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FINANCE NOTES
CHAPTER # 4
“ANALYSIS OF FINANCIAL STATEMENT”

FINANCIAL STATEMENT ANALYSIS DEFINED:

 The process of using the information provided by financial statements to answer

questions pertaining to the financial health and performance of an organization.
 Financial analysis seldom provides final answers; rather it indicated were further
investigation is warranted.
 A typical analysis begins with a review of the company’s history, products,
markets, earnings and financial position. Dates for the firm are then compared with
information about the industry in which it operates, to its competitors within the
industry.
 Analysis of individual firms must also encompass management and its decision
making philosophy, marketing capabilities, production facilities and changes in all of
the elements as they have occurred over time.

BANKS:
 The Banks – Financial Assets. Financial Assets depends upon claims. While in
other sector there are Real Assets. Real Assets – machines which are use for the
generation.

BANK BALANCE SHEET ASSETS:

 We advance in investor account receivable, inventories, major of Banks assets re

loans, in addition to cash, cash equivalent etc.

 For most Banks, loans and investments are the largest asset category and would
be counterpart to inventory and account receivable accounts for a retail firm. Loans
are generally listed in terms of maturity and some times also include leases because
leases sometimes are substitute of direct lending.
 Lease sometimes giving to borrower – restriction by Pakistan – in what extent
banks or party take loans. Banks sometimes operating (which is of Balance Sheet), a
one hand utilizing the assets.
 Direct Purchase  Direct outflow to save from direct outflow), Lease  No
direct outflow. Bank purchase and give to people. There is no stretch on Balance
Sheet.

DIFFERENTIATE BETWEEN LEASE & LOANS:

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ASSETS:

 Cash balances with treasury. (State Bank reserve it for the banks  5% Cash and
15% Securities etc)
 Balances with other Banks.
 Lending to financial institutions.
 This is done through Reverse REPO under which securities are held by others
Banks are purchased under an agreement to sell. The difference between the
contacted price and the resale price is recorded as Interest Income.
 Direct Credit Line (1 or 3Years) – Some sort of securities, Money Market
Operation is REPO is short form of repurchase option. Money is short for short term
period sell it to Banks which is excess to in Bank.
 Investments. (Government Securities as well as shares)
 Advances. (Main earning and source of the Bank. In the Balance Sheet are usually
Gross Form  Advances in Balance Sheet is always of Net of Provisions (100M) 
allowances for bad debt (10M) but balance sheet show 90M but in notes there will be
detail)
 Other Assets (Small %).
 Bank  Letter of Credit &  Client.
 KIBOR are usually 99% secured with some premium.

ADVANCES:

Rs. In (000)
2004
Loans, Cash, Credits etc 66,185,570
Net Investments in lease 8,034
Bills discounted and purchased 3,042,023
69,235,627

Carry out Transaction (COT) Financing 0

Provisions for NPLs (10,430,532) – Allowance for Bad debt
General Provisions (5,402)
Net Advances 58,799,702 – Asset Sheet for the Balance Sheet

PROVISIONS:

 Provisions are also known as Loan Loss Coverage.

 From Gross loans and leases an allowance that is provisions are deducted to arrive
at the net loan figure. The provision account is comparable to non bank business
firm’s allowances for doubtful account but us more significant for banks because is
loan loses are the major source of risk and loss at any banking institution.

 Cheaters are in great advantage.

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CLASSIFIED LOANS (NPLS) & PROVISIONS:

 Performing Loans and Non Performing Loans (which are classified).

 Other Asset Especially Mentioned (OAEM)

INVESTMENTS:
 Investments for banks consist primarily in Govt. Debt Securities because of risk
free and reserve requirements. Banks generally invest a very small amount in the
equity securities because of being highly volatile in nature and restrictions by the
Central Bank. Investments in Govt. debt securities mostly consist of Treasury Bills
and Pakistan Investment Bonds (PIB’s).
 Two thing investments being are bank that is short term and long term securities
 1st part consists of reserve (short and long) requirements  mix of T’Bills and
PIB’s.
 Incase the banks has excess liquidity and no big proposal for bank and any
advances which are highly used nature  specially when rising interest rate scenario
 preferred to T’Bills.

