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Unit 6 Financial Statements and Bank Performance Evaluation

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UNIT 6

FINANCIAL STATEMENTS AND BANK PERFORMANCE EVALUATION


6.1. FINANCIAL STATEMENTS OF BANKS

6.1.1. BALANCE SHEET OF A BANKS

Balance sheet is a statement that shows the firm’s assets, liabilities and capital on a particular

date. The bank’s balance sheet items are dimensionally different from other balance sheet of an

ordinary firm. The balance sheet lists what the business owns (assets), what the firm owes to

others(liabilities) and what the owners have invested ( capital) as of a given time.

The basic balance sheet equation expresses the relationship between these accounts as: -

Asset = Liabilities + capital

The capital account (or net worth) is a residual that can be calculated by subtracting liabilities

owed to creditors from the total assets owned by the bank. The right-hand side of the equation

can be viewed as the sources of funds for a bank. Funds are supplied by either creditors

(liabilities) or the owners (capital). The lift-hand side of the equation shows the uses of funds

(Assets) that the bank has obtained from the creditors and owners.

The primary function of a bank is accepting deposits for credit creation purpose. The bank is thus

a dealer in debts. It issues its own debts (mainly deposits) and it holds the debts of borrowers.

Both types of debts are recorded on the bank’s balance sheet, which is simply a double entry

statement of assets and liabilities.

Deposits are the largest sources of funds for most banks, but they are a much more important

source for small banks. Borrowed funds are more important sources of funds for large banks.

Banks in general are thinly capitalized, but small banks tend to be better capitalized than large
ones-Most bank liabilities are short term. Because it is difficult to attract more deposits and

investments by smaller banks, their capital is relatively higher.

Economically deposit accounts are similar to other sources of funds borrowed by the bank.

Legally, however, deposits take precedence over most other sources of borrowed funds in case of

a bank failure. At the time the bank fails to meet depositors claim their balance is recovered just

before other creditors. Furthermore, insurance companies insure the holders of such accounts

against any loss.

1) THE BANK’S LIABILITY ACCOUNTS

Major liability items of a bank shown on its balance sheet can be discussed as follows.

A. Demand/Transactions Accounts
Banks hold a number of different types of transaction accounts, which are more commonly

called checking accounts or demand deposit accounts. A demand deposit or a checking

account is an account whereby the owner is entitled to receive his or her funds on demand

and to write checks on the account, which transfers legal ownership of funds to others.

Demand deposits serve as the basic medium of exchange in the economy. Individuals,

government entities and business organizations may own them. Legally a demand deposit is

defined as a deposit that is payable on demand or issued with an original maturity of less than

seven days. Because they are closely associated with consumer transactions, demand deposits

are relatively more important as a source of funds for small consumer oriented banks than for

large banks. The demand deposits of individual corporations, state and local governments are

held primarily for transaction purposes.

B. Saving Deposits
Saving accounts are the traditional form of savings held by most individuals and non-profit

organizations. They are a more important source of funds for small banks than for large
banks. Historically, savings deposit had low handling costs because of their low activity

level.

C. Time Deposits /Time Liabilities/ Fixed Deposits


Time deposits, unlike demand deposits, are usually legally due as of a maturity date and

funds connote be transferred to another party by a written check. Both consumers and

corporations can own them, and their characteristics vary widely with respect to maturity,

minimum amount, early withdrawal penalty, negotiability and renewability. The principal

types of bank time deposits are savings certificates, money market certificates and

certificates of deposits.

D. Borrowed Funds
They are typically short-term borrowings by commercial banks from the wholesale money

markets or a national bank reserve. They are economically similar to deposits but are not

insured by the national bank. Borrowed funds are a source of funds primarily for large banks.

E. Capital Notes and Bonds

Issuing bonds to raise funds is a common practice of most industrial firms. It is only in recent

years that a few large commercial banks began raising funds by selling short-term capital

notes or longer-term bonds.

2) THE BANK’S CAPITAL ACCOUNTS

Bank capital represents the equity or ownership funds of a bank, and it is the account against

which bank loans and security losses are charged. The greater the proportion of capital to

deposits, the greater the protection to depositors. Banks maintain much lower capital accounts

than other businesses. Capital is a more important source of funds for small banks than for large

banks.
There are three principal types of capital accounts for a commercial bank. Capital stock, retained

earnings and special reserve accounts. Capital stock represents the direct investments in to the

bank; retained earnings comprise that portion of the bank’s profit that is not paid out to

shareholders as dividends; special reserve accounts are set up to cover un-anticipated losses on

loans and investments. Reserve accounts involve no transfers of funds or setting aside of cash.

