Financial Ratio Ranking: The Composite Method (Banking Sector)

One distinctive characteristic of banks is their asset composition.  Generally, non-financial companies’ assets are predominantly tangible assets, such as plants, properties and equipment.  While bank assets are predominantly financial assets such as loans and securities and their liabilities are primarily deposits.

Banks are also heavily regulated by authorities as such, capital, minimum liquidity, and the riskiness of assets must meet authorities’ requirements.

Hence, certain conventional financial ratios such as Gross Profit Margin, Inventory Turnover, Current Ratio and D/E etc are not relevant.

The most common rating approach for banks is “CAMELS”, an acronym of six components as follows:

Capital adequacy

Capital adequacy for banks is described in terms of the proportion of the bank’s assets funded with capital. For purposes of determining capital adequacy, a bank’s assets are adjusted based on their risk, with riskier assets requiring a higher weightage.

Asset quality

Asset quality pertains to the amount of existing and potential credit risk associated with a bank’s assets and focuses primarily on financial assets.

Management capabilities

Management capability is the ability to identify and control risk, including credit risk, market risk, operating risk, legal risk, and other risks.

Earnings sufficiency

Earning sufficiency means banks should ideally generate an amount of earnings to provide an adequate return on capital to their capital providers and specifically to reward their stockholders through capital appreciation and/or distribution of earnings.

Liquidity position

Adequate liquidity is essential for any type of entity. Banks’ systemic importance increases the importance of adequate liquidity. If a non-bank entity’s insufficient liquidity prevents it from paying a current liability, the impact would primarily affect the entity’s own supply chain.

Sensitivity to market risk

Banks’ operational sensitivity to interest rates, exchange rates, equity prices, or commodity prices are key to its financial strength.

Table 1 shows some selected ratios that fall within CAMELS rating methodology, amongst other:

Category	Financial Ratio
Capital Adequacy	Common Equity Tier (CET) 1 Capital Ratio;           Total Capital Ratio
Asset Quality	Gross Impaired Loan Ratio (GIL)
Management Capabilities	Cost to Income Ratio;           Efficiency Ratio
Earnings Sufficiency	Return On Equity (ROE)
Liquidity Positions	Liquidity Coverage Ratio (LCR);           Net Stable Funding Ratio (NSFR)
Sensitivity to Market Risk	Value at Risk (VaR)
Non-CAMELS
Liquidity	Loan to Deposit Ratio (LDR)
Valuation	Price to Book (PB)

Table 1.  Selected Financial Ratios for CAMELS and non-CAMELS rating methodology

The ratios for CAME are readily available in Annual Reports, but the "Liquidity Positions" and "Sensitivity to Market Risk" are not commonly reported in banks’ Annual Reports.  For instance, BASEL III (Read more here) requires banks to report LCR and NSFR on monthly basis but they are not disclosed in the Annual Report.  Also, VaR is not published in an annual report as well.  Thus, for retail investors to evaluate the ratios of bank stocks, both “Liquidity Positions” and “Sensitivity to Market Risk” categories are replaced with liquidity and valuation ratio such as LDR and PB.

Table 2 and 3 are some real-world examples of the above ratios based on eight commercial banks listed on Bursa Malaysia.  Readers are reminded not to rely solely on the brief financial ratio ranking for investment decision.

     Table 2. Selected Financial Ratios for eight commercial banks listed on Bursa Malaysia

Source:

Dynaquest Sdn. Bhd. STOCKBASE platform, except *.  See “Notes” at the end of this article for Copyrights details.

* Calculated based on latest Annual Report

Table 3.  Ranking based on Financial Ratios in Table 2

Reference:

Analysis of Financial Institutions by Jack T. Ciesielski, CPA, CFA, and Elaine Henry, PhD, CFA

Disclaimer:  The above analysis does not imply any buy or sell recommendation.  The author disclaims all liabilities arising from any use of the information contained in this article.

Disclosure: The author may have interest in the stocks of the companies in this article.

Notes:  The data are the property of Dynaquest Sdn. Bhd.  It is subject to Intellectual Property Rights and T&C.  Do not reproduce without the consent from Dynaquest Sdn. Bhd.  (The author has signed a “Data Sharing Agreement” with Dynaquest Sdn. Bhd., based on a “Data Sharing Fee”, to use the data from Dynaquest Sdn. Bhd.’s STOCKBASE platform in this blog.  The content of this blog in no way represents the views or opinions of Dynaquest Sdn. Bhd.)