 Held for Trading Securities.

 These are securities which are acquired for generating profit from short term
fluctuations in the market price.
 Available for sale securities.
 These are securities with fixed or determinable payments (interest) and fixed
maturity that the bank has the positive extent and ability to hold to maturity.
 Held to maturity securities.
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 The management determines the appropriate classification of its investments as
held for trading, available for sale or held to maturity.
 Associated Company = 20% & Subsidiary Company =50%
INVESTMENTS BY SEGMENTS:

 Federal Government Securities.

 Provincial Government Securities.
 Fully paid up listed and non-listed shares.
 TFC’s, Debentures, Bonds and PTC’s (Participation Term Certificate).
 Investment in associated companies.
 Investment in subsidiary companies.
 Provision for diminution in the value of investments is deducted from the gross
investments to arrive at the net investments.

 Assets  Lending to the Bank while Liabilities  opposite to the assets means
borrowing to the Bank.

EARNING ASSETS?

 Net loans and leases and total investments comprise a bank’s earning assets.

LIABILITIES:

 Main liabilities of bank is deposits, it is mentioned in liabilities  other are fixed

deposits and other  other major source of borrowing of financial resources.
 The major liabilities for banks are different types of deposit accounts that are used
to fund lending and investment activities. These are the primary source of finding to
the banks and vary according to the interest payments and maturity etc. The type
includes fixed deposits, saving deposits and current accounts.
 Other liabilities include borrowing from financial institution and represent
secured and unsecured borrowings from different banks including the central banks.
Most of the borrowing is done through REPO that is securities are sold to other banks
subject to repurchase. The difference between sale and repurchase value is recorded
as Interest Expense. (REPO Short period)

CAPITAL STRUCTURE:

 Consist of Paid in Capital  In some Banks show bonus shares.

 In Equity: 1) Paid in Capital 2) Bonus Shares 3) Retained Earning 4) Revaluation
of Capital.

REVALUATION RESERVE:
 Requirement  International Organization which consist of all Central Banks,
they prepares the rules to monitor the Banks in respective Countries. Mandatory for
every member Country, how to run, policy guidelines (www.bis.org)  1970’s or
1980’s then late 90’s.
 BIS stands for Bank of International Settlement.
 BIS requires that should have a capital adequency ratio of 8% of the weighted
average.
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 Capital adequency ratio which is necessary to retain by Bank. Every bank is
required to maintain 80% of it.
 Capital revaluation is to improve the capital to meet the capital adequency.
HOW BANKS MAKE PROFIT OR LOSS:

 Main source of income is spread (difference between interest received and get).
 Main assets of Banks are loans – Assets are usually generates profits – loans
generate largest income of the Banks.

INTEREST RATE SPREAD:

 The higher the spread the higher what you are get what you paid for expense.
 One way of judging better profitability of Banks is spread.

INTEREST RATE:

 Received or loan portfolio to interest ratio paid on the deposits or borrowed funds.

INCOME ACCOUNTS:

 Because loans are the largest category of assets in any Bank, Interest on loans id
the major source of income, it also includes fees and other charges levied and
recovered against loans.

 The other source of Income is Fee Based Income.

FEE BASED INCOME:

 When bank form a syndicate to arrange a fund for you then they charges
management fee and other fee.
 First total cost of project & what resource you need.
 Syndicate Financing.
 Under Writing.

 Other sources of income include income from non interest activities such as
dividend income, commission, advisory fee, trading profits on securities and foreign
exchange.

FEE CHARGED FOR SERVICES RENDERED SUCH AS:

 Originating and processing new loans.

 Providing retail banking services such as check processing DD (Demand Draft) &
TT (Telegraphic Transfer) etc.
 Underwriting new equity or bond.
 Providing advisory services of the corporations.