They are merely a form of retained earnings designed to reduce tax liabilities and stockholder’s

claims on current revenues.

3) The Bank’s Asset Accounts


The earning assets of bank are typically classified as either loans or investments and there are

important differences between these two classes.

Loans are the primary business of bank and usually represent an ongoing relationship between

the bank and its borrowers. A loan is a highly personalized contract between the borrower and

the bank and is tailor-made to the particular needs of the customer. Loans are the most important

earning assets held by banks. They have high yields, but they are typically not very liquid.

Investments, on the other hand, are standardized contracts issued by large, well-known

borrowers and their purchase by the bank represents an impersonal or open market transaction.

Consequently, they can be resold by the bank in secondary markets. Unlike loans, investments

represent pure financing because the bank provides no service to the ultimate borrower other

than the financing securities is a much more important asset for small banks than for large ones.

Large banks concentrate in commercial loans, while small banks focus on consumer, agriculture

and real estate loans.

A bank asset includes the following items and discussed as follows.

A. Cash Assets
Cash items consist of vault cash, reserves with the Federal Reserve Bank (National Bank in

Ethiopia), and balances held at other banks and cash items in the process of collection. Cash
asset are non-interest bearing funds. Banks try to minimize their holdings of these idle balances

within their liquidity constraints. Because large banks must hold larger amounts of legal reserves

and have more checks drawn against them than small banks; cash item accounts are typically a

greater percentage of total assets for larger than smaller banks.

i. Vault Cash
Vault cash consists of coin and currency held in the bank’s own vault. Banks typically maintain

only minimum amounts of vault cash because of the high cost of security, storage and transfer.

Vault cash, however, perform two important functions for banks. First, it provides banks with

funds to meet the cash needs of the public. Second, banks can count vault cash as part of their

legal reserve requirements.

ii. Reserves at Federal Reserve Banks /National Bank


These deposits held by banks at the National Bank represent the major portion of the bank’s legal

reserve requirements and serve as check- clearing and collection balances. Rather than physically

transferring funds between banks, check clearing and collection can be done by simply debiting

or crediting a bank’s account at the National Bank. Banks may also transfer funds to other banks

for reasons other than check clearing

iii. Balances of other Banks


Banks hold demand deposit balances of other banks for a number of reasons: to meet state

reserve requirements by holding balances at approved large banks and to secure correspondent

services from large city banks.

iv. Cash Items in the process of collection


This account is the value of checks drawn on other banks but not yet collected. After a check

written on another bank is deposited into a customer’s account, the receiving bank attempts to

collect the funds through the check clearing mechanism. This is done by presenting the check to

the bank on which the check is drawn. Before collection, the funds are not available to the bank
and show up in the cash items in the process of collection account. At the time the funds become

available to the bank, the cash Items in the process of collection account is decreased (reverting

the original entry), and the bank’s reserves are increased by the same amount. The CIPC account

is analogous to the accounts receivable on the balance sheet of a non-financial corporation.

B. Investments.
The investment portfolios of commercial banks are major use of funds by the banking system.

Bank Investments consist of primarily of Treasury Securities, Government Agency Securities

and Municipal Securities. Bank investment portfolios serve several important functions.

First, they contain short-term, highly marketable securities that provide liquidity to the bank.

These short-term securities are held in lieu of non interest-bearing reserves to the maximum

extent possible.

Second, the investment portfolio contains long-term securities that are purchased for their

income potential. Their income generating ability is high. However, their marketability and

liquidity is low compared to primary & secondary reserves.

Finally, they provide the bank with tax benefits and diversification beyond that possible with

only a loan portfolio.

C. Federal Funds Sold (National Bank Funds Sold)


They correspond to the lending of excess bank reserves in the Federal Funds market discussed

earlier. Banks that sell (lend) excess reserves in the Federal Funds market acquire assets (Federal

Funds sold) and lose a corresponding amount of reserves on the balance sheet. Banks that borrow

Federal Funds gain reserves but aquire a liability (Federal Funds Purchased). These transactions

are reserved when the borrowing bank returns the reserves to the selling bank. A Fed Funds

transaction is basically an unsecured loan from one bank to another, usually for a period of one

day. Thus the Fed Funds rate is the interbank lending rate.

D. Other Assets
Fixed assets are the most important group in this category and include such real assets as

furniture, banking equipment and the bank’s real estate buildings. Other items considered as

asset items are; prepaid expenses, income earned but not collected, foreign currency holdings,

and any direct lease financing.

