Four key ratios which you should consider before investing in a banking stock

There is no denying the fact that selection of an industry to invest for a specific period of time demands a lot of scrutiny through their financial statements, Michael Porter 5 forces model, SWOC analysis and unconventional William O Neil CANSLIM approach. An analyst requires to walk through various sleepless nights before channelizing his or firm’s funds into any new theme to bet upon. However, investing in the banking sector has never been a serious pain because banking sector runs parallel with the economy. Therefore, investing in banking industry is directly proportional to investing in the economy.

History has always shown that betting on the financial system of a country has never been an unhealthy decision for the investors. The product portfolio of almost every industry follows the product cycle and enters into decline stage after a particular period of time but banking services never go out of fashion and keep continuing. Moreover, the banking industry in any country grows in tandem with the growth of the economy, sometimes outperform. While, it is hard truth now that “Banks too fail” due to their inability to maintain the associated risks with their assets and sub-prime loans. Moreover, their inefficiency in recovering loans has deteriorated their balance sheet. Therefore, a scrutiny of their balance sheet is highly required on the basis of four key ratios.

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Important key ratios to be considered before investing in a banking concern:

  1. Net Interest Margin (NIM) Ratio: The major attribute of a going concern is their direct revenues which it earns from their key operations. This ratio is calculated by deducting net interest paid out to lenders from net interest earned by disbursing loans and investments, relative to the amount of assets that earns interest. This factor encompasses the real revenue of the banks and attains supreme importance in the analysis of a bank. This ratio helps the bankers to analyze how well they have managed to earn on the assets, which can be provided for advances. Higher the NIM margins a bank has been able to generate, healthy will be the revenue generation capacity of the bank.
  2. Cost to Income ratio:  This ratio has a unique identity in the scrutiny of the balance sheet which clearly describes how well the management of the company has done their job in disbursing loans to the borrowers keeping in mind the attribute of cost reduction. The ratio is calculated by dividing the operating expenses with operating income (net interest income plus other income). This attribute help us in identifying how effective the employees of a bank are in disbursement of loans. Lower Cost to income ratio determines that the bank has been able to generate business at lower cost.
  3. Capital Adequacy Ratio: The stability of a bank relies upon their capital that can be used for advancing loans to the borrowers. The Basel committee norms have stated that the bank’s capital (Tier1 +Tier2)/Risk-Weighted Assets should be around 8%. While, the Reserve Bank of India has stipulated 9% for Scheduled Commercial Banks. As high as the Capital Adequacy ratio is maintained by the banks, their chances of insolvency get reduced and their potential to counter the potential losses get increased.
  4. CASA Ratio: The banks deposit the amount from lenders in either their current account or savings account.  On current account, the banks don’t require to pay any interest to the depositors while the savings accounts are tied with interest obligations. This ratio helps in bifurcation of the current accounts and savings accounts of a bank. If a bank has more savings accounts in comparison with current accounts, it states that the bank is more a personal rather than a corporate one and liable to pay more interest to the depositors. While, higher current accounts in comparison with savings one claims for lesser interest obligations and fruitful for Cost to Income ratio and Net Interest Margins for the bank.

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