Is the bank in your portfolio healthy? Check how it fares on these 7 key metrics

In two of our previous stories, we laid out a guide to help you read the profit & loss statement and balance sheet of banks and non-banking financial companies (NBFCs). But if you hold a banking stock or are planning to invest in one, you also need to know how to assess their financial health and overall quality. This can only be done by understanding the core financial metrics that measure their performance. We have laid out these metrics below, explaining what they indicate about a bank or an NBFC's operations. So, let's begin.

1) Net interest margin

We know that the net interest income (NII) is an absolute figure that reflects the total income of a bank (total interest earned minus interest expended). Net interest margin (NIM), meanwhile, is NII expressed as a percentage of the bank's interest-earning assets (loans and investments). This margin reflects the income the bank makes from every Rs 100 it lends—so, naturally, a higher margin is better!

Why look at NIM instead of NII? A large bank might report a high NII simply because it handles more money, but that doesn't necessarily indicate efficiency. NIM, however, reflects how efficiently the bank is utilising its loans to generate profits. A higher NIM indicates that the bank is getting more profit out of each unit of its assets (like loans), regardless of its size.

Take an example of two large banks. In FY24, State Bank of India (SBI) reported an NII of Rs 1.6 lakh crore, while this was Rs 26,000 crore for Kotak Mahindra Bank. While SBI's income was much higher than Kotak's, its NIM was just 3.3 per cent against the latter's 5.3 per cent, suggesting Kotak fared better than SBI on efficiency.

2) CASA ratio

Customers deposit money in banks through savings and current accounts, fixed deposits, and recurring deposits. Among these, current and savings accounts (CASA) are the cheapest source of funds for banks as they carry low interest rates.

The CASA ratio is a key metric that measures how much of the bank's deposits are in the current and savings accounts out of its total deposits. A higher CASA ratio means that a larger proportion of the bank's deposits come from current and savings accounts, meaning it has a healthy access to low-cost funds, which helps it boost its profitability.

To evaluate it more effectively, compare a bank's CASA ratio with that of its peers and monitor the trend over time. A rising ratio suggests a strong deposit base, while a decline might indicate competition or challenges in retaining low-cost deposits. Also assess how the bank is growing CASA deposits—expansion, digital banking, and customer service are usually positive signs. However, if the growth is driven by higher interest rates on savings accounts, it might hurt profitability.

(Note: CASA ratio doesn't apply to NBFCs as they can't raise money through current and savings deposits.)

3) Non-performing assets or NPA ratio

This is a crucial measure to spot signs of trouble. Some loans inevitably turn bad and become non-performing assets (NPAs). These are loans overdue for over 90 days and their proportion in the total loan book is a critical indicator of the bank's loan book quality.

A high NPA ratio suggests that a significant portion of the bank's loan portfolio is of poor quality, indicating that many borrowers are struggling to repay their loans, which can be a sign of underlying economic difficulties, or poor credit assessment and monitoring practices by the bank.

Here's an example of a healthy NPA ratio. HDFC Bank, known for its conservative lending and stringent risk policies, has maintained a median gross NPA ratio of 1.2 per cent and a net NPA ratio of 0.3 per cent over the past decade.

It's also essential to keep a tab on NPAs as they reduce the bank's interest income, even as costs remain constant. This negatively impacts both NII and NIM. Additionally, banks have to set aside more provisions if the likelihood of loan defaults rises. You will also want to keep an eye on the slippage ratio , which indicates the rate at which fresh loans turn bad during a given period.

4) Provision coverage ratio

The provision coverage ratio (PCR) measures how well a bank is prepared to cover potential losses from NPAs. It's calculated by dividing the provisions set aside for bad loans by total gross NPAs.

A high PCR indicates that the bank has reserved more funds to cover potential losses, reducing risk. For example, in FY18-19, Yes Bank's PCR averaged just 47 per cent (at least 70 per cent is considered ideal), which was a warning sign before its collapse. When the bank's defaults surged, it couldn't adequately write off bad loans. As a result, the bank went from having Rs 4,233 crore profit in FY18 to a loss of Rs 16,433 crore in FY20.

Ideally, banks should build up their PCR during periods of strong earnings. However, a significant increase might also indicate concerns about loan quality. You can gauge this by assessing the past NPA trends.

5) Capital adequacy ratio

The capital adequacy ratio (CAR) measures the bank's financial strength and ability to meet its obligations using its own capital during periods of financial distress. It's calculated as the ratio of available capital (tier 1 and tier 2) to risk-weighted assets (RBI assigns risk weights to banks' assets by the credit risk level they carry).

A good CAR indicates that a bank has enough capital to absorb potential losses and is less likely to become insolvent. This also ensures the protection of depositors and stability in the financial system. The RBI mandates that all banks in India maintain a minimum CAR of 9 per cent.

6) Return on assets

Return on assets (ROA) measures a bank's profitability relative to its total assets. It's calculated by dividing net profit by average total assets, showing the profit earned per unit of asset. For example, an ROA of 1 per cent means that for every Rs 100 of assets, the bank is generating Rs 1 in net income. A higher ROA reflects good management and operational effectiveness.

7) Return on equity

Return on equity (ROE) gauges how well a bank is generating profits from the equity that shareholders have invested. It is calculated by dividing net profit by average shareholders' equity. A higher ROE is seen as a sign of strong profitability. This ratio also depicts whether the bank is creating value for its investors or not.

That said, it's important to note there are additional factors like high other income that can also influence both ROA and ROE. A sharp increase can be due to short-term earnings boosts that might be driven by under-provisioning for bad loans. So, evaluating a bank's return ratios requires a deeper assessment.

Here's an example of a healthy ROE driven by all the right reasons-HDFC Bank has consistently achieved an ROE of above 15 per cent from 2000 to 2024 due to steady profits, conservative lending, low-cost deposits, branch expansion, and technological upgrades.

Before we wrap up, take a look at the table below showing how the top five Indian banks fare on the key financial metrics discussed in this story.

Your takeaway

It's important to know how to assess the financial health and quality of banks and NBFCs before one decides to invest in them. This is due to their unique and slightly complex nature of operations that are different from non-financial companies. It's also crucial to remember that all the metrics that we explained in this story should not be analysed in isolation. Rather, they need to be evaluated together to get an accurate picture of a bank's strengths and weaknesses.

Also read: Warren Buffett's timeless wisdom from his letters to Berkshire shareholders (1966-1976)