FIN 4324 EXAM II REVIEW COVERS CHAPTERS 6 7 8 9 10 6 CHAPTER 6 MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIR PRINCIPAL COMPETITORS a Introduction i Performance how adequately a financial firm meets the needs of its stockholders owners employees depositors and other creditors and borrowing customers 1 Ever important because banks rely on the open market to raise funds 2 Financial statements are examined thoroughly b Evaluating Performance i Determining long range objectives 1 When evaluating performance one must consider the objectives of the company ii Maximizing the value of the firm a key objective for nearly all financial institutions 1 Increasing the value of stock 2 Stock Value Function Pg 169 a Assumes that dividends will vary over time 3 Situations that tend to raise the price of stock a Value of the stream of future dividends is expected to increase b Financial institution s level of risk decreases c Market interest rates decrease d Combo of dividend increases and declining risk 4 If dividends are expected to grow at a certain rate over time use this formula a b D1 is the expected dividend on period 1 c R discount rate d G expected constant growth rate of dividends iii Profitability Ratios A surrogate for stock values 1 Stock price is the best indicator of a firms performance but is not always available 2 Profitability ratios can be used as a substitute a See ratios Pg 171 3 Interpreting Profitability ratios a Return on assets ROA indicates managerial efficiency how capable management has been in converting assets into net earnings b Return on equity ROE a measure of the rate of return flowing to shareholders approximates the net benefit that stockholders have received from investing their capital in the financial firm c Net Operating Margin Net Interest Margin Net noninterest margin i Efficiency measures and profitability measures ii Indicate how well management has been able keep revenues loan investments service fees ahead of rising costs interest on deposits misc expenses iii Net interest margin how large a spread between interest revenues and interest costs management has been able to achieve by close control over earning assets and cheap funding iv Net noninterest margin the amount of noninterest revenues stemming from service fees the firm has been able to collect relative to the amount of noninterest costs incurred 1 Generally negative v Net Operating Margin d Earnings Per Share EPS e Earnings spread i ii Measures the effectiveness of a firms intermediation function in borrowing and lending money iii Also measures the intensity of competition in the firm s market area iv Useful profitability formulas for banks and other financial service companies 1 ROE and ROA are closely related because of their common numerator net income 2 Return to a financial firm s shareholders is highly sensitive to how its assets are financed v Return on equity and its principal components 1 2 Component 1 Return on Assets a Net profit margin effectiveness of expense management cost control and service pricing policies Or i Tax management efficiency use of security gains or losses and other tax management tools to lower tax exposure ii Expense control efficiency how many dollars of revenue survive after operating expenses are removed measures operating efficiency and expense control b Degree of asset utilization portfolio management policies mix and yield on assets c Determined by i Mix of funds raised and invested ii Size of institution iii Control of operating expenses iv Pricing of services v Size of the firm s tax liability 3 Component 2 Equity multiplier leverage or financing policies sources chosen to fund the financial firm debt or equity a Determined by what sources of funding that are used what dividends are paid to stockholders b Higher greater exposure to failure risk greater the potential for high returns vi The return on assets and its principle components 1 ROA consists of the following components vii What a breakdown of profitability measures can tell us 1 A firm s profitability depends on five factors a Careful use of financial leverage proportion of assets financed by debt compared to equity capital b Careful use of operating leverage from fixed assets proportion of fixed cost inputs used to boost operating earnings as output grows c Control of operating expenses so more revenue becomes net income d Management of asset portfolio to meet liquidity needs while seeking highest returns e Control of exposure to risk so that losses don t overwhelm income and equity from assets acquired capital viii Measuring risk in banking and financial services 1 Risk the perceived uncertainty associated with a particular event 2 Measures of risk a Standard deviation or variance of stock prices b Standard deviation or variance of net income c Standard deviation or variance of ROE and ROA i The higher the standard deviation or variance the greater the risk 3 Types of risk a Credit Risk the probability that some of a firm s assets esp loans will decline in value or even become worthless i Due to the large amount of assets to capital equity only a few loans need to go bad in order for the bank to fail ii Credit risk ratio indicators past due for 90 days 2 off 1 a Nonperforming assets income generating assets inc loans that are a Charge offs loans that are declared worthless and have been written 3 4 5 6 a As the ratio grows concern increases because loans are considered the riskiest assets for depository institutions iii As the above ratios rise the credit risk increases b Liquidity Risk the risk of not having enough cash and borrowing capacity to meet customer withdrawals loan demand and other cash needs i Measures of liquidity risk a b i Heavier use of purchased funds increases liquidity risk in the event of mass deposit withdrawals c i The lower the above ratios are the greater the liquidity risk ii Financial firms can decrease their liquidity risk by increasing the amount of funds committed to cash or using longer term liabilities to fund the firm s operations c Market Risk the risk of losses arising from movements in market prices Consists of d Price Risk the risk of decline in the value of a security or a portfolio price risk and interest risk i Measures of price risk 1 2 3 e Interest Rate risk the impact of changing interest rates on a financial institution s margin of profit i Measures of interest rate risk 1 2 When interest sensitive assets exceed interest sensitive