Studying the Financial Statements of a Bank

The term Banking is defined as, accepting (for the purposes of lending or investment) deposits of money
from the public, repayable on demand or otherwise, and which may be withdrawn either by cheque, draft
or any other accepted mode. If the purpose of accepting of deposits is not to lend or invest, the business
will not be called banking business. Also, the banker accepts deposits of money (and not of anything
else), from interested parties for such purposes. The banker, however, can refuse to open an account in the
name of the person who is considered as an undesirable person. The essential feature of banking business
is that the banker does not refund the money on his own accord, even if the period for which it was
deposited expires unless the depositor makes a demand to that effect.

Above discussion highlights that, the underlying principle of the business of banking is that the resources
mobilized through the acceptance of deposits must constitute the main stream of funds (liabilities of
banks) which are to be utilized for lending or investment purposes (assets of banks). The banker is, thus
an intermediary and deals with money belonging to the public. The specialized financial institutions, e.g.
Industrial Finance Corporation of India and State Financial Corporations, are not banks because usually
they do not accept deposits in the prescribed manner as explained earlier.

Banking business differs from other business’ for various reasons: particular nature of risks associated
with the transactions undertaken by banks; the continuing development of new services and banking
practices which may not be matched by concurrent development of accounting principles and auditing
practices, etc. Due to these reasons and numerous others, financial statements of a banking business is
prepared in a format prescribed by the Banking Regulations Act 1949 which is different from that
provided by Companies Act 1956. An extract from the financial statements (Balance Sheet and Profit and
Loss Account) of ICICI Bank is presented in the next two pages for your ready reference.

Main source of funds for a banking business are deposits and borrowings. Deposits
consist of (i) Demand Deposits from banks and others; (ii) Savings Bank Deposits; and
(iii) Term Deposits from banks and others. Take note of the fact that Deposits is a
liability for the Bank. To understand why this is so, try to see it this way: when you
deposit money in your account in the bank, then the transaction you pass in your books
would be Bank account debit, simultaneous credit given to your Cash account, hence the
bank shall be your debtor pursuant to such transaction. For the Bank, however, you shall
be a creditor and it shall credit your account with the equivalent amount.

Banks can borrow from RBI, other Banks and Financial Institutions, by issue of Commercial Paper1, issue
of various kinds of bonds and debentures, or from outside India through Multilateral/Bilateral Credit
Agencies, International Banks, Institutions and Consortiums, and Foreign Bonds and Notes. Other
liabilities of a bank may include Bills Payable, Interest Accrued, Security Deposits from Clients, Sundry
Creditors, Tax liabilities, Dividend Payable, etc.

Balance Sheet of ICICI Bank Ltd as on 31.03.2003. (Figures in Rs’000)

Schedule Rs ‘000
1
Check glossary at the end
A CAPITAL AND LIABILITIES
1 Capital 1 9,626,600
2 Reserves and Surplus 2 63,206,538
3 Deposits 3 481,693,063
4 Borrowings 4 343,024,203
5 Other Liabilities and Provisions 5 170,569,258
Total 1,068,119,662

B ASSETS
1 Cash and balance with RBI 6 48,861,445
2 Balances with Banks and Money at call and 7 16,028,581
short notice
3 Investments 8 354,623,002
4 Advances 9 532,794,144
5 Fixed Assets 10 40,607,274
6 Other Assets 11 75,205,216
Total 1,068,119,662

C Contingent liabilities 12 894,385,070

D Bills for collection 13,367,843
E Significant Accounting Policies and Notes to 18
Accounts
F Cash Flow Statement 19

Investments that a Bank makes in Government Securities, Shares, Debentures and Bonds, and other
financial instruments and balances with RBI and other inter bank funds provides the bank with earnings in
the form of interest and/or other income in the form of capital gain/loss. Hence, these items appear as
assets in balance sheet of banks.