E. Bank Loans
Bank loans are the primary business activity of a commercial bank. They generate the bulk of a

bank’s profits and help attract valuable deposits. Although loans are very profitable to banks,

they take time to arrange, are subject to grater default risk, and have less liquidity than most bank

investments. However, they do not have special tax advantage of municipal bonds.

Most bank loans consist of promissory notes. Repayment can be made

a) Periodically, in installment

b) In total on a single date

c) On demand, only in some cases.

Bank loans can have either a fixed rate of interest for the duration of the loan commitment or a

floating -rate. Banks have increasingly turned toward floating -or variable-rate loans because of

the high and volatile interest rates.

Bank loans may be secured or unsecured. Most are secured. The security or collateral may

consist of merchandise inventory, accounts receivables, plants and equipments and in some

instances, even stocks or bonds. The Purpose of collateral is to reduce the financial injury to the

lender if the borrower defaults. An assets value as collateral depends on its expected resale value.

If a borrower fails to meet the terms and conditions of the promissory note, the bank may sale the

collateral assets to recover the loan loss.

Commercial and industrial loans are the biggest component of total bank loans. This heavily

emphasis on commercial and industrial loans is not surprising since banks have a strong

comparative advantage in making such loans. Retail banks, though not the large wholesale
banks, make most of their loans to fairly small, local borrowers. Such loan application requires

the evolution of someone on the spot. This gives banks a powerful advantage over large, distant

lenders, such as insurance companies.

An important characteristic of bank lending to business is credit rationing. A bank, unlike other

firms, does not stand ready to provide as much of its product, loans, to customers though he/she

is willing to pay higher prices. A seller of an apple, unlike the banker, will normally be happy to

provide the buyer with, say, ten times as much as he/she buys normally, but a bank will usually

not be ready to make a loan two times, not ten times, of the normal loan. Similarly, a bank will

not make loans to just any one who applies for, even if he/she is willing to pay an interest rate

high enough to offset the fact that this loan may be risky. Banks ration loans among applicants,

both by turning away some loan customers and by limiting the size of loans to others. A major

reason why banks, unlike sellers of utilities, limit the amount of their product, the loans, they

provide to each customer is surely that the bank assumes a risk much greater and different from

the utility seller. It hands over its funds, and cannot be certain that it will get them back.

One factor that plays an important role in credit rationing is the existence of customer

relationship between the banker and the business borrower. Most of the business loans that the

bank makes are to previous borrowers; business lending is a repeated business. Firms establish a

customer relationship with a particular bank (or in the case of large firm, with several banks) and

as long as the arrangement is mutually satisfactory, continue to both borrows from this bank and

keep to deposit with it. This customer relationship comprises more than just a borrower- leader

relationship; not only does the firm keep its deposit account with the bank it borrows from, but it

also uses other services of the bank, such as provision of foreign exchange, the making up of

payrolls, etc… Thus services are often as profitable and important for the bank.

This customer relationship implies that the bank has an obligation to take care of the reasonable

credit needs of its existing customers. A bank is therefore not a completely free agent in making
loans; it has to accommodate the reasonable demands for loans by its customers. To do this it

may have to turn away other potential customers, even though these new customers would be

willing to pay a higher interest rate than do exiting customers. Similarly, it may have to ration

loans among its existing customers rather than turning some of them down altogether.

The maturity of bank loans varies widely. Short-term loans, that are loans for less than a year,

thus some of these loans were renewed automatically and hence were, in effect, long-term loans.

There are three types of loan commitments that may be agreed up on by businesses borrowers

and commercial bank; line of credit, term loan and revolving credit. Consumers usually do not

inter in to these types of arrangements. A line of credit is an agreement under which a bank

customer can borrow up to a predetermined limit on a short- term basis (less than one year). The

line of credit is a moral obligation and not a legal commitment on the part of the bank. Thus, if a

company’s circumstances change, a bank may cancel or change the amount of the limit at any

time.

A term loan is a formal legal agreement under which a bank will lend a customer a certain

amount of money for a period exceeding one year. The loan may be amortized over the life of

the loan or paid in a lump sum at maturity.

Revolving credit is a formal legal agreement under which a bank agrees to lend up to a certain

limit for a period exceeding one year. A company has the flexibility to borrow, repay or re-

borrow as it sees fit during the revolving credit period. At the end of the period, all outstanding

loan balances are payable, or, if stipulated, they may be converted into a term loan. In a sense,

revolving credit is a long-term, legally binding line of credit.

Bank loans may also be fixed-rate and floating-rate, Commercial and Industrial, Agricultural,

consumer, Real Estate, and loans to other financial intuitions (see the detail under the title “types

of loans”).
6.2. Measuring and Evaluating Performance of Banks

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