How to read the balance sheet of banks and NBFCs?

In a previous story, we detailed how the profit and loss statement of banks and non-banking financial companies (NBFCs) differs from others. The next step is to explain what makes their balance sheet unique, and different from that of non-financial companies.

A balance sheet shows a company's financial position at a particular moment, represented by what it owns (assets), what it owes (liabilities), and the difference between the two (shareholder's equity).

For banks and NBFCs, the nature of assets and liabilities differ due to their unique operations. Let's understand how:

How are liabilities different?

We know that a bank takes capital or deposits by customers in various accounts like savings, current, fixed, and recurring. This money is the primary source of funds for the bank, used for daily operations and lending.

Deposits are classified as liabilities on a bank's balance sheet because they represent money that the bank owes to its customers. For example, HDFC Bank's deposits made up 66 per cent of its total liabilities in FY24. Other obligations include loans or borrowings that the bank takes to run its business.

For NBFCs, the primary source of funds is the money they borrow from banks or other financial institutions, which are then used to fund their lending operations. These borrowings form a significant part of an NBFC's liabilities. For example, India's largest NBFC Bajaj Finance's borrowings constituted 61 per cent of its total liabilities in FY24.

How are assets different?

An asset is a source of income for any business. Banks earn income in the form of interest charged on the loans they lend out. Therefore, a major portion of their assets is the portfolio of loans or advances lent out in different segments like housing, automobile, or personal use. For instance, around 69 per cent of HDFC Bank's total assets in FY24 were advances.

The more loans a bank gives, the more money it earns. Factors like economic growth, attractive interest rates, or the bank's ability to reach more customers support this growth. However, it's important to be cautious as rapid growth in advances might mean loans are being given to customers with low repayment ability. In that case, high bad loans (non-performing loans) can accumulate, increasing the need for provisions, which reduces profitability. To judge these quality issues, we use two metrics-gross and net non-performing assets ratio. We will discuss these metrics in a separate story. For now, remember that quality is as necessary as growth for banks.

The other major assets for banks are cash and equivalents. This includes the head cash and balances with Reserve Bank of India (RBI). This is a minimum level of capital that banks keep with the RBI at all times to ensure they are able to cater to their depositors' needs.

Another head is balances with banks and money at call and short notice. Balances with banks refers to funds that a bank holds in accounts with other banks to ensure adequate liquidity in the banking system.

Money at call and short notice represents short-term loans or deposits that a bank keeps with other financial institutions, often for one day (call money) or up to 14 days (short notice). These are highly liquid assets that can be recalled or withdrawn at very short notice.

Shareholder's equity

This is the residual interest of shareholders in every company, broadly classified into capital and reserves and surplus.

Like other businesses, capital is the initial money invested by the bank's owners (shareholders). It acts as a financial safety net, ensuring stability and absorbing potential losses. This foundational funding helps the bank start operations and maintain its financial health during challenging times.

Reserves and surplus represent the bank's retained earnings from profits. These savings are kept aside to cover unexpected losses, fund future expansions, and meet regulatory requirements. It strengthens the bank's financial position and ensures long-term stability and growth.

Below is an example of what a bank's balance sheet looks like.

Your takeaway

Understanding the balance sheet of banks and NBFCs is crucial for evaluating their financial health. Key items like loans, deposits, and shareholder equity provide insights into their operations and stability. In our next article, we'll delve deeper into the metrics that connect these financial statements, giving you a more comprehensive understanding of how to analyse these companies effectively. Stay tuned!

Also read: How to read the P&L statement of banks and NBFCs?

This article was originally published on August 23, 2024.