securities, which offer less return than long-term securities

Management might seek a ratio other than 1.0 if they think they can predict interest rate changes

Question 19

CREDIT RISK

Answer 19

Credit risk is the risk that borrowers will default

“Loan quality” refers to the creditworthiness of the borrower, so the lower the quality of loans the more credit risk faced by the ADI

The higher the ratio, the more credit risk

Question 20

Credit Risk Ratio

Answer 20

Medium quality loans / Assets

Question 21

CAPITAL RISK

Answer 21

As previously discussed, leverage increases returns to ordinary shareholders, but the more debt, the more risk–interest payments represent fixed, contractual obligations, so the more there are, the more variable (i.e. risky) are shareholder returns

This capital risk ratio is the reciprocal of the leverage multiplier

In this case the higher the ratio, the lower the level of capital risk

Question 22

Capital Risk Ratio

Answer 22

Equity / Assets

Question 23

BENCHMARKS FOR COMPARISON

Answer 23

The ratios we have looked at give us a snapshot of the level of return and risk, but they don’t tell us much in isolation –we need benchmarks to determine whether the return and risk are high or low, getting better or worse

Typical benchmarks we might use include: 
Past performance 
Comparison with similar institutions or peer groups Assessment against targets or objectives Consideration of share price

Question 24

THE RISK-RETURN TRADE-OFF for

Liquidity Risk

Answer 24

Liquidity risk
This can be reduced by investing in more shortterm, liquid assets, but these generally have less return than long-term asset

Question 25

THE RISK-RETURN TRADE-OFF for

IR Risk

Answer 25

Interest rate risk
Most liabilities are interest rate sensitive, so achieving a ratio of 1.0 usually involves acquiring more interest rate sensitive assets, which usually provide a lower return

Question 26

THE RISK-RETURN TRADE-OFF for

Credit Risk

Answer 26

Credit risk
This can be reduced by improving loan quality, but higher quality loans have a lower interest rate than lower quality loans

Question 27

THE RISK-RETURN TRADE-OFF for

Capital Risk

Answer 27

Capital risk
This can be reduced by increasing equity and/or decreasing debt, but this reduces the leverage multiplier, which in turn reduces returns to ordinary shareholders