Introduction to Banking: Financial Statements of Banks

DuPont System

• A comprehensive financial statement analysis provides insight into a firm's performance and standing in areas of efficiency, liquidity, operating profitability, and leverage.
• The DuPont analysis breaks down Return on Equity (ROE) and Return on Assets (ROA) into areas of profitability, efficiency, and leverage.
• ROE is the most important key ratio, as it indicates the rate at which owner wealth is increasing.
• An increase in ROE can be a good sign, but it can also rise due to increased debt, which increases leverage and makes the stock more risky.
• DuPont analysis shows the causes of shifts in ROE, and an alternative way to evaluate ROE is by breaking down ROA into net profit margin and asset turnover.

ROE Analysis

• If ROE increases due to an increase in net profit margin or asset turnover, it is a positive sign for the company.
• If ROE increases due to increased leverage, it may be a bad sign if the company is already appropriately leveraged.
• If a company's ROE remains unchanged, but net profit margin and asset turnover decrease, it is a bad sign.

Balanced Scorecard

• The balanced scorecard provides a broader view of a company's performance by considering non-financial measures, such as customer relationships and support processes.
• Managers use indicators like market share, customer retention, customer profitability, and service quality to evaluate performance.
• Non-financial indicators provide information on whether a bank is truly customer-focused and whether its systems are appropriate.

Banking Operations

• Banks can be divided into two main areas: the Customer Bank and the Investment Bank.
• The Customer Bank includes activities related to customer-facing services, such as loans, core deposits, and payment services.
• The Investment Bank includes activities related to the bank's own investments, such as the investment portfolio and non-core assets.

Performance Measurement

• Banks use internal funds transfer pricing systems to assign asset yields and cost of funds to different lines of business and products.
• Risk-adjusted income and economic income are two adjustments made to income in line of business profitability analysis.
• The return is adjusted for risk by subtracting expected losses, and the return nets out required returns expected by stockholders.
• The specific concern is whether RAROC (Risk-Adjusted Return on Capital) is greater than the firm's cost of equity.

Earnings-at-Risk

• Earnings-at-risk measures the volatility of earnings from a line of business.
• One way to measure earnings-at-risk is to relate it to the volatility of earnings from the line of business.
• Risk capital is estimated as one (or two) standard deviation of earnings, divided by the risk-free interest rate.

Financial Statements of Banks

• Financial statements provide a "road map" of a bank's past, current, and future performance.
• The two main financial statements are the balance sheet (Report of Condition) and the income statement (Report of Income).
• The balance sheet lists a bank's assets, liabilities, and equity capital on a given date.
• A bank's assets can be classified into four main types: cash, government and private securities, loans and lease financings, and miscellaneous assets.

This quiz covers the topic of financial statements in the context of banking, focusing on how a bank's services and size are reflected in its financial statements. Explore the importance of financial statements as a road map of a financial firm's history and current status.