OTHER FEE SOURCES:

 Commitment Fee.
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 Project Evaluation Fee.
 Legal Charges.
 Exchange Differences (Buying Rate etc).

TRADING PROFITS:

 Securities repurchase derivates currency selling purchase.

 From buying and selling securities to speculation on movement of interest rates or

equity prices.

 Depositors bust in BCCI Banks.

 Depositors Insurance Scheme in U.S.A (Insured by the Banks).
 Incase of Bankrupt or then the insurance dept. will give the amount to the
depositors.

EXPENSE ACCOUNTS:

Interest Expense that is the Interest Paid on Deposits:-

 It includes any interest paid on deposits. These are booked on accrual basis that is
when funds are utilized by the Bank rather than when the interest is actually paid to
the depositors.
 Interest paid on borrowings from other financial institutions.

Administrative Expenses:-

 This includes salaries of all the employees and other benefits such as bonuses,
contribution to person or retirement plan, medical expenses etc.

Provision for Possible Loan Losses:-

 This is equivalent to the Bad Debt Expense of the year in non banking
institutions. The amount estimated by Bank management to be sufficient to bring the
balance in the provisions account to a level adequate to absorb expected loan losses.

 Net Advances  Sort of Allowances for Bad Debt &  Expenses of the
particular year.
 When every year bank reviews its loan. If it is falls in that 4 categories. So they
had to provision the additional provision in bad debt or allowances for depreciation.
 Total Provision is different than this  Don’t Confused it.
 Major Sources if Income is Advances.

RESERVED:
 To allocated specifically in Retained Earning. To don’t run, it is for the specific
purpose.
 Several period groups in industry.
1) You must form the strength and weaknesses.
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2) You shouldn’t take the doing figure, always the average all the figures in Balance
Sheet.

INTER BANK EVALUATION:

 This is done by analyzing published accounts of the common size banks. While
analyzing banks it should be ensured that we cannot compare a small bank with a
large bank rather similar size of banks should be selected preferable on the basis of
deposits or no. of employees or no. of branches. The group of similar size of the
banks is called the “PEER GROUP”.
 The other point to be kept on mind is the averaging of absolute and closing
figures should be taken from the balance sheet and income statement and divided by
two to have average.

GROWTH RATIOS:

 Calculation of Horizontally.
 No. of employees, accounts, no. of branches.

 The growth ratios are calculated horizontally form year to year. The growth
percentages are compared internally and externally with peer group or compared with
the budgeted figures to visualize trend of growth. These may be calculated for the
bank as a whole or for the branches.
 The popular growth ratios are:-

 Total Assets growth ratio.

 Advances growth ratio.
 Earning growth ratio.
 Pre-tax profit growth ratio.
 Deposit growth ratio. (Important looked upon)
 Man power growth ratio.
 Equity growth ratio.

 Late 90’s Allied Bank small bank – the management employees of the bank –
purchase by employees – so they just wanted to show that the balance sheet is
increasing. Acquiring deposit at any cost started offering high rate to attract customer
and to use technique to bring customer at one point interest rate. (No loan coming).
No asset to generate profit only way is to invest in treasury bills and securities –
money market bank. 12% to 11% per rupee (downward) house building and other
take loan @ 8% - and sell it to 14% to 15% - and pay interest so they still left to 6%.

PROFITABILITY:

 Return on Total Assets.

 Return on Equity.
 Net Interest Margin.
 Yield on Earning Assets (Consider only performing loans and investments).
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 Pre Tax Profit/Total Income.
 Operating Expenses/Total Income.
 Cost of Funds.

ASSET QUALITY:

 Non-performing loans/Total Advances.

 Provision held/Non Performing Loans.
 Classified Loans Mix/Total classified Loans.
 General Provisions Held/Performing Loans.
 Sector wise Exposure/Total Advances. (Balance Sheet is very IMP)
 Average Earning Assets/Total Assets.

