Basic Fundamental Analysis of Banking

When I made an ebook about methods of fundamental analysis, I forgot to tell you that there are some companies that have a structure of financial statement that is somewhat different from the usual. In the ebook, I show you the example of Unilever Indonesia (UNVR), and that's the view of financial statements in general. However, for companies in the field of financial services, like banking, multifinance, insurance, etc., the structure of the statement is not like it (although the essence is the same), so that you need to read it a bit differently. This article will discuss the issue.

Because the listed companies in the multifinance sector (ADMF, WOMF, etc.) and insurance (AMAG, ABDA, etc.) are not so popular as they are also not liquid, then here we will only discuss about fundamental in banking (BMRI, BBRI, etc.). In addition to some fundamental ratios that we already know, like return on equity, debt to equity rato, etc., the banks have several other important fundamental ratios to see if we wanted to assess its financial performance. Basically, there are three ratios that must be considered, namely the Capital Adequacy Ratio (CAR), Net Interest Margin (NIM), and Non-Performing Loans (NPL). Okay, we will discuss it one by one. 

1. Capital Adequacy Ratio

Capital Adequacy Ratio (CAR), is a ratio between net capital of a bank with its total assets. For example, you have a capital of Rp20 billion, you then set up a bank. Your bank then managed to acquired a number of customers and collect deposits of Rp50 billion. You also have other assets outside the capital and deposits, totaling Rp30 billion. Thus, the total assets of your bank are 20 + 50 + 30 = Rp100 billion. Then how much the CAR? Just divide net capital by total assets, 20 / 100 = 0.20 = 20%. 

The illustration above is a way to roughly calculate the CAR. To accurately calculate the CAR, you must include the risk factors that might reduce the total equity and/or the assets of your bank, into the formula for calculating the CAR. 

Examples. Of deposits of Rp50 billion earlier, you then channeled it back into the community in the form of credit/loan, say Rp40 billion. Then, if you give a loan to someone, then there is always the possibility that the person will fail to return it back aka default, right? This is what is meant by risk factor, in this case the credit risk. Let's say the default risk is 5%, which means that from Rp40 billion of the funds you lend to the public, there are Rp2 billion that could have been lost (because it is not returned by the debtor). If this Rp2 billion is totally lost, what does it mean? This means that the total assets and total equity of your bank will decrease Rp2 billion respectively. For assets, from the initial Rp100 to 98 billion, and for capital, from the initial Rp20 to 18 billion. So, the formula to calculate the CAR would be 18 / 98 = 0.184 = 18.4%. 

So we can say that your bank's CAR including the credit risk is 18.4%. 

In its practice, the formula for calculating the CAR is fairly complicated and lengthy, and totally not as simple as illustrated above. In addition to credit risk, there are also two other risks that must also be taken into account, namely market risk and operational risk. Fortunately, we do not need to count them all because the banks are already showing their CAR in their financial statements. For example, in the third quarter of 2010, Bank Mandiri (BMRI) recorded a CAR of 14.1%. Thus we can say, the net capital of BMRI including its risk factors is 14.1% of its total assets. 

Bank Indonesia (BI) as the banking authority in Indonesia, setting a limit on the minimum CAR of 8%. So if there is a bank that has CAR of less than 8%, then the bank will be liquidated. This regulation is certainly needed, because the bank is an institution that is directly responsible to the community at large (bank is where we entrust our money). If there was a bank whose capital is less than 8% of total assets, then of course the banks are at high risk to fail to refund customer's savings and deposits. Remember the story about Bank Century? When it was bailed out, the CAR is minus 153.7% (said the head of LPS, Firdaus Djaelani). It was very strange, because when a bank's CAR is below 8%, BI should have taken action. But it was minus, and also at large number! 

Back again to the matter of CAR. As the amount of deposits collected by banks is increasing every year, then the assets of the bank will also continue to increase. As a result, the bank's capital must also be increased to compensate. If not, the CAR can be less than 8%. That’s why BMRI, Bank BNI (BBNI), and also some other banks, is reportedly to hold a right issue to increase their capital, so that their CAR remain above 8%. 

The number of CAR is easy to read: The greater the number, the better the bank, because it means that its capital is stronger. Be careful on bank with CAR approaching minimum level of 8%. When compared with the ratio of the issuer's fundamentals are generally, CAR is approximately equal to (but not exactly) by EAR (Equity to Assets Ratio), aka the ratio of capital to assets.

2. Net Interest Margin 

Net Interest Margin (NIM) is the ratio between net interest income (interest income of banks that have reduced by cost of goods) with the value of productive assets.  Productive asset is an asset that generates the interest (usually called net bearing assets). For example, a bank's assets value is Rp100 billion. Of the total assets, Rp80 billion of which is channeled to and fro in the form of loans, securities, bonds, etc., thus generating interest revenue for the bank. Thus, this Rp80 billion is called the productive assets. 

If the bank's interest income was Rp5 billion in a year, then after deducting by the cost of goods the result is Rp4 billion, then its NIM is 4 / 80 = 0.05 = 5%. 

Such as CAR, you do not need to count the NIM, because the bank already place the number in its financial statement. The greater the value of NIM, the better their ability to use their assets to produce income, so the better the bank.

If compared with general ratio in the fundamental analysis, NIM is roughly the same with ROA (Return on Assets), aka the ratio of net income to assets.

3. Non-Performing Loans

Non Performing Loan (NPL) is the ratio between loans that are not returned by the debtor (bad debts), or returned but halting, with total loans extended by banks to the public. For example, as already discussed above, the bank’s loan portfolio amounted to a total of Rp40 billion. Of these, Rp1 billion has default. So the NPL is 1 / 40 = 0.025 = 2.5%.

At the bank, if based on the level of collectibilities, the loans are classified into five states, namely 1. current, 2. special mention, 3. substandard, 4. doubtful, and 5. loss/default. For current status, meaning that the credit is not a problem at all, and can be billed smoothly. For the status of special concern, then the credit is starting to make some problem. And the most bad group is the default status, which the loan could not be charged at all, or can not be sure when it will be returned by the debtor. 

At the financial statements, there are two kinds of NPL, namely gross NPL and net NPL. Gross NPL is comparing the amount of the credit that on status of substandard, doubtful, and loss accumulated, with total loans. While net NPL is comparing the loss only, with the total loans disbursed. In the financial statements, both displayed. For me, gross NPL is more important to note than the net NPL, because the credit of substandard and doubtful status may become loss in the future.

The greater the gross NPL is, the more ugly the bank, because it shows that they can not properly disbursed their credits. The bank recorded as bad loan as a loss, as the money that they lend was just dissapear.

Conclusion

Okay, I think that is. Actually there are many other banking ratios that are also important. But to asses a bank's fundamentals, the above three is relatively enough to be taken into consideration. So if you read the news that a bank won the award of 'The Best Bank in blah blah blah ..' or 'Platinum Award Bank bla bla bla ..', you do not have to be amazed. Just take a look at the bank’s three ratios, and also its performance, then you can judge for yourself whether the bank is excellent or not.

Original article was written at Oktober 29, 2010

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