All credit exposures are classified as per the RBI guidelines (alternatively known as the prudential
norms), into performing and non-performing assets (NPAs). Further, NPAs are classified into sub-
standard, doubtful and loss assets for provisioning based on the criteria stipulated by the RBI. This
criterion is of 90 days. As in, if an asset doesn’t pay interest / principal for more than 90 days then it
would become a sub-standard asset. And a sub-standard asset which doesn’t pay interest/ principal for
more than 90 days since it became a substandard asset shall be referred to as doubtful assets. An asset
which the valuers feel would not pay in future can be written off as a loss asset, irrespective of the above
mentioned time-barred criterion.

Provisions are generally made on substandard and doubtful assets at rates equal to or higher than those
prescribed by the RBI. The secured portion of the sub-standard and doubtful assets is provided at 50%
over a three-year period instead of five and a half years as prescribed by the RBI. Loss assets and
unsecured portion of doubtful assets are fully provided / written off. Additional provisions are made
against specific NPAs over and above what is stated above, if in the opinion of the management,
increased provisions are necessary.
Profit and Loss Statement of ICICI Bank Ltd.
For the year ending 31.03.2003 (Rs. In ‘000s)
 Schedule Year Ended
31.03.2003

I Income

Interest Earned 13 93,680,561

Other Income 14 19,677,741
Profit on sale of shares of ICICI Bank Ltd. held 11,910,517
by erstwhile ICICI Ltd.
Total 125,268,819

II Expenditure

Interest expended 15 79,439,989

Operating Expenses 16 20,116,900
Provisions and contingencies 17 13,650,139
Total 113,207,028

III Profit/Loss

Net Profit for the year 12,061,791

Profit brought forward 195,614
Total 12,257,405

IV Appropriations / Transfers

Statutory Reserve 3,020,000

Transfer from Debenture Redemption Reserve (100,000)
Capital Reserves 2,000,000
Investment Fluctuation Reserve 1,000,000
Special Reserve 500,000
Revenue and other Reserves 600,000
Proposed equity share Dividend 4,597,758
Proposed preference share Dividend 35
Interim dividend paid 0
Corporate dividend tax 589,092
Balance carried over to Balance Sheet 50,520
Total 12,257,405
Significant Accounting Policies and Notes to Accounts 18
Cash Flow Statement 19
Earning per Share (Refer Note B. 9 )
Basic (Rs.) 19.68
Diluted (Rs.) 19.65
 Cost Concepts
Cost: It is defined as the benefits given up to acquire goods and services.
Fixed Costs: These are costs which are unaffected by the variations in the volume of
activity or output of the firm. They remain constant over a relevant range of output, but
the fixed cost/unit varies with output. Ex. Salary, Rent, Insurance etc.
Variable Costs: These are costs which vary in direct proportion to changes in volume of
output. The variable cost/unit remains constant with output. Ex. Direct material, direct
labor cost etc.
Semi-variable Costs: These are neither wholly variable nor fixed in nature and have
characteristics of both. The fixed part represents the minimum fees charged for a service,
while the variable part is the fee actually charged for using the service each time.
Ex. Telephone charges.
Controllable Costs: Cost are said to be controllable when the amount of cost incurred
can be influenced by the action of a specified member (supervisor) of the firm.
Uncontrollable Costs: Cost which cannot be influenced by the members of the firm are
said to be uncontrollable.
Product Costs: These are costs directly identified with the product. They are the cost of
the goods produced. They include the direct material, labor costs and overheads incurred.
Period Costs: These are costs which are not directly related to the product; rather they
are related to the passage of time. Example - In manufacturing organizations, all
manufacturing costs are product costs, while the non-manufacturing costs are period
costs.
Direct Costs: These costs can be directly identified with a product, process or
department. Ex. Materials and labor used in manufacturing a product.
Indirect Costs: These costs are not traceable to any particular product, process or
department, but common to different products, processes or departments. Ex. Factory
manager’s salary, factory rent etc.
Opportunity Cost: In choosing between alternatives, management has to select the best
alternative but in doing so, has to give up the returns that could have been derived from
the rejected alternatives. This rejected return is called the Opportunity cost. These costs
are classified under relevant costs for decision making purposes.
Sunk Cost: It is a cost incurred as a result of a decision made in the past which cannot be
reversed or altered by any decision in the future. These costs are irrelevant for decision
making purposes. For example, while deciding whether to replace a machine or not, the
cost incurred on purchase of the original machine is a sunk cost.
 Cost-Volume-Profit (CVP) Analysis
CVP Analysis examines the behavior of total revenues, total costs, and profits as changes
occur in the output level, selling price, variable cost/unit or the fixed costs. Simply put, it
tries to answer questions like how will the total revenue and cost be affected if the output
level (production volume) changes or if sales increase by a certain amount. These
questions have a common “what if” theme. By examining the results of these what-if
possibilities and alternatives, CVP analysis illustrates the profits from those possibilities
and alternatives. Brief explanations of terms used in CVP Analysis are given below.