 Performing Loans, Net Advances, Borrowing to the bank, Lending to the bank &
Investing.
 Read IT (ARTHUR HALLOWS NOVELS “MONEY”).
 Traded Policy formulated, each sector – usually identify – and this exposure limit
fixed by depend on research department – heavy exposure = textile industry.

LIQUIDITY RATIOS:

1) Total Liquid Assets/Total Assets (Ratio).

(The higher the ratio the liquid bank is).
2) Total liquid Assets/Total Deposit (Ratio).
(This measures the Bank’s ability to meet with drawls).
3) Loans/Total Deposit (Ratio)
(This would indicate the gap between the existing Advances portfolio and the
budgeted asset portfolio).

FUNCTIONAL CONDITION:

 Employees/Total Assets.
 Employees/Branches.
 The lower the employee ratio more efficient is the bank.

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MINIMUM PAID-UP CAPITAL

MINIMUM PAID-UP CAPITAL DEAD LINE BY WHICH TO

BE INCREASED

(Net of Losses) to be increased to:

a) Rs. 3 Billion. By 31-12-2006

b) Rs. 4 Billion. By 31-12-2007
c) Rs. 5 Billion. By 31-12-2008
d) Rs. 6 Billion By 31-12-2009

FINANCIAL RATIOS USEFUL FOR BANK ANALYSIS:

 ADVANCES/DEPOSIT RATIO:

= Net Advances x 100

Total Deposits

 This ratio indicates the extent to which deposits has been utilized to finance the
advances.
 If Net Advances Increase bank portfolio good thus bank reserve (Provision)
decreases.

 EQUIT/DEPOSIT RATIO:

= Total Equity x 100

Deposits of the Bank

 This ratio is a sort of Debt/Equity ratio and in this ratio depositors and
shareholders both are interested higher the ratio higher the safety.

 AVERAGE EARNING ASSETS/TOTAL ASSETS:

= Average Earning Assets x 100

Total Assets

 This ratio indicates the relationship between the average earning assets with total
assets. In the Earning Assets Advance and Investments or Placements with other
banks and institution where income is generated are taken into account.
 The higher the ratio (better the performance) more and more assets are earning
and increase in income.

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 The lesser the ratio so less assets are generating for the banks and decrease on
income. (They are fixed asset).
 This ratio indicates the efficiency of the management in developing its resources
where earning assets ratio is lower, the amount might have been un-necessarily spent
on Non Earning Assets. Such as renovation and civil works. The ideal ratio for a bank
should be 75% to 80%.
 Other Non Earning Assets are Cash, NPLs (Provision), Fixed Assets etc.
Earning Asset of the Bank:
1) Advances.
2) Investments.
3) Lending to the other banks.
4) Investment (Treasury Bills).

 RETURN ON TOTAL ASSETS:

= After Tax Profit x 100

Average Total Assets

 This ratio helps in comparing banks with tax earning with other peer banks and
for own bank. The ideal ratio is usually 1% plus.

 RETURN ON EQUITY:

= After Tax Profit x 100

Average Equity

 This ratio indicates earning efficiency on equity and helps a fair assessment of
banks earning capacity and comparative efficiency in the peer group.
 Preferred Stock in Banks re-introduced in Pakistan.

 NET INTEREST MARGIN RATIO:

= Interest Received – Interest Paid x 100

Average Gross Earning Assets

 The margin should be compared with the peer group. If the Interest rates on
advances and investments are the same and quite identical in the peer group but the
margin has a vide fluctuation the ratios of Deposit Mix and borrowing period should
be further analyzed.
 Net Interest Income is the difference between the total interest earned and interest
paid.
 The percentage of Interest rates on advances of spread is common. All Banks are
charging same rate of interest.
 Why Bank is paying more Interest? Because of two sources: - 1) Deposit 2)
Borrowing Period.
 It should be higher than peer group for perfect liquid funds for short term period.

