1. Financial Ratios
FOUR BASIC TYPES - most commonly used for each - can be used for some financial companies.
LIQUIDITY
Current ratio = Current Assets / Current Liabilities
Not so relevant for financial firms - most assets liquid.
MANAGEMENT SKILL
Total Asset Turnover = Sales / Total Assets
Again, not so relevant because traditional sales are typically not very large. Interest and investment income is more relevant.

2. PROFITABILITY
Operating profit margin = Operating Profit/Sales
Return on Revenues = Net Income (or EBIT)/Tot. Assets
Return on Assets = Net Income (or EBIT)/Total Assets
Return on Equity = Net Income/Equity
These are measures of top-line profitability and bottom-line profitability, respectively. Similar for financial firms.
FINANCIAL RISK
Debt Ratio = Debt / Assets
Times Interest Earned = Net Operating Income /
Interest Expense
Leverage and interest-paying ability - used for financials.

3. Depository Institutions - Banks, S&L, Credit Unions
Financial Statements
National-charter banks must submit uniform accounting statements to the Comptroller of the Currency.
State charter banks submit accounting statements to their state regulator.
LIQUIDITY RISK - different than typical liquidity ratios
Liquidity ratio = (Cash+short-term securities)/Assets
Loans to Deposits = Loans/Deposits
Deposits Times Capital = Deposits/Equity
A mixture of profit potential and risk measures.

4. MANAGEMENT EFFICIENCY
Earning Assets to Total Assets = Assets-(Cash+Fixed Assets+Non-earning Deposits) / Total Assets
Burden = (Noninterest Exp.-Nonint. Inc.)/Tot. Assets
Efficiency = Nonint. Exp./(Nonint. Inc. + Net Int. Inc.)
Asset Utilization = Total Operating Income / Total Assets
PROFITABILITY
Interest Margin to Earning Assets = (Interest Income-Interest Expense)/Earning Assets
Profit Margin = Net Income/Total Operating Income
Return on Earning Assets = Net Income/Earning Assets
Return on Equity = Net Income/Equity

5. FINANCIAL RISK
Loan Loss Coverage = (Pretax Income+Loss Provisions) /Net Charge-offs
Provisions to Charge-offs = Loss Provisions/Net Charg.
Loss Allowance to Loans = Loss Allow./Loans
Equity to Assets = Equity / Total Assets
Other issues important to financial analysis of banks
Examine assets for risky asset types (LDC debt, related party loans, allowance for loan loss etc.).
Examine shareholder equity for unrealized gains/losses.

6. Loan Loss Reserves (part of the common equity account) should be sufficient to meet actual and potential losses.
Review footnotes and management discussion for disclosure of non-performing assets- observe trend.
Review footnotes for data on Off-Balance Sheet Activities which can add risk and profits.
Review trend in demand and time deposits - these are low-cost sources of funds.
Examine “Other Income” typically from services - this income is more stable and desirable than interest income.

7. Making Loans and Reserving for Losses Versus Guarantees
Financial firms, particularly banks, can make risky loans or provide loan guarantees and both are conceptually the same.
Risky loan value = risk-free value + loan guarantee value
When a loan is made, the bank earns interest above the risk-free rate. The premium above the risk-free rate is a premium for bearing risk as well as compensation for analyzing the and monitoring the borrower’s financial condition.
Loan rate = risk-free rate + risk premium and compensation

8. Effect of Loans vs. Guarantees on Financial Statements
1. The effects of loans - transparent.
The loan appears as an asset on the balance sheet.
A loan loss reserve appears as a contra-asset that reduces the loan value by an amount to cover the expected loss on the loan - a risk measure.
Interest is collected periodically and appears on the balance sheet.
2. The effects of loan guarantees - opaque
Off-balance sheet “intangible” liability - no contingent liability is booked. Footnote should provide some info.
Large up-front fee may appear immediately on income statement or periodic fee shows up over time.

9. 3. The cash payment for the guarantee goes to the cash account and a portion of the payment appears as a reserve for default and the rest goes to equity. The size of the reserve is supposed to be commensurate with risk of the borrower.
4. Problems with guarantees
Guarantor may reserve too little when loan is not on balance sheet.
If reserve is set properly, competitor lenders are able to see the value you place on particular customer’s creditworthiness.

10. Insurance Companies FINANCIAL STATEMENTS
State insurance regulators require annual reports based on statutory accounting practices (SAP).
Reports are similar across states and focus on the balance sheet to help assure solvency for policyholders.
A.M. Best provides “Best’s Insurance Reports” which rate insurance company financial strength.
Ratios used by best include operating, profitability, leverage, liquidity ratios - specific to insurance type.
Annual reports filed with the SEC follow GAAP.