Contribution:- Contribution is mathematically defined as “sales less variable costs”. The

name is so framed because, first it contributes towards recovering the fixed cost and once
the fixed cost is fully recovered, it contributes towards profit.

Contribution Sales Ratio:- As the name suggests this ratio is given by “contribution /
sales”. This is one of the most important ratios to identify and monitor in any business
house. The standard interpretation of this ratio is “higher the better” for obvious reasons
and it is regarded as an important profitability measure. This ratio is alternatively known
as the profit volume ratio or simply the PV ratio.

Operating Income:- Operating income (under the CVP approach) is defined as the
difference between contribution and operating fixed overheads. Thus operating income
under CVP approach = Sales – Variable Cost – Fixed Overheads.

Breakeven Point (BEP): Break even point is defined as that level of turnover (by unit or
by value as the case may be) where the business entity is just able to recover its fixed cost
i.e. it is operating at a level where there is no profit or no loss. In other words, at the BEP
level of operation the operating income is equal to zero.

Break Even Chart : Companies often make a pictorial representation pertaining to

behavior of different kinds of cost and revenue applying a graphical presentation, where
the x-axis represents volume in units and y-axis represents cost / revenue in rupees. The
break even volume is often identified or depicted with the aid of such graphical
presentation, which is commonly known as the break even chart.

Margin of Safety :- Margin of safety is defined as the positive difference between actual
sales (by value) and break even sales by value.

Standard Costing and Variance Analysis.

Standard costs are technically specified or predetermined costs. These are target costs,
carefully established before the production process begins and are based upon some pre-
specified measures. They are expected to remain unchanged over an extended period of
time.
Standard costing is a valuable planning and control technique. By receiving timely
reports which compare the actual costs with the standard costs, management is able to
locate areas of production inefficiency. The object of standard costing is to plan
operations systematically in advance to improve processes, methods and procedures. The
purpose is also to secure low costs as well as keeping spoilage, waste and loss to the
minimum. An analysis is made of the causes of variations.

A variance means an exception or deviation. It denotes the difference between

standard/pre-determined cost of an object and its actual cost. Variances, in fact, are
financial performance gaps, i.e. the difference between benchmarks and the actual costs.
The object of variance analysis is to detect the operating problems and report them so that
corrective action may be initiated wherever possible. Such reporting of variances serves
as red flags to alert management.

Activity Based Costing (ABC).

ABC is a comparatively recent development in the study of cost ascertainment under
which attempts are made to absorb overheads costs into product costs on a more realistic
and appropriate basis. It is argued that under the traditional techniques of cost
ascertainment, many items of costs are unnecessarily treated as common costs and are
arbitrarily absorbed using conventional methods of overhead allocation and
apportionment.

The basic concept of ABC is that, different items of costs are grouped giving due
importance to the parameters which drive these costs or more precisely by identifying the
physical activities which causes these costs to be incurred.

The supporters of ABC concept strongly and rightly believe that the cost of products and
services may be appropriately ascertained / assessed by applying this method. They also
argue that costs can only be controlled by proper and adequate monitoring of the cost
drivers itself.