 YIELD ON EARNING ASSETS:

= Funded Income x 100
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Average Gross Earning Assets
 Funded Income is total income earned during the period by way of interest on
securities. Investments and interest received on advances. The denominator is
Average Gross Earning Assets represented by opening plus closing balances of
advances plus Investments divided by 2.
 This ratio measures average yield on Earning Assets and can be conveniently
compared with the peer banks.
FUNDED INCOME:

 2 Ways of Bank Money 1) Funds 2) Advisory Service (Fee Based Income) =

Securities (Example would be underwriting).
 Earned by its funds or it assets.
 Percentage of banks earns through services.

LOCAL BANKS FOREIGN BANKS

% of Funded Income Higher. % of Non-Funded Income Higher (B/c of Trusties

and others). City Banks, Green lays.

 PRE-TAX PROFIT/TOTAL INCOME:

= Pre Tax Profit x 100

Total Income

 This ratio indicates the relationship between the pretax profit and the total income
and is comparable with Peer group to measure efficiency of the management.
 If you are comparing ratio analysis of banks. If fluctuation in banks than expenses
will increases. This ratio fallen down.
 Ratio Fallen because of three Reasons:-
1) Your Income Decreasing (Why is fallen because Earning Assets decreasing).
2) Excess will Increasing.
3) Income Constant.

 Total Income = Gross Income = Net Income.

SPREAD:

 Spread which we earlier study is the amount and which will we study now is in
the % ratio.
 This is the difference between the yields on earning assets minus cost of funds.

 COST OF FUNDS:

= Interest Paid x 100

Average Deposits + Borrowings

 The numerator is the total amount of interest paid on deposits and borrowings.
The denominator represents average of deposits and borrowing. This ratio indicated

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average cost of funds and is comparable with other similar size banks or within the
bank from period to period.
 Only represent the cost which bank pay on fund. Not consider when pricing a loan
 Pricing a loan (You don’t basically cannot consider cost of funds and other cost is
Administrative cost).
 Pricing Loan = Interest Paid + Administrative Expense + Premium
Average Deposits + Borrowings
 High rate = Lower security.
 OPERATING EXPENSES/TOTAL INCOME:

= Personal cost plus over heads ** x 100

Total Income

 Normally it should range between 10% to 15%.

** Includes Rent, Property Taxes, Insurance, Electricity, Depreciation, Traveling,
Advertisement, Entertainment, Auditors fee etc.

 EMPLOYEES/TOTAL ASSETS:

= Total Employees x 100

Total Assets
 This ratio indicates how many times are the assets per employee. When compared
with the PEER group. This ratio indicates overstating. Lower the ratio the better the
efficiency of the bank.

 EMPLOYEES/BRANCHES:

= Total Employees x 100

Total Branches
 This ratio is used to compare the operational performance of the branches of the
Bank. Lower the ratio, efficient is the branch.

RATIO TO MEASURE ASSET QUALITY: (BAIC OR MAIN RATIOS)

 NON-PERFORMING LOANS/TOTAL ADVANCES:

= Non performing loans x 100

Gross Loans Outstanding

 The non performing loans are those loans where income has been suspended and
instead income is credited to the suspense account.
 It shows the degree of infection of the loan portfolio and the quality of total loan
portfolio to well managed banks, this ratio should be up to 5%. However, a
comparison should be made with PEER group.
 Suspense Account  Dummy Account – Name of account, Income of non
performing loans are credited.

 PROVISION HELD/NON PERFORMING LOANS:

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= Total Provisions Held x 100
Non Performing Loans

 This ratio calculates the coverage of non-performing loans by total provision.

Ideally the provisions held should be at least 75% of total non-performing loans for
full coverage. The higher the ratio, the more the bank is secure.
 In the below ratio we discuss: % of Categories  Higher the ratio of the doubtful
and gross ratio there is more.
CLASSIFIED LOANS MIX/TOTAL CLASSIFIED LOANS:

 The four categories of classified loans as defined in Prudential Regulations No.

VIII are: -
 OEAM (Other Assets Specially Mentioned).
 Substandard.
 Doubtful.
 Loss.

