RATIO ANALYSIS GUIDELINES

Ratio Definition and Analysis

The Bank Scope describes a number of ratios to analyse the Asset Quality, Capital
Adequacy, Liquidity and Operations of a bank.
Ratio analysis should be performed on 3 years data and figures should be examined from
two perspectives:
 vertically, to understand the significance of the values of the ratios and compare
the same against minimum criteria. For example Tier I Capital ratio of 4% or
more.
 horizontally, to identify the various trends in the ratios over the years.

The guidelines' for minimum and maximum acceptable ranges are as follows:

MINIMUM/ (MAXIMUM)
ACCEPTABLE LlMITS (%)

Asset Quality
Asset Quality ratios can be interpreted in contradictory. way's, therefore, further
interpretation and judgment is required
 Loan Loss Reserves: Gross Loans
High ratio: Hidden reserves (acceptable risk) OR poor asset quality (high risk)
Low ratio: Latent losses (high risk) OR strong asset quality (acceptable risk)
 Provision for Losses: Net Interest Revenue
High ratio: Poor loss coverage (poor profitability) OR hidden reserves
Low ratio: Strong loss coverage (good profitability) OR latent losses
 Non Performing Loans (NPL): Gross loans
High ratio: Poor asset quality
Low ratio: Good asset quality

Solvency (capital adequacy)

 Tier 1 Capital ratio = Tier I Capital/Risk adjusted assets 4
 Capital Adequacy ratio = Tier I + Tier 11 Capital/Risk adjusted assets 8
 Total Equity: Total assets 4
 Total Equity: Net Loans 8

Operations
 Net Interest Margin = Net interest revenue/Average earning assets 2-3
 Return on Average Assets (ROM) = Net Income/Average total assets 0.8-1.5
 Return on Average Equity (ROAE) = Net Income/Average total equity 12
 Cost to income = Operating expenses/(Net interest revenue
+ other operating income): Maximum acceptable (60-
70)

1
 Liquidity
 Inter bank ratio = Due from banks: Due to banks
 High ratio signifies the position of net lender and low ratio signifies position of
net borrower. The position is to be viewed in the light of the market conditions,
the position of the bank in the market and the way the bank manages its funding.
 Net Loans: Customer Funding: Maximum acceptable (75-
85)
 Liquid Assets: Customer Funding 20-30

The guidelines for early warning criteria are provided below. These criteria list the
changes in financial figures and ratios which should be thoroughly investigated and
reasons for the same completely understood from the borrower.

PERCENTAGE CHANGE

Net Loans + / - 20%

Loan Loss provision + / - 20%
Capital adequacy 8% and/or + / - 0.5%
Tot. Equity / Tot. Asset 4% and/or+ / - 0.5%
Tot. Equity / Net Loans + / - 5%
Net Interest Margin + / - 10%
Return on Assets < 0.3% and/or+ / - 20%
Return on Equity < 10% and/or + / - 10%
Net Loans / Tot. Deposits + / - 20%

The following tables provide briefly for each ratio:

 the definition of the ratio
 what the ratio analyses
 the purpose of the analysis

Significant and available amongst these are fourteen ratios which are the basis for
analysis of the borrower. These ratios are identified in the following sections.

Ratio Definition Analysis Purpose/Description

1. Loan Loss Prov I Net Int
revenue
2. Loan Loss reserve I
Non-performing Loans
(Reserves Coverage Ratio)
Asset Quality
Indicates what proportion of
Loan Loss Prov / Net Int
the Net Interest Revenue is
revenue
used for provision
Loan loss Reserve/ Non- Often used in conjunction with
performing loans the below ratio
Analyses the impact of provisions
on Profitability from commercial
lending operations
Provides insight into ability to
quickly absorb write-off~ without
higher provision

Loan Loss Prov / Net Int Does not indicate the adequacy Vs
3Loan Loss Reserve/ Gross Revenue Does not provide the complete NPL
Loans picture

Measures the extent of the loans

4. Non-performing Loans / Non Performing Loan I
Best ratio for loan quality which are in default or closer to default
Gross Loans (NPL Ratio) (Loans + Loan Loss reserve)
against performing loan book.

2
 Indicative of how much NPL
5. Net Charge offs / Gross Net Charge Offs / (Loans + Loan Loss reserve) actually gets written off. Also
Loans indicates management's philosophy
regarding write-offs.

Ratio Definition Analysis Purpose

Capital Adequacy
6. Tier I Capital' Risk
This is the BIS Basle May not be reported by a Measures adequacy of core capital
Weighted
Agreement definition. bank adjusted for the risk profile of assets.
Assets
7. Total BIS Risk-
Adjusted
(Tier I + Tier 11 capital) / risk May not be reported by a Measures adequacy of ratio # 5
Capital
weighted assets bank plus non-equity capital components
Ratio (Capital
Adequacy Ratio)
Usually equals core capital, if
8. Equity' Total Assets Equity' total assets Most basic capital ratio
assets have been risk weighted
Indicates the proportion of sub
Subordinated debt / (Equity +
9. Subordinated Debt' ordinated debt in the capital
Hybrid Capital +
structure of the Bank
Subordinated debt)

Ratio Definition Analysis Purpose

Operations
Indicates the net yield on
Fluctuation may indicate
earning assets that is affected
net interest revenue / susceptibility to interest rate
10. Net Interest Margin by the mix of earning assets
average earning assets volatility or highly competitive
on a bank's books. Very
cyclical environment.
important.
Most widely used
Around 1 % or better for well-run
11. Net Income / performance
net income / average total bank. Makes banks of different
Average indicator; how efficiently and
assets sizes and situations somewhat
Assets (ROA) effectively management
comparable.
employs assets.
12. Net Income / Measures how efficiently and
net income / average total
Average effectively management 12% or better for well-run bank.
equity
Equity (ROE) deploys shareholder funds.
13. Non Operating Indicates extent to which a bank
items / Other / Net income relied on non operating income on
Net Income for generating revenue
Does not correlate to profitability.
(operating expenses) / (net Indicates the cost to generate
Result will look better for banks that
14. Cost to Income Ratio interest revenue + other one dollar of revenue before
are not loan oriented_60% -70% is
operating income) provisions for loan losses
the average.

Ratio Definition Analysis Purpose

Liquidity
Due from banks / Due to Indicates access to counterparties
15. Interbank ratio banks
Easy to calculate.
for funds
Indicate capacity to grow loan
16. Net Loans / Total Loans / Total assets
Indicates level of risk assets in
portfolio without concentrating more
Assets asset portfolio·
in non earning assets
Compares all assets that can
be converted to cash quickly Very useful for ability to meet short
to all Customer & ST liabilities; term demand. Moreover, there is a
17. Liquid Assets / Liquid Assets / Customer similar to a current ratio. VVhen minimum level of operating liquidity
Customer funding Funding the information is available, required to run a bank which is
deduct pledged securities from determined by Central Bank &
the numerator and deduct the management
supported obligation