How to analyze Banking and NBFC stocks?

How to analyze Banking and NBFC stocks?

Banking and non-banking financial institute stocks analysis needs an understanding of some special parameters which are specific to this industry. 

Let's have a look -

(1) Net interest margin

This ratio is only applicable to banks and Non-Banking Finance Companies.
It is a measure of the difference between the interest income generated by banks and NBFC’s and the amount of interest paid out to their lenders relative to the amount of their assets.

Net interest Margin= (Interest Income Earned-Interest Income Paid)/Total Assets

It is a measure of how successful a firm is at investing its funds in comparison to the expenses on its investments.

A negative value signifies that the firm did not make an optimal decision, because interest expenses were greater than the amount of returns generated by investments.
If the demand for savings increases relative to the demand for loans, then the net interest margin will decrease. If the demand for loans is higher than the demand for savings than the interest margin will increase.

This can be checked on MoneyControl. Net interest margin 2019

Bandhan bank 7.96

HDFC 3.87

Kotak Mahindra bank 3.6

ICICI 2.8

SBI 2.4

(2) CASA Ratio (%)

 CASA ratio of a bank is the ratio of deposits in current and savings accounts compared to its total deposits. Banks do not give any interest in current account deposits and the interest on a savings account is usually very low between 3-4%. CASA deposits are a cheaper source of raising funds as compared to a certificate of deposits, term deposits which relatively require higher interest to be paid.

CASA Ratio (%) = (Current acct deposit + saving account Deposits)/Total Deposits

A higher CASA ratio means a larger portion of a bank’s total deposits are in current and savings accounts, thus indicating, lower cost of funds. Banks pay interest at 3-4% on savings deposit which is way below its lending rate thus decreasing the cost. For instance, most banks lend at over 10%.

Higher CASA ratio leads to higher net interest income which means better operating efficiency of the bank.

It tells us about the profitability and operating efficiency of a bank.

(3) Efficiency Ratio

An efficient company gives better returns.
If a company is efficient it can stay afloat for a more extended period of time.

The Efficiency of a company is determined based on their Accounts receivables, Accounts Payables, Inventories, and Working Capital. Now Accounts receivables deal with the payments that a company has to receive against services rendered or products sold to clients, which means the credit the client owes. Accounts Payables means the payment that a company has to render against its credits. Inventories take into account the goods remaining with the company after the end of the Quarter or Year. Inventories are those which could not be turned into sales as did not get processed into finished products.

A company is said to be efficient if days of receivables are decreasing.

(I) What Is Account Receivables?

Account Receivables is an accounting term. It is a balance sheet item and comes under the head's currents assets. Now understand its impact in detail.

Increased days of Receivables means that debtors are taking more time to repay for the goods consumed thus increasing working capital requirement which puts stress in the company’s books. It can also create a liquidity crunch for the company. If Account Receivables go on rising it can end in default by some debtors leading to bad debts for the company. Decreased days of receivables mean that the debtors are making the payments as per the specified time frame or even early thereby reducing the need for a working capital requirement which is a healthy sign for the company’s books. It improves or rather doesn’t deteriorate the liquidity of the company. Thus companies with decreased days of receivables should be filtered for investments.

Days of Accounts Receivables= (Accounts Receivables/Credit Sales)* No. Of days in a year

(II) What Is Account Payables?

Account Payables is an accounting term. It is a balance sheet Item and comes under the head current liabilities. Now understand its impact in detail.

Increased days of payables mean that the company is taking a long time to repay for the goods purchased on credits from its suppliers which sends a negative signal about the company’s liquidity position. It means the company does not have the required cash flow to meet its short term debt obligations. Decreased days of payables mean the company’s liquidity is strong thus it's able to repay its creditors diligently. It also means that the company has the ability to fulfill its short term debt obligations. Therefore one should monitor this closely to understand the company’s financial strength.

Thus companies with decreased days of payables should be filtered for good returns.

Days of Accounts Payables= (Account Payables/Cost of goods sold) * No of days in a year

(III) What Is Inventory?

Inventory is the term used for the raw materials which are in turn used to make finished products for sale purposes. Thus the goods which could not be sold are termed as Inventory. Thus turnover of Inventory represents how fast it can be converted to sales to generate earnings for the company. Inventory is a balance sheet item.

Increased days of Inventories mean that the company is unable to convert its goods into sales as it has purchased more than it can sell. Thus the cash flow is impacted negatively if the Inventory turnover ratio increases. It raises concern about the company’s ability to convert its inventory to sales if the Inventory turnover ratio continues to increase. Decreased days of Inventory mean that the demand for the product is robust and thus the company is able to convert its inventory into sales and thus decreasing inventory turnover ratio hence increasing earning as well as cash flow.

Thus companies with decreased days of Inventory should be filtered to make investments.

Inventory Turnover ratio=Cost of Goods Sold/ Average Inventory

(IV) What Is Working Capital?

Working Capital is the short term component required to meet the daily requirements of a business from purchasing of Inventory to sales of goods. It is a measure of a company’s liquidity and operating efficiencies and its short-term financial health.

Working Capital= Current Assets – Current Liabilities

If the working capital is positive, it implies that the current assets are greater than current liabilities and the company is able to meet all its current obligations and run the company operation. It is positive for the company. If the working capital of the company is negative, it implies that the current assets are or sufficient enough to cover the current liabilities and hence these are affecting the operation of the company. This is viewed as a negative for the company and the business of the company will be affected.

(4) credit to deposit ratio

Credit means loans given out to borrowers by the banks. Credits are assets of the Bank. Deposits are the amount received from customers as deposits in the banks. Deposits are a liability to the bank. So; the credit-deposit ratio broadly means the ratio of assets and liabilities of the banks.