GENERAL PROVISIONS HELD/PERFORMING LOANS:

 Generally provision is not made against performing loans but in addition to

specific provisions against non performing loans, a small percentage per performing
loans should be set aside. An analysis of good borrowers along with substandard and
doubtful each year will reveal trend hence say 2% of performing loans should be set
aside from profit and loss account each year, as blanket provision.

SECTOR WISE EXPOSURE/TOTAL ADVANCES:

 According to Trade Policy which sector take exposure – Cement, Sugar etc –
Respective exposure in each sector of industry. Ratio is increasing approved by BOD
that contains the financial sector.

 This ratio indicates the exposure in each sector of the economy and is used by the
Bank management for credit risk management purposes. Usually the maximum per
sector risk is identified in the credit policy of the bank.

OBJECTIVES OF FINANCIAL STATEMENTANALYSIS:

 Investors, creditors and other users use financial statement analysis in decision
making to: -
1) Measure financial position.
2) Measure performance and predicting returns.
3) Assess financing and investing activities.
4) Check compliance and accountability. (Regularity authority) They are checked by
(IMPORTANT).

SOME KEY ISSUES IN INTERPRETATION OF ACCOUNTS:

 The importance of users needs:

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 Who is the user?
- Supplier.
- Bondholder.
- Shareholder.
 Short term creditor.

 Management: management will be interested in all ratios, through will emphasize

some over others, such as asset utilization or turn over ratios.

STATUTORY RULES:

1) Corporate Law (Issue general guidelines, company should prepare financial

statement – 3 months period, must be completed before the period – Deadline time
frame of financial statement.
2) Institute of Charted Accountant Pakistan.
3) Issues Accounting Advices for auditors.

REPORT:

1) 3 Financial statements. (Current and Comparative year)

2) Notes to financial statement.
3) Summary of Accounting policies.
4) Auditor’s Report and notice to AGM. (dividend payment any other major changes
in structure)
5) Director’s Report. (Very Important for the management point of view)
6) Selected summary data. E.g: 5 Year Ratio Analysis.

AUDITOR’S REPORT:
 Unqualified are those course on which auditors have confirmed that financial
statement are prepared according to the guidelines given by the International
Accounting Standard (IAS) and GAAP (Generally Accepted Accounted Principles).
 Qualified are who to set objection that it is increase from IAS and GAAP.

SOURCES OF COMPARATIVE DATA:

 Accounting data can be compared with external as well as with internal data.
When making comparison there can be problems in deciding what type of business
should be regarded as comparable. The following factors might be considered: -
 Types of Industry: -
 Regional Area (In a same industry there be change according to regional area.
E.g: Northern Areas and in Karachi same company (Total) won’t be same –
Balance Sheet will affect Regional Area.
 Size of Business (Pizza hut).

OTHER IMPORATANT FACTORS:

 Read the Director Report.

 Auditors Report.
- Unqualified Report.
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- Qualified Report.
- Adverse Opinion – Any characteristics.

IMPORTANT RATIOS ANALYSIS:

CURRENT RATIO:
 A very high current ratio indicated excess current assets which may have an
adverse effect on the large profitability, because of excess cash. Account Receivable
or Excess Inventories.

QUICK RATIO:
 A high quick ratio may suggest excess cash or a very liberal credit policy which
may needs to be looked into.

INVENTORY TURN OVER RATIO:

 A low inventory turn over ration may indicate obsolete inventory, lack of
inventory management or problems in sales in case of a trading company.

DAYS:
 Avery high days sales outstanding probably indicate uncollectible receivables and
a low ratio may indicate that credit granting policies are too restrictive which may
affect sales in the era of competition.

OTHER QUALITATIVE FACTORS TO BE LOOKED INTO:

 All the company’s sales tied to a single customer.

 To what extent are the company’s revenues tied to a single product.
 To what extent does the company rely on a single supplier?
 What is the company’s competitive position?

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