Measuring Bank Performance

What is performance?
How adequately a financial firm meets the needs of its stockholders, employees,
depositors and other creditors and borrowing customers
Keep regulators satisfied that operating policies, loans and investments are sound

Must be directed towards specific objectives

To understand how well a bank is doing, we need to start by looking at a banks income
statement, the description of the sources of income and expenses that affect the banks
profitability.

Evaluating Performance
Performance must be directed toward specific objectives
A fair evaluation of any financial firms performance should start by evaluating whether
it has been able to achieve the objectives its management and stockholders have chosen
A key objective is to maximize the value of the firm

What is Profitability?
is a banks first line of defense against unexpected losses, as it strengthens its capital position and
improves future profitability through the investment of retained earnings.

Why Profitability based performance measurement?

Traditionally, a common metric used to measure performance has been Net Income. However, it does not
totally serve the purpose of measuring how effectively a bank is functioning in relation to its size and
does not truly reflect its asset efficiency. Net Interest Margin captures the spread between the interest
costs and earnings Banking Profitability and Performance Management on banks liabilities and assets and
indicates how well the bank manages its assets and liabilities. But it fails to measure the operational
efficiency of a bank. Profitability based measurement on the other hand can serve as a more robust and
inclusive means to measure the performance by gauging the extent of operational efficiency as well as
capturing the nuances of banks diversifying earnings through non-interest income activities and
management of their costs

Operating Income
Operating income is the income that comes from a banks ongoing operations. Most of a banks operating
income is generated by interest on its assets, particularly loans. Interest income fluctuates with the level
of interest rates, and so its percentage of operating income is highest when interest rates are at peak
levels.

For example, a retailer's main operating activities are the buying and selling of merchandise or
goods.
Noninterest income
Noninterest income is generated partly by service charges on deposit accounts, but the bulk of it comes
from the off-balance-sheet activities, which generate fees or trading profits for the bank. The importance
of these off-balance-sheet activities to bank profits has been growing in recent years.

Operating Expenses

Operating expenses are the expenses incurred in conducting the banks ongoing operations. An important
component of a banks operating expenses is the interest payments that it must make on its liabilities,
particularly on its deposits. Just as interest income varies with the level of interest rates, so do interest
expenses.
Noninterest expenses
Noninterest income include the costs of running a banking business: salaries for tellers and officers, rent
on bank buildings, purchases of equipment such as desks and vaults, and servicing costs of equipment
such as computers.

Operating expenses include:

Advertising
office expenses
supplies
legal fees
utilities, such as telephone

Provisions for loan losses

When a bank has a bad debt or anticipates that a loan might become a bad debt in the future, it can write
up the loss as a current expense in its income statement under the provision for loan losses heading.
Provisions for loan losses are directly related to loan loss reserves

Achieving superior profitability for a financial institution depends upon

several crucial factors

Careful use of financial leverage (or the proportion of assets financed by debt as opposed
to equity capital)
Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs
used to boost operating earnings as output grows)
Careful control of operating expenses so that more dollars of sales revenue become net
income
Careful management of the asset portfolio to meet liquidity needs while seeking the
highest returns from any assets acquired
Careful control of exposure to risk so that losses dont overwhelm income and equity
capital

Traditional bank performance analysis carries three basic flaws

1. It ignores the wide diversity in strategies pursued by different institutions

2. A banks total assets no longer serve as a meaningful yardstick when banks engage in offbalance sheet activities
3. The analysis provides no direct information concerning how or which of the banks
activities contribute to the creation of shareholder value

Lets use an abridged balance sheet for the Doobie Company to see how these ratios are
calculated and used:

Doobie Company
Balance Sheet
For the year ending December 31, 200x
Assets
Current Assets

$ 65,000

Fixed Assets

115,000

Total Assets

180,000

Liabilities
Current Liabilities
Long-term Liabilities
Owners Equity
Total Liabilities and Assets

40,000
100,000
40,000
180,000

Doobie Company
Common Size Income Statement
for the period ending December 31, 200x
$
100
Sales
200,000
%
Cost of goods sold

130,000

65%

70,000

35%

22,000

11%

General expenses
Administrative
expenses
Total operating
expenses

10,000

5%

4,000

2%

36,000

18%

Operating income

34,000

17%

2,500

1%

36,500

18%

500

0%

36,000

18%

1,800

1%

34,200

17%

Gross Profit
Operating expenses
Selling expenses

Other income
Total income
Interest expense
Income before
taxes
Income taxes
Net income

Profitability ratios

Interpreting the key profitability ratios

Return on Equity
(ROE)

Measure of rate of return flowing to shareholders

Approximates the net benefit that the stockholders have received
from investing their capital in the financial firm

Return on Assets
(ROA)

Managerial efficiency
How capable management has been in converting assets into net
earnings

Net Interest Margin

How large a spread between interest revenues and interest costs

management has been able to achieve

Return On Equity
Return on assets = Net income before taxes/Total assets x 100
(36,000/180,000) x 100 = 20%
This ratio is useful when you compare the figure for the most recent period with results from earlier
periods in your companys history. It can also be very informative when you compare your
companys return on assets with the returns generated by other businesses in your industry.
If your companys return on assets ratio is lower than those of other companies, this may indicate
that your competitors have found ways to operate more efficiently. If your companys current return
on assets is lower than it was a year ago, you should look at what has changed in the way your
company is using its resources.

Return on Investment
Return on investment = Net profit before Tax/Net worth
Return on Investment for the Doobie Company:
36,000/40,000 = .90
Doobie Company return on investment = 90%.

Return on investment is considered by many executives to be the most important profitability ratio. It
measures the return on the owners investment (or owners, if there are more than one.) For you as
a small business owner, the return on investment figure can help you decide whether all of your hard
work has been worth it. If the return you are receiving on the money invested in your company does
not at least equal the return you would receive from a risk-free investment (such as a bank CD), this
could be a red flag.

Net Interest Margin

Net interest Margin = Net interest income/ total Assets
36500/180000= 0.202 x 100
Doobie Company Net Interest Margin= 20.27 %