Efficiency Ratio: How Profitable Is Your Bank?

 

Banks are either hated or loved, depending on when you ask customers. If they’ve been approved for that loan or denied a refund of any fee, you will get different answers. As a value investor, banks and financial institutions can be a frustrating experience to try to value. They don’t fall into the same category that other companies do, so therefore they often get ignored. Today we will continue with our series of looking at the different formulas that can help us unravel the mysteries of these institutions. In this post, we will delve into the efficiency ratio and what it means, and how to calculate it.  

In the end, banking is a very good business unless you do dumb things.” 

Warren Buffett

The cool thing about learning to value banks is that once you learn how to analyze one, you pretty much can analyze all of them. There are about 500 banks that trade on the major exchanges, so this should give you plenty of options to choose.

Now, don’t get me wrong they can be very complicated with all the financial instruments, heavy regulations, old account rules, macro factors, and the intentionally vague jargon to try to throw you off.

But at their core, all banks are similar in that they borrow money at one interest rate and then hopefully, lend it out at a higher interest rate, pocketing the spread between the two. Which is the main avenue that banks use to make money.

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

Warren Buffett

Definition of Efficiency Ratio

The Efficiency Ratio is calculated by dividing the bank's Noninterest Expenses by their Net Income.Banks strive for lower Efficiency Ratios since a lower Efficiency Ratio indicates that the bank is earning more than it is spending. ... A general rule of thumb is that 50 percent is the maximum optimal Efficiency Ratio

Sageworks

Sounds and looks pretty simple, doesn’t it? And as ratios go it is pretty simple and straightforward.

But there are some accounting terms I want to go over, so we understand what it is we are looking at, and what the terms mean so we comprehend the meaning behind this ratio.

The nice thing about this ratio is that we don’t need a degree in finance to figure it out or years in banking to decipher the meaning behind it.

This ratio is nothing more than a bank’s operating costs, referred to on a bank’s income statement as “noninterest expenses.”, divided by its net revenue ( a bank’s total revenue minus interest expense ).

Efficiency Ratio = Net Interest Income + Non-Interest Income – Provision for Credit Losses / Non-Interest Expenses

Pretty simple, huh? No higher math here, just need to explain some accounting terms, so we understand where the numbers are coming from and what impact they have on our formula.

First, we will only be using the data from the income statement to calculate this formula, so that is easier.

Next, let’s break down each term in the formula, so you understand what they mean.

Net Interest Income: Net interest income is the difference between the revenue generated from a bank's assets and the expenses associated with paying out its liabilities. A typical bank's assets consist of all forms of personal and commercial loans, mortgages, and securities. The liabilities are the customer deposits. The excess revenue generated from the interest earned on assets over the interest paid out on deposits is the net interest income.

The types of assets earning interest for the bank can vary quite radically from mortgages, car loans, personal loans to commercial real estate loans. This product mix will greatly affect the interest rate a bank earns on its assets. For example, Wells Fargo, who is the nation's largest home mortgage lender, can have big fluctuations in their interest earned based on what types of mortgage interest rates their customers carry.

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Please let me know if you have any questions or comments on this article, or if you would like to have any help with any of these formulas.

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