The efficiency ratio is commonly used to assess how well a corporation manages its assets and liabilities on a daily basis. The rotation of receivables, the repayment of liabilities, the quantity and use of equity, and the general utilisation of goods and machinery can all be calculated using an efficiency ratio. This ratio can also be used to measure and analyse commercial and investment bank performance.
What Can You Learn From an Efficiency Ratio?
Analysts utilise efficiency ratios, commonly referred to as activity ratios, to assess a company’s short-term or current performance. All of these ratios quantify a company’s operations by using statistics from its current assets or current liabilities.
An efficiency ratio assesses a company’s capacity to generate revenue from its assets. An efficiency ratio, for example, may consider a variety of factors, such as the time it takes to collect cash from clients or the time it takes to convert inventory to cash. This emphasises the importance of efficiency ratios, as an increase in efficiency ratios usually corresponds to increased profitability.
These ratios can be compared to those of peers in the same industry to find companies that are better managed than the rest. Accounts receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales, and stock turnover ratio are all popular efficiency ratios.
Ratios of Bank Efficiency
An efficiency ratio has a special meaning in the banking industry. Non-interest expenses/revenue is the efficiency ratio for banks. This demonstrates how well the bank’s executives manage their overhead (or “back office”) costs. Analysts can use this, like the efficiency ratios above, to evaluate the performance of commercial and investment banks.
The Importance of the Efficiency Ratio
The efficiency ratio of a bank reveals how profitable the institution is, as well as its level of financial stability. The safer it is to trust a bank or credit union with your money, the more stable it is.
Banks that are losing money are more likely to fail or merge, and they may not be able to give competitive prices on the products you use. Profits enable banks to absorb loan losses and economic shocks while also allowing them to reinvest in their operations.
Using Efficiency Ratios to Compare Banks
Efficiency ratios in banks do not exist in a vacuum. The efficiency ratios of banks can vary greatly due to differences in their architecture and business practises.
Because they don’t have to pay for real estate or tangible promotional materials, online-only banks, for example, have cheaper operational costs. They do, however, frequently offer greater interest rates on checking and high-yield savings accounts.
In an expensive real estate market, a regional bank that promises high-touch, in-person service will have greater operating costs. It’s also possible that it’ll process more high-interest loans, resulting in more revenue.
When comparing efficiency ratios between banks, look for institutions with similar business strategies and client bases, and then aim to locate the institution with the best ratio in that area.
Why Does the Efficiency Ratio of a Bank Change?
As the economy changes, so do efficiency ratios.
To respond to the competitive environment, banks may make investments or cut costs. Extreme cost-cutting can help a bank’s efficiency ratio, but it can also hurt future profitability, customer satisfaction, regulatory compliance, and other areas of the organisation.
If you’re going to use the efficiency ratio to analyse banks, be sure to look at how the figures vary over time, what a particular bank does differently than its competitors, and how it compares to banks of comparable size and business style.
The Efficiency Ratio’s Components
The data needed to calculate a bank’s efficiency ratio can be found on its income statement. Calculating a bank’s efficiency ratio can be as simple as copying and pasting figures, but the final ratio will be more meaningful if you understand what’s going on behind the numbers.
Operating Profits
The operating revenue of a bank is derived from a variety of sources. This revenue can be separated into two categories: interest and non-interest income.
Banks generate interest through investing the money they have in checking and savings accounts, as well as through loans, mortgages, credit cards, and other financial products. Some of this interest is given to clients, but the majority is kept by the bank as profit. The difference between interest earned and interest paid out to customers is referred to as net interest income.
Non-interest income: Banks also make a lot of money via fees. Maintenance costs, low balance fees, overdraft fees, and service fees for wire transfers or ATM withdrawals are all fees that customers pay. Others, such as swipe fee earnings on bank-issued cards, may be paid by retailers.
Provision for Loan Losses
Expected losses are frequently included as an expense area in financial companies’ financial statements. A small percentage of borrowers will fail on their loans, and banks must plan for this eventuality. When consumers default on their payments, banks write off the bad debts and cover the costs of the loss.