Explainer: Here are key financial ratios to evaluate performance of banks

Banking and finance stocks have earned stellar returns over the past few years, thereby attracting retail investors. The sector index BSE Bankex has gained over three times since April 1, 2020, the year of pandemic, closely tracking similar gains in the benchmark Sensex. Given the importance of the lending sector not only in the stock market but also for the economy, it is important to know about various financial ratios for banks and finance companies– some of them are unique to the sector.

Net Interest Margin (NIM):

Net interest income (NII), is the difference between the interest earned on the loan assets and the interest paid on the liabilities such as deposits. To obtain NIM, NII is divided by the amount of assets that earn interest. Higher NIM is better.

Cost of Funds

is the interest rate that banks have to pay when they borrow money. A lower cost of funds means that the bank can generate more profit when it lends the money.

Cost to income ratio

measures the proportion of the bank’s operating costs with its operating income. A lower cost to income ratio indicates higher operating efficiency.

Return on Assets (ROA)

It measures the extent of income generated from the bank’s assets. It is obtained by dividing net profit with assets. Since a bank’s assets mostly include the outstanding loans, it is an important metric to judge the management’s ability to generate profit. Banks generally have a low ROA of 1-2%.

Statutory Liquidity Ratio (SLR)

It is the ratio of liquid assets and net demand and time liabilities. Itis the minimum percentage of deposits that commercial bank need to maintain. Currently, RBI stipulates an SLR of 18%.

Capital adequacy ratio (CAR)

This ratio compares a bank’s capital to cover potential losses, against its total risk-weighted assets. To calculate CAR, a bank’s capital needs to be divided by its total risk-weighted assets. Banks are required to maintain a minimum CAR of 9% on an ongoing basis. A higher CAR is desirable.

Cash reserve ratio (CRR)

is a minimum percentage of the total deposits that the banks have to hold as reserves with the RBI to ensure that they do not run out of funds when paying out customers. CRR can be adjusted to control the money supply in the economy. Currently, CRR is 4.5%.

Non Performing Assets (NPA) ratio

It refers to the proportion of loans that are overdue for over 90 days in total assets. A lower NPA is desirable.

Provision coverage ratio (PCR)

It is the percentage of funds that is allotted for losses as a result of NPAs. A higher PCR is better as it provides the bank with more buffer if NPAs start increasing.

Loan to Deposit Ratio (LDR)

It measures how much money is loaned for each rupee that is deposited with the bank. The ideal loan to deposit ratio is between 80% and 90%. If the deposits are decreasing, it would limit the bank’s future lending potential.

Liquidity coverage ratio (LCR)

It is the minimum amount of liquid assets such as government bonds that the banks need to hold in order to cover the cash outflows for a period of 30 days. While a higher LCR is desirable, it also means that there are more assets that are not able to generate interest leading to lost revenue.

Price to Book (P/B)

It is a valuation multiple, which compares a bank’s stock price to its book value. Banks with high quality assets and strong margins often command a higher P/B multiples.