Measuring Financial Well-Being (2/2)

Measuring Financial Well-Being (2/2)

In this lesson, you’re expected to learn about:
– asset management
– how banks generate earnings by charging interest
– using ratios to measure operating asset management

Banks generate the majority of their earnings by charging interest on assets they lend out that were freely given to them in the form of deposits on which they pay interest.

Thus, banks make money by generating more interest income in loans than they pay to their depositors, which is called the spread.

As a bank lends out a higher percentage of its total assets, it generates more income along with a much higher financial risk.

We’ll now look at some ratios used by banks for assessing liquidity, financial risk and effective asset management.

These calculations are not always necessary to make effective decisions but the information can be very useful.

1) Earning Assets to Total Assets Ratio 

Of all the assets that a company owns (i.e. total assets), analysts want to know what percentage of them are actually generating income.

Earning assets usually includes any assets that are directly generating income, such as interest-bearing investments or income-generating rentals, but in some cases it can include other forms of assets that directly contribute to income.

Earning assets to total assets ratio = Average Earning Assets / Average total assets

2) Net Interest Margin 

By looking at the proportion of income that’s being generated for the value of the company’s assets, you can determine whether a company is using its earning assets effectively.

Essentially, you want to know whether the earning assets are making enough money to justify the interest expense or if the company would be better off paying off its debts to decrease the interest expense.

Net Interest Margin = Interest income – Interest expense / Average earning assets

3) Loans to Deposits Ratio

A high ratio means that the bank is issuing more of its deposits in the form of interest-bearing loans, which in turn means that it generates more income. The problem however is that the bank’s loans are not always repaid.

In addition, the bank has to repay deposits on request so having a ratio that’s too high puts the bank at risk. A very low ratio means that the bank is at low risk but it also means that it isn’t using its assets to generate income and may even end up losing money.

Loans to deposits ratio
 = Average net loans / Average deposits

4) Loan Loss Coverage Ratio

‘rainy-day fund’ is the money that you set aside in case you lose your job and stop making money. Companies have rainy-day funds as well, which they measure by using the loan loss coverage ratio.

Loan Loss Coverage Ratio = Pre-tax profit + Provision for loan losses / Bad debts expense

If a bank lends someone money and that person doesn’t pay it back, the bank loses that money. Similarly, if a company sells a customer a product and the customer never pays the bill, the company loses that money.

Companies need to know how much money to keep on hand to cover these losses. If a company has too much money on hand, it isn’t using its assets efficiently but if it has too little on hand, it risks insolvency.

Of course, decreasing the bad debts expense is the best option but a company should always have potential losses covered as well.

[Optional] Subprime Lending: Helping Hand or Underhanded?
These ratios are for people who manage, own or lend to companies with large capital investments – firms that need things that are expensive to operate.

These companies may be part of the manufacturing industry(which usually requires machines of some sort), the transportation industry (such as airlines) or utilities (electricity, water).

Operating Assets

These types of organizations tend to have an extremely high proportion of their assets held in extremely expensive pieces of capital that are directly related to their operations, called operating assets. For example, an airplane is an operating asset for an airline.

The thing that these industries, as well as others, have in common is that they’re heavily dependent on operating propertyand long-term debt.

If you’re analyzing a company with lower levels of operating assets or long-term debt, don’t forget to take that fact into consideration and use the ratios in context with other equations.

1) Operating Ratio 

The operating ratio shows the financial effectiveness of a company’s core operations.

It is a measure of the ratio of assets that are taken up by expenses, all related to the company’s core operations.

Operating Ratio = Operating expenses / Operating revenue

For example, if the company is an airline, the operating revenuesare ones generated from ticket sales and in-flight purchases, whereas the operating expenses are the cost of the planes, the cost of fuel, the wages for pilots and everything else related directly to the transportation service.
[Optional] Fixed Assets vs. Operating Assets
2) Percentage Earned on Operating Property 

After a company has bought its operating property, it likes to determine whether it is capable of generating earnings.

You measure the ability of a company’s operating property to create income with the percentage earned on operating property.

Percentage Earned on Operating Property
= Net profit / Operating property

For many companies, this ratio is the ultimate measure of whether they’re investing effectively in their primary operations.

– Low ratio: may indicate that the company isn’t investing enough, is investing too much or is simply investing in the wrong assets.

– High ratio: may indicate that the company is generating a high level of income by using its available assets.

Jim Rohn Sứ mệnh khởi nghiệp