Key Financial Ratios to Assess Banking Stocks

The banking industry is an extremely crucial component of any country’s economy as it acts as the source of funding for other industries to operate. Leadingly, banking stocks are also considered to be a viable investment avenue. It then becomes important for investors to understand the parameters around which one can assess the financial strength and positioning of a bank. There exist certain ratios which can throw some light on how efficient a bank is in its business operations, but before that one must understand how banks generate revenue.

Business model of a bank

The premise of a bank's business model is staged around the concept of intermediation, which in other words is the process of connecting borrowers with lenders. Banks play the role of intermediaries who take deposits from savers and lend these funds to the borrowers as loans. Banks charge a higher rate of interest on loans which they give out relative to the interest paid by them on deposits. By calculating the difference between these two rates of interest, one arrives at the Net Interest Income, which is the revenue generated by the bank through its lending activities and is also a key indicator of the bank’s profitability levels. Banks consider loans to be their assets as they are the primary revenue drivers for them.

Banks also generate revenue through a variety of other activities, including fee-based services such as account maintenance, foreign currency exchange, trading financial instruments and managing their investments.

Let’s now go through some key financial ratios which are helpful in assessing banking stocks.

Growth in Advances and Deposits

Advances refer to the money which has been lent out by the bank as loans to others, and leadingly is one of the most important sources of revenue generation for banks. Deposits, although considered as a liability, play a crucial role in determining a bank’s ability to give out loans, as a drop in the number of deposits might lead to a reduction in the loans given out.

Generally speaking, if the advances and deposits of a bank are increasing on a year-to-year basis, it is considered as a positive indicator of growth in a bank’s profitability and operations.

The advances and deposits of 5 Indian banks are:

Source: ICICIdirect, data as of quarter ended Mar 2023

Capital Adequacy Ratio (CAR)

The Capital Adequacy Ratio (CAR) measures a bank's financial strength and its ability to absorb potential losses. This ratio compares a bank's capital set aside by it to cover potential losses, against its total risk-weighted assets, which are loans and other investments. To calculate CAR, a bank's capital needs to be divided by its total risk-weighted assets.

The importance of CAR is that it indicates how able a bank is in absorbing potential losses while maintaining stability in its financial position. A higher CAR is indicative of the bank having a stronger buffer against potential losses and is more financially stable, as compared to a lower CAR. As per RBI guidelines, banks are required to maintain a minimum CAR of 9% on an ongoing basis.

The Capital Adequacy Ratios of 5 Indian banks are:

Axis Bank: 18.54%

HDFC Bank: 18.90%

ICICI Bank: 19.16%

Kotak Mahindra Bank: 22.69%

State Bank of India: 13.83%

Source: ICICIdirect, data as of Mar 2022

Cost to Income ratio (CIR)

The Cost to Income ratio (CIR) measures how efficient a bank is in managing its costs relative to its income. The ratio is calculated by dividing a bank's operating expenses by its operating income.

The CIR is important for banks because it indicates the bank’s ability in managing its costs by making use of its operating expenses in maximizing its profits. A lower ratio is indicative of the bank being more efficient in managing its costs, and leadingly, being more profitable in general.

Current Account Savings Account (CASA)

CASA stands for Current Account Saving Account and is used to refer to the deposits that banks hold in current and savings accounts. These accounts enable easy access to cash, usually with minimal or zero balance requirements, and generally pay lower interest relative to other deposit accounts, such as time deposits or fixed deposits.

CASA deposits are a crucial metric for banks as these are low-cost, stable and reliable sources of funding as the money in these accounts is deposited by customers for the convenience and ease of access. Hence, they are less likely to withdraw these funds as compared to other types of deposits.

Having a higher proportion of CASA deposits in the overall deposit base, known as CASA Ratio, is considered as a positive indicator of a bank's financial health, as it means that the bank has a larger pool of stable funding to lend out and generate revenue. Banks with a higher CASA ratio are generally in a better position to weather economic downturns, as they have a larger pool of stable funding to lend out.

Gross Non-Performing Assets (GNPA)

The gross non-performing assets (GNPA) ratio measures a bank's ability to manage its loans. It is representative of the percentage of a bank's total loans that are classified as non-performing assets (NPAs). Non-performing assets can be defined as those loans that no longer generate income for the bank, usually because the borrower has defaulted on their payments.

Why the GNPA ratio is important is because it is indicative of how able a bank is in managing its loans and how risky its loan portfolio is. A higher ratio usually means that a sizable proportion of the loans given out are not generating income and hence, are carrying a higher level of risk for the bank.

