How is a bank profit and loss statement different from a manufacturing company’s profit and loss account (P&L)?
As the name suggests, a manufacturing company manufactures a product. The cost involved in the process of manufacturing is the cost of goods. Other incidental costs like salaries, electricity and rent are clubbed under selling, general and administrative expenses. Upon the sale of the goods, net sales are recorded in the accounts. Unlike a manufacturing company, a bank does not manufacture anything. It’s an intermediary between a lender and a borrower. Therefore, it accepts deposits and lends advances. Hence, the two most important elements of a bank’s P&L are interest expense on deposits and interest earned on advances. In a manufacturing company’s P&L, other income is a trivial entry including one-off items like profit/loss on sale of assets. However, in a bank’s P&L, other income includes income from distribution of financial products, income from investment banking related activities, treasury gains and other fee incomes. While a manufacturing company makes a provision for bad customers, a bank makes provision for bad borrowers.
What are the factors that contribute to the bottom line of a bank?
As a bank’s business depends upon interest rate at which borrows and then lends it to borrowers, general level of interest in an economy plays a huge part in a bank’s performance. In a rising interest rate scenario, a bank often has to borrow at higher rate and is unable to shift the entire incremental cost of borrowing to its customers. So the percentage increase in interest expense is more than that in interest earned. And the difference between them, which is known as net interest income (NII) in banking parlance gets compressed. On the other hand, in a falling interest rate scenario, a bank normally improves its spread leading to high growth in NII. In a rising interest rate scenario, the market value of bank’s investments fall, as price of investment is inversely proportional to interest rate. So a bank has to book losses on investment. In Indian context, bank’s have made huge strides in increasing the share of non-fund based revenue, which includes revenue from distribution of insurance and mutual funds, revenue from investment bank related activities like debt syndication and etc. Such non-fund based revenue comes under other income, which contributes an important share to a bank’s bottom line today.
What are the key items that determine the efficiency of a bank?
Be it a bank or any other company, its efficiency is measured by how well it utilises its assets. So in a bank’s case return on assets (RoA) is very important measure to separate the wheat from the chaff. The return from assets should not come at the cost of comprising the asset quality. And therefore, what percentage of loan-book are non-performing assets (NPA) is another most important criterion. NPA is often expressed as a percentage of advances. Another important criterion to measure a bank’s efficiency is net interest margin (NIM), which is a measure of spread between the interest rate at which a bank’s lend and borrows. In Indian context, a 3% NIM is considered as a benchmark level. Among large banks, only a handful banks including HDFC Bank, Punjab National Bank & Axis Bank have been able to maintain that level of NIM. Banks improve their NIM by controlling their cost of funds, which in turn is done by improving the share of low cost current account and saving account (CASA) deposits in total deposits.
What are the other factors that display strengths or weaknesses of a bank?
A low NPA indicates high asset quality and vice versa. Apart from it, capital adequacy ratio (CAR) shows whether the bank has sufficient capital to grow in short to medium term. Since banking is a capital-intensive business, the regulator requires banks to maintain a minimum percentage of their assets as capital. As per Reserve Bank of India (RBI) regulation, Indian banks have to maintain a minimum CAR of 9%. Most of the Indian banks meet this regulatory requirement. A capital adequacy ratio of higher than 9% indicates that the bank has sufficient capital to grow for sometime without bothering to raise more funds. So a high CAR provides a kind of cushion to the bankers.