Under the ABC concept, the costs are directly linked to the cost drivers or more precisely
the physical activities resulting in such costs, which is essentially in agreement with the
above understanding. This may be treated as the main reason due to which the concept of
ABC had gained in popularity in the industry over the last decade or so. It may be
observed that, more and more companies are replacing their traditional methods of cost
ascertainment and reporting of costs by shifting to an ABC model.

The Concept of Time value of money

Two basic principles on which the concept is based are provided below-

A rupee today is more valuable than a rupee tomorrow.

 A safe rupee tomorrow is more valuable than a risky rupee tomorrow.

The difference between what we receive today and we receive tomorrow (or on some
future date) is the reward for parting with our money. This differential is called interest.
A Rupee today is worth more than a rupee tomorrow, because the rupee today can be
invested to start earning interest immediately.

If you deposit Re 1 for a period of n years at an interest rate of r (r expressed in fraction),

then after n years you will get
(1+r)n

If we are going to receive Re 1 after ‘n’ years and the discount rate is given by ‘r’, then
the present value is given by
1/ (1+r)n

Introducing opportunity cost of capital:

The opportunity cost of capital (of a project) is the return foregone by investing in the
project rather than investing in alternative investment opportunities which are
characterized by the same degree of risk exposure as that of the project under review (for
example - comparable financial securities).

Introducing weighted average cost of capital (WACC)

The capital employed by a firm typically consists of two basic components: equity and
debt.

The WACC is the Sum of cost of debt (after tax) multiplied by proportion of debt in
capital employed and cost of equity multiplied by proportion of equity in capital
employed.

The expected return on the capital employed by the firm is often referred to as the
weighted-average cost of capital (WACC).

In the world of finance, as the financing decisions and investment decisions are
invariably interlinked, the importance of opportunity cost of capital and weighted
average cost of capital in the study of finance can hardly be over emphasized.

Concept of Present Value and its applications

Present value of a cash flow in nth year = (cash flow) * 1/ (1+WACC)n
Net present value (NPV) Rule.
It may be defined as the time adjusted value of the expected future cash flows less cash
outflows. NPV is used to evaluate the viability of a project.

As NPV is defined as Present Value of cash inflows minus the Present Value of cash
outflows, the firm accepts all projects that have positive NPV and reject all projects with
negative NPV. Projects with positive NPV may be construed as value creators as it would
add to shareholders wealth.

In computation of NPV, the WACC pertaining to project under consideration may be

applied as the discount factor while discounting estimated future cash flows in order to
arrive at the present value of such estimated future cash flows.

Internal Rate of Return (IRR) rule.

The Internal Rate of Return (IRR) of a project is defined as that discount rate for which
its NPV is equal to zero. In other words, while applying the NPV technique, the discount
rate is ascertained and the NPV is determined whereas in this case the NPV is assumed as
zero and the corresponding discount rate is computed.

When we are evaluating two or more projects for decision making purposes, the project
with the highest IRR is considered better.

It needs to be remembered and appreciated that conceptually there is a distinct line of

difference between opportunity cost of capital and internal rate of return.

The IRR of a project is a profitability measure which depends solely on the amount and
timing of project cash flows. The opportunity cost of capital is a standard of profitability
for the project which we use to compute how much the project is worth. The opportunity
cost of capital is generally established in the capital markets. It is the expected rate of
return offered by other assets equivalent in risk to that of the project which is being
evaluated.
 Risk and Return
Return
When you make an investment (in stocks, bonds, or a haircut) you expect to derive
benefits from that investment. In case of investment in financial assets (such as stocks
and bonds) you would like the value of your wealth to increase. This increase in worth is
called return. In case you invested in a haircut it could result in more batting / bowling
opportunities on campus due to an improved appearance (although I seriously doubt it).
Return can be broadly defined as the performance of an investment, either realized
through the sale of the investment or recorded as of a specific time period. Returns are
commonly expressed as annual percentage rate of gains or losses.