The GNPA ratios of 5 Indian banks are:

Axis Bank: 2.82%

HDFC Bank: 1.17%

ICICI Bank: 3.60%

Kotak Mahindra Bank: 2.34%

State Bank of India: 3.97%

Source: ICICIdirect, data as of Mar 2022

Net Non-Performing Assets (NNPA)

The Net Non-Performing Assets (NNPA) ratio is similar to the Gross Non-Performing Assets (GNPA) ratio, but it measures the net value of non-performing assets (NPAs) instead of the gross value. NNPA is calculated by subtracting the value of the bank's provisions for bad loans from the gross value of NPAs. Essentially, NNPA is representative of the loans which are expected by the bank to default, but the bank has not created any provisions against these.

Just like the GNPA, a higher NNPA is indicative of riskiness in the bank’s loan book.

The NNPA ratios of 5 Indian banks are:

Axis Bank: 0.73%

HDFC Bank: 0.32%

ICICI Bank: 0.76%

Kotak Mahindra Bank: 0.64%

State Bank of India: 1.02%

Source: ICICIdirect, data as on Mar 2022

Net Interest Margin (NIM)

Net Interest Margin (NIM) measures the profitability levels of a bank's lending and deposit operations and is calculated by dividing the bank's Net Interest Income (NII) by its total interest-earning assets. The Net Interest Income is calculated by calculating the difference between the interest earned on loans given out by the bank and the interest paid on the deposits made in the bank.

A higher NIM is indicative of the bank earning more on its loans than paying on its deposits which usually points towards higher profitability.

The Net Interest Margin of 5 Indian banks are:

Axis Bank: 3.47%

HDFC Bank: 3.96%

ICICI Bank: 3.96%

Kotak Mahindra Bank: 4.62%

State Bank of India: 3.36%

Source: ICICIdirect, data as of Mar 2022

Loans to Deposits Ratio (LDR)

The Loans to Deposits ratio (LDR) measures a bank's liquidity and its ability to fund its loan portfolio and is calculated by dividing a bank's total loans by its total deposits.

The LDR is important because it is indicative of the bank's ability to fund its loans with deposits. If the LDR levels are too high, then it suggests that the bank is lending out a larger proportion of its deposits, which may lead to a lack of liquidity if any unforeseen events were to occur.

Price to Book (P/B) ratio

The Price to Book (P/B) ratio measures the value of a bank's stock price relative to its book value and is calculated by dividing the bank's market capitalization, which is the total value of all its outstanding shares by its book value, which is the bank's assets minus its liabilities.

Usually, a lower P/B ratio is indicative of a bank’s stock being undervalued and a higher ratio indicates that the bank is overvalued. Banks with a lower P/B ratio may be more attractive to investors as they might deliver greater returns. However, it is crucial that the bank measures its asset quality correctly with proper provisioning for NPA. The Price to Book ratio of 5 Indian banks are:

Axis Bank: 2.33

HDFC Bank: 3.69

ICICI Bank: 3.59

Kotak Mahindra Bank: 4.02

State Bank of India: 1.66

Source: Screener, data as of 12 May 2023

Provision Coverage Ratio (PCR)

The Provision Coverage Ratio (PCR) measures a bank's ability to cover its bad loans or non-performing assets (NPAs) with the money it has set aside for that very purpose. It is calculated by dividing the total value of the bank's provisions for bad loans by the total value of its non-performing assets.

Provision Coverage Ratio is indicative of the bank's ability to absorb potential loan losses. A higher ratio indicates that the bank has set aside more money to cover potential NPAs, and therefore has a stronger buffer against potential defaulters.

Return on Assets (ROA)

Return on Assets (ROA) measures how profitable a bank is by comparing the bank's net income to its total assets and is calculated by dividing the bank's net income by its total assets.

ROA is indicative of how efficient the bank is in deploying its assets to generate income. A higher ROA suggests that the bank is generating more income from its assets and might be more profitable.

The Return on Assets of 5 Indian banks are:

Axis Bank: 1.21%

HDFC Bank: 2.03%

ICICI Bank: 1.84%

Kotak Mahindra Bank: 2.13%

State Bank of India: 0.67%

Source: ICICIdirect, data as of Mar 2022

Conclusion

It is important to note that a thorough analysis involves reviewing all these ratios in unison along with the socio-economic and macro environment using a stock market app for one to decide the most optimal position to take in a banking stock. We hope that these ratios will help you in building a better understanding of banking stocks and their market price.