How to analyse banks

In India banks occupy a substantial portion of the overall stock market and hence, they probably form at least some part of the investment portfolios of equity investors. No matter whether an investor invests through mutual funds or directly in stocks, it is difficult for him/her to escape banks or financial firms. With credit penetration in India still remaining low, financial firms have a long runway for growth in the coming years. It translates into the growing popularity of banking and financial stocks.

However, analysing banks is very different as compared to analysing an FMCG or say an auto company because of the following reasons.

• The financial statements of banks can prove to be a black hole. Lots of numbers can lead to more confusion than any clear understanding.
• Unlike non-financial firms wherein metrics like gross margin, working-capital cycle, debt to equity, etc., are important criteria to consider, banks altogether have different metrics. To analyse a bank's financial statements, one needs to first have a clear understanding of these metrics.

In this story, we have discussed some of the most important metrics that investors need to know while researching a banking firm.

Capital adequacy ratio (CAR)
It is the measure of a bank's available capital divided by the loans (assessed in terms of their risk) given by the bank. CAR is used to protect depositors and promote the stability and efficiency of financial systems. It helps measure the financial strength or ability of the financial institution to meet its obligations by using its assets and capital. The higher the CAR, the better capitalised the bank is. In India, as per the RBI norms, Indian-scheduled commercial banks are required to maintain a CAR of 9 per cent, while Indian public-sector banks are emphasised to maintain a CAR of 12 per cent.

Suppose, the CAR for an XYZ Bank stood at -2.8 per cent during certain quarter. This shows that XYZ Bank had no capital to be absorbed as losses from bad loans.

Gross and net non-performing assets
Non-performing assets (NPAs) indicate how much of a bank's loan book is in danger of not being repaid. A loan turns non-performing if the interest or instalment of the principal amount is not received for a period of 90 days. NPAs are further categorised as gross and net NPAs. Gross NPA includes both the principal and interest aspects of the loan, whereas net NPA is calculated mainly by subtracting the provisions made by the bank from the gross NPA.

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Public-sector banks in recent years have been plagued by bad loan problems. State Bank of India, the largest public sector bank, recorded 11 per cent of its outstanding loans as NPA (Gross NPA) as of FY18.

Provision coverage ratio
In banking, it is a fact that some portions of loans will always turn bad. Banks, therefore, make provisioning for such bad loans by setting aside funds to a prescribed percentage of their bad assets. For example, if the PCR is 70 per cent for a particular category of bad loans, banks have set aside funds equivalent to 70 per cent of those bad assets out of their profits. A high PCR means that most asset-quality issues have been taken care of.

The PCR for troubled Yes Bank stood at just 43.1 per cent as of FY19, depicting that the bank had an asset-quality issue and it wasn't able to provide adequately for bad loans.

Return on assets
In the balance of banks, loans given out to borrowers are assets whereas depositors' money is a liability. Return on assets depicts how profitable the bank is relative to its total assets. It is calculated by dividing net profit by total assets. A high ROA relative to other banks can be on account of various factors, including substantial other income, aggressive lending practices, operational efficiency and other factors.

CASA ratio
It stands for current account saving account. CASA is the per cent of deposits held by banks in current and savings accounts. Banks pay low interests on such accounts. A high CASA ratio is positive for the bank, as it is able to reduce the total borrowing rate.

Net interest margin
As the name suggests, it is the difference between the interest income generated from borrowers and the amount of interest paid to depositors, relative to total deposits. It is a profitability ratio and similar to the gross margin of a normal company.

HDFC Bank on the back of its ability to raise capital at a low cost and good lending practices has one of the best net interest margins in the banking sector. HDFC Banks NIM consistently ranged around 4.3 per cent during the past few years till FY20.

Cost to income
It is an important ratio to determine how efficiently a bank is being run. Cost to income is calculated by dividing operating expenses by the bank's operating income (interest income plus other income). There is an inverse relation between cost to income and the bank's profitability. The lower the cost-to-income ratio, the better the profitability is.

For HDFC Bank, the cost-to-income ratio has consistently decreased over the last few years and stood at 38.6 per cent as of FY20. On the other hand, SBI, which has an operating income of more than double that of HDFC Bank, is able to generate an operating profit only slightly higher than HDFC Bank, as its cost-to-income ratio stood at 52.5 per cent as of FY20. HDFC Bank is able to generate better profitability because of operational efficiency.