11. Insurance Ratios MANAGEMENT EFFICIENCY
Loss Ratio = Incurred Losses/Premiums Earned
Expense Ratio = (Sales + Service Expenses)/Premiums Earned
Dividend Ratio = Dividends/Premiums Earned
Combined Ratio=Loss Ratio+Expense Ratio-Dividend Ratio
Combined Ratio after Dividends =Loss Ratio+Expense Ratio
If the Combined Ratio after Dividends exceeds 1, then the company must rely on investment income for profit.

12. Note: Earned premiums are premiums paid on policies with time elapsed - unearned premiums are paid but no time elapsed.
PROFITABILITY
Investment Return =Net Investment Income/Premiums Earned
Operating Ratio = Combined Ratio After Dividends Investment Return
Overall Profitability = Operating Ratio
Return on Revenues = Net Income / Revenues
Return on Equity = Net Income / Equity

13. Other issues in financial analysis of Insurance Companies
Look for significant differences between fair value of investments and their costs or amortized costs.
Check the equity section for unrealized gains (losses).
Check for a deferred policy acquisition cost buildup.
Check that loss reserves grow adequately with insurance in force.

14. Other Financial Companies’ Ratios and Financial Issues
Other financial companies have more conventional financial statements and one can use the conventional ratios discussed at the beginning of this lecture.
Issues for Securities Companies and Investment Banks
Look for excess leverage using Equity to Assets.
Examine the degree of long or short positions relative to total assets for extreme positions.
Look at the list of securities held for large positions in risky securities.
Is income largely from fees (more stable) or trading?

15. Issues for Investment Companies - Mutual Fund Managers
Examine
Expense Ratio = Expenses / Operating revenues, or
Expense Ratio = Expenses / Assets Under Management
Marketing Ratio = Marketing Exp. / Operating Revenues.
Management Fee Ratio = Management Fees / Assets Under Management
Many of the traditional ratios apply also.

16. Issues for Finance Companies
Examine
Expense Ratio = Expenses / Operating revenues
Loans to Equity = Loans / Equity
Return on Revenues = Net Income / Revenues
Can be treated similar to banks in many ways because they provide loans, otherwise, use traditional ratios.

17. Issues for Real Estate Companies
Focus on funds from operations = Earnings+Depreciation+Differed Taxes.
Consider current value of real estate as market or discounted future income value, not book value.
Short-term or variable rate debt used to fund real estate increases earnings risk.

18. Dupont Analysis - ROE
ROE = (Net Income/Total Assets) x (Total Assets/Equity)
= ROA x (Equity Multiplier)
= (Net Inc./Total Operating Income) x (Total Operating Income/Tot. Assets) x (Total Assets/Equity)
= (Profit Margin) x (Asset Utilization) x (Equity Mult.)
This says that ROE is determined by; (1) how profitable a company’s products are; (2) how well it uses its assets and; (3) how much leverage it has.
Net Income components to consider are Interest and Noninterest Income and Expenses, Taxes and Loan Loss Provisions. Financial firms’ tax rates don’t change much because they have few assets to depreciate or write down.

19. Cash Flow Statement Illustration of Inflows and Outflows
Inflows Outflows
Operations Operations
Cash Revenues Payment for Supplies
Collection of A/R Wages, Rent, Tax, etc.
Investments Investments
Sell Securities, Assets Working Capital
From Subsidiaries Capital Investments
Financing Financing
Issue Securities Pay Interest & Dividends
Obtain Loan Repay Loans and Bonds
Retire Equity
Handout Cash Flow Statement or show on web.

20. Ratio Analysis for Fleet Bank
For a ratio analysis,
Analyze at least 3 years to look for trends ( ).
Compare to similar firms (average-$10 Billion Banks).
% Fleet Comp. Fleet Comp. Fleet Comp.
Lns/Dep
Burden
Prov./Ch
Int. Marg
Eq/Asset
ROE
Question: Are there any trends in Fleet’s ratios?
Question: Explain the changes in Fleet’s ROE year-to-year.

21. The data for this example was taken directly from www. fdic. gov
The data for this example was taken directly from It also has income statement, balance sheet, ratio and common size statements for banks and thrifts. Similar data can be found at
Ratios and financial data may also be found in analyst reports at
For other companies, use EDGAR-ONLINE and find the 10k statements for a company. Click on FDS to get spreadsheets with raw income statement and balance sheet data. Alternatively, use EDGAR at These sites also have quarterly data from 10Qs which can be used for more up-to-date analysis.
For some Credit Union Data try

22. Other Approaches to Financial Analysis
1. Common Size Statements
All income statement lines expressed as percentages of total revenues.
All balance sheet lines expressed as percentages of total assets.
Compare changes in percentages over time and in comparison to industry (comparable group) average.
For banks and thrifts, both of these are are available at
Handout Financial Statement and Notes or use Web.