When examining bank stocks, it may be hard for an investor new to the sector to know where to begin in sorting out the reams of data provided by banks nowadays. And like a car owner, those with bank stocks already in their portfolio may want to kick the tires occasionally to check on how a bank is doing. Using financial ratios can help investors give a bank an initial once-over, and hopefully raise questions that will lead to further analysis. Here is a sampling of a few ratios commonly used to evaluate banks:
Financial ratios can shed light on how a bank earns its money. Does making loans provide most of its bread and butter? The Loans-to-Assets ratio is a good indicator of whether it does.
Banks with high loans-to-assets ratios, like Comerica (CMA), with a 73% ratio in 2010, rely on interest income from loans and investment securities for a good portion (for Comerica, 68%) of their total revenues (the combination of net interest income and noninterest income, like service charges). Those with low levels of loans to assets, like JPMorgan Chase & Co. (JPM - Free JPMorgan Stock Report), where loans are 31% of assets, have more diversified sources of revenue, including from investment banking and asset management.
In this case, neither high nor low is better. Banks historically have garnered most of their revenues from lending and investing. But strength in noninterest income-producing businesses, like trading, can bolster revenues in times of weak lending activity, and vice versa. Note that the loans-to-asset ratios for most banks have declined since the onset of the recession in late 2007, reflecting the negative effect of slower economic activity on loan demand.
Financial ratios also convey information regarding how well a bank is performing.
The Net Interest Margin is a bank’s return on its assets that earn interest income (its loans, bonds, and other investment securities). The margin is influenced by a variety of factors, including the level of interest rates, the mix of the bank’s assets and sources of funds, and the size of the bank’s interest-earning asset base. A decline in high-cost time deposits supported improvement in Huntington Bancshares’ (HBAN) net interest margin, from 3.11% in 2009 to 3.44% in 2010.
Investors can also get a sense of how well a bank manages its expenses via the Efficiency Ratio, the percentage of a bank’s operating expenses needed to produce each dollar of its revenue. The lower the efficiency ratio, the better.
FirstMerit (FMER) had an efficiency ratio of 64.85% in 2010 (up from 62.85% in 2009), indicating that 64.85 cents of expenses were used to generate $1 of revenue. Acquisitions boosted that company’s salary expenses last year. Because banks have different business profiles, and some bank activities have higher expenses than others, this measure can vary greatly between banks. Some banks reported higher efficiency ratios in 2010 due to the increased costs of maintaining and disposing of foreclosed properties.
There are also quite a number of ratios that give insights into a bank’s credit quality.
The Nonperforming Asset Ratio compares the level of problem loans and foreclosed properties to total loans and foreclosed properties. In good times, this ratio can fall below 1%. In bad times, it can be much higher.
For the nonperforming asset ratios, the lower the better. And theyhave been coming down recently, due to better economic activity and the bank industry’s efforts to work down problem loans. U.S. Bancorp (USB) reported a nonperforming assets ratio of 2.55% at the end of 2010, down from 3.02% at yearend 2009.
Investors also look at the Charge-off Ratio, the losses that a bank has had to take as the result of loans that have gone bad. This figure has also been falling, for U.S. Bancorp, from 2.3% of its average loans in the final quarter of 2009 to 1.9% in the 2010 December period.
U.S. Bancorp seems to have enough reserves to absorb the losses inherent in its loan portfolio, as indicated by its healthy Loan Loss Reserve Ratio, which indicated its reserves stood at 2.81% of its loans at the end of 2010.
Moreover, U.S. Bancorp’s positive asset-quality trend seems likely to continue, as indicated by the decline in the portion of its loans that were 90 days past due with respect to interest or principal. This Loan Delinquency Ratio has been edging lower over the past year, from 1.19% of loans in the final quarter of 2009 to 1.11% in the comparable period of 2010. Many banks also report early-stage delinquencies, that is, loans 30 days past due.
Investors who dig deeper into bank financial reports will discover numerous variations on the aforementioned financial ratios, which have evolved due to regulatory changes and as analysts have sliced and diced information provided by the banks over the years. Those considering bank stock investments might use the ratios discussed above as a starting point in gaining an understanding of how a particular bank is doing.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.