Credit to Deposit ratio (%) = Total loan given/Total Deposits

The credit-to-deposit (CTD) or a loan-to-deposit ratio (LTD) is used for measuring a bank’s liquidity by dividing the bank’s total loans disbursed by the total deposits received. It indicates how much of a bank’s core funds are being used for lending which is the main banking activity. CTD ratio helps in assessing a bank’s liquidity and indicates its financial health. It tells us about liquidity position as well as the usage of funds by banks.

If the ratio is too low, banks may not be earning as much as they should and it also indicates that banks are not mobilizing their resources fully.
If the ratio is too high, it means that banks might not have enough liquidity to cover any unforeseen fund requirements, which may cause an asset-liability mismatch. A very high ratio is considered alarming because, in addition to indicating pressure on resources, it may also hint at capital adequacy issues, forcing banks to raise more capital.
Ideally, there is no range in which the ratio should be, but it should be neither too high nor too low hence it should be kept in a balanced range.

Credit to Deposit ratio in the year 2019
ICICI 90.54
Bandhan Bank 89.96
Kotak Mahindra Bank 89.7
HDFC Bank 86.32
SBI 73.35

(5) Yield on advances

The average yield on investment results from adding all interests, dividends, or other income generated from the investments divided by the average of the investments for the year. The average annual yield on an investment is a useful tool for floating rate investments, in which the fund’s balance and/or the interest rate changes frequently.

Yield on advances= Interest earned/Advances

The higher banks and financial institutions’ loan to asset ratio, the higher is its yield on returning assets. This is because higher-yielding vehicles bring in more income relative to the amount of money on loan.

(6) Net NPA

NPA (Non-performing Asset) issue. Almost all Indian banks whether PSU or private or NBFC’s have all been dealing with severe NPA levels.
A bank’s business involves providing loans to borrowers. The borrowers could be a company, an individual, or any organization. The loans that are issued by the banks are known as bank's assets because the banks earn interest on the loans. But there is always a possibility that borrowers may default on the payment of interest as well as the principal amount. As per guidelines issued by the RBI, banks classify an account as NPA only if the interest due and charged on that account is not serviced fully within 90 days from the day it becomes payable. An asset becomes non-performing when it does not generate any income for the bank. Now, there can be scenarios where the borrower does not pay the loan amount even after the lapse of 90 days or more than these kinds then start coming under NPA’s.

Classifications Of NPAs:

Banks classify NPA’s into the following 3 categories based on how long they remain non-performing. 

The three categories are – 

1. Substandard Assets,
2. Doubtful Assets and
3. Loss Assets.
Standard Assets are those assets whose payment is received by the due date.

Gross NPA consists of Substandard Assets, Doubtful Assets, and Loss Assets.

Substandard Assets– If a loan account remains NPA for a period less than or equal to 12 months. Doubtful Assets– An asset is doubtful if it has remained in the sub-standard category for 12 months. Loss Asset– A loan account is declared as a loss asset when the bank’s internal or external auditors declare it so or the RBI inspection declares it as one.

Gross Non-Performing Assets (GNPA):
Gross NPA is the summation of all loan assets that are classified as NPA as per RBI guidelines. When the NPA occurs, it is not just an interest income loss to the bank, but a principal loss as well. That means, if a bank has lent Rs.100 Crores to a company with an outstanding loan amount of 80 Crores, then the bank would lose these 80 Crores along with the future interest payments as well when the company does not repay back.

Provisions As Per RBI Guidelines:
For precautions and to meet unforeseen losses, banks are required to make provisions as per RBI guidelines. RBI issues guidelines on Income Recognition, Asset Classification, and Provisioning. 

• Banks have to provide a 25% provision for unsecured substandard assets. 
• In case of doubtful assets (NPA for 1 year and more) 100% provision is to be made for the unsecured portion of doubtful assets and 25% for the secured portion. 
• In case of doubtful assets of more than 1 year but up to 3 years,100% provision is to be made for the unsecured portion and 40% for the secured portion. 
• If the asset is doubtful for more than 3 years, 100% provision is to be made for the entire asset. In case of Loss Assets, 100% provision is made. 

After detailed calculations for each and every account, banks arrive at Gross NPA.

However, sometimes certain factors like ECGC coverage, insurance claims and various subsidy by govt in different loans are admissible. So, from the gross amount, these amounts and provisions provided are netted to arrive at Net NPA.

Intervention Of Regulators:
It is the responsibility of the risk management and regulators to prevent the banks from taking excessive risks with respect to lending. There is always a possibility that banks would take extra risk in giving the loans, thus the regulators have defined provisioning regulations for bad assets. To elaborate, banks need to continuously assess their loans and set aside an amount, at the beginning itself, to accommodate for any losses.

Banks with higher NPAs effectively have lesser funds to advance because of the higher provisioning that they have to provide i.e. lesser funds on which they can potentially earn interest income. Other negative impacts of high NPAs are that the higher NPAs will increase the amount of provisioning thereby impacting the profitability of the banks. Thus Banks will face difficulty maintaining capital adequacy ratio. There will be increased pressure on Net Interest Margin (NIM) and compulsiveness to reduce high NPA’s.

(7) Provision coverage ratio

The key ratio in analyzing the asset quality of the bank is between the total provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided for the weaker part of its loan portfolio. A high ratio suggests that further provisions to be made by the bank in the coming years would be relatively low as the provision coverage is high(if gross non-performing assets do not rise at a faster rate).

Net non-performing assets = Gross NPAs – Provisions.

Gross NPA Ratio is the ratio of total gross NPA to total advances (loans) of the bank.

Net NPA to Advances (loans) Ratio is the ratio of Net NPA to advances. It is used as a measure of the overall quality of the bank’s loan book.

Provision Coverage Ratio = Total provisions / Gross NPAs.