Risk
Risk may be defined as the possibility of losing money or not gaining as much as
anticipated. Taking out pathetic haircut analogy even further, risk in that investment is
getting a really horrible haircut and then having to spend the next fortnight with an
embarrassing smile on your face.
The most important part of the whole deal is that risk is not really a bad thing. In fact you
can’t get returns without taking risk - can’t look any better unless you get that haircut! In
fact, the more whacky (risky) the style you choose the more the chances of your looks
improving appreciably (return)! Why is it riskier? – imagine yourself walking on campus
with a crow’s nest on your head. The amount of risk you are willing to take to get a
certain level of return is governed by your nature. Most people expect to get higher
returns for any additional risk they take. Such people are called risk averse individuals.
There are some among us though who love taking risk and derive pleasure from the risky
nature of the investment and hence don’t expect to be compensated for it. Such
individuals are called risk lovers and obviously they are few by number.
All the above points are directly applicable for investments in stock markets. By virtue of
the firms and industries they belong to some stocks are riskier than others. This would
mean that their prices are more prone to fluctuate widely resulting in higher returns or
correspondingly in higher losses. Returns from a stock consist of:
• Any increase in the price of the stock.
• Dividends paid to stockholders by the company.

Mathematics gives us a nice and convenient tool to quantify the amount by which the
price (and hence return) of a stock fluctuates. It’s called the standard deviation. Using
historical data one can calculate the standard deviation of the returns of a stock. Now
there are some financial instruments (such as government bonds) that are considered risk-
free meaning - come what may, one usually gets the money that is promised. These
instruments give you a return known as the risk-free rate of return (for obvious reasons!)
( Rf).
A portfolio is a bunch of investments that a single investor has invested in. The group of
stocks you choose to invest in will be your portfolio. A portfolio has a return and a
certain amount of risk associated with it. While the return of the portfolio can be
understood simply as the total of individual returns (in moneys worth) from each stock
divided by the total amount invested, understanding the risk of a portfolio requires
concepts that I am too lazy to put down on paper right now. So suffice to say that risk of
a portfolio is NOT the sum of the risks of the individual stocks but is also dependent on
how the stock prices behave with respect to each other (this relationship is quantified
using covariance). That is to say if you can reduce the total risk associated with your
portfolio by choosing wisely the stocks you include in it. This reduction in risk by
choosing different stocks is called diversifying risk.

For a moment let’s just assume that there is something called a market portfolio. Imagine
a portfolio with stocks from a large number of industries chosen so that all risk
(unsystematic) that arises due to specific industries are eliminated and only the risks
arising out of factors that affect all stocks (systematic risk) remains. Let the return from
this portfolio be called market return (Rm).

Beta: Beta is the way in which we quantify the performance of a stock (its returns) with
respect to the way the market is behaving. It’s a sort of relative measure of the risk that
the stock carries. The way Beta is calculated is to find the covariance of the returns of
the stock and returns of the market portfolio (to see how closely they move together) and
divide this by the variance of the returns of the market portfolio. (If you didn’t get that –
its ok, no big deal). Just remember beta tells you how much risk a stock is carrying with
respect to the risk that exists in the market portfolio.

This means we know how much return one can get for a risk free investment (rf)). We
know how much risk a stock is carrying. We know what the market portfolio is giving us.
Can we tell how much return the stock (ra) should be giving for the additional risk? Of
course we can. Let’s just assume a linear relationship between the return from the stock
that we get over and above the risk free rate and the risk (beta) of the stock. We‘ll end up
with a simple equation that looks something like this:

Ra = rf + Beta * (rm – rf)

This is nothing but the Capital Asset Pricing Model (CAPM). Although the original
derivation is slightly more complicated what we need to understand is - what the utility of
the model is. If you were to plot a graph between return and beta we would get a straight
line. This line is the Security Market Line. This line describes the returns that can be got
for different levels of risk.

We shall end this discussion here. You will be studying this model in FM - 1.