Earning Season is here again! For the banking sector the golden goblet is Net Interest Income. In this article we explore what NII is and how you can use it to invest.
Earnings announcements play a great role in this. But investors often go blindly by the growth in profits and revenues. That is like giving your exams by learning only one subject out of six. Will you pass the exam? Definitely not.
Suppose you go to the market to buy fruits and vegetables; would you analyze them all using a single parameter – that they look as green as possible? If that is the case, your bananas and mangoes would be raw. Let’s not even get into what a green colour means for veggies like carrots and pumpkins.
Exactly the same way, every company works in a different way. And that’s why analyzing different sectors needs you to look at various financial parameters beyond simple profit and loss. Especially if you want to forecast the trend in the near future.
Let’s understand by taking the case of the banking sectors.
- The money game: Unlike most companies, banks make money by dealing with money. They don’t produce or manufacture goods. The only service they offer is safeguarding your money. They accept money from you through deposits and give it out in the form of loans. In exchange for both, an interest amount has to be paid. You may have noticed you get about 4-6% interest over your savings bank deposits, and about 9-10% on your Fixed Deposits. But, when you go to take a loan, you attract a much higher interest rate. This is the key to a bank’s profitability! For example, suppose your mother gave you Rs 1,000 to safeguard. You assured her you will pay her back Rs 1,100 after a certain period. This means you will be paying an interest of 10%. Now, during this period, you lend Rs 1,000 to your friend, who promises to pay you back Rs 1,500 after a week. You thus offered a loan at the rate of 15%. At the end, once you pay back your mother, you pocket a cool profit of Rs 400. This is how banks work.
- It is all in the interest: And this is where the Net Interest Income (NII) comes into the picture. Banks earn profits by earning a higher interest rate on loans that it pays on deposits. The Net Interest Income calculates this difference in interest payments. However, remember, the bank has to pay for its operations. It may also earn from other sources like royalty, payments for niche services, and so on. It could also earn from other investments. So, the growth in NII may not tally with the overall growth in profits. For example, IndusInd Bank’s NII grew 19% to Rs 833.11 crore in the July-September 2014 quarter from Rs 699.94 crore in the corresponding period last year. In contrast, its profits grew 30% to Rs 430 crore in the quarter.
- What about the margins? Analysts love comparisons, and since you can’t compare apples and oranges, everything is usually converted into percentages. Exactly the same way, analysts want to measure net interest income as a percentage of the total interest-earning assets a bank has like loans. Simply put, it means comparing the net interest income with the total money lent out. This is called Net Interest Margin (NIM). It thus measures profitability of a bank’s loans, and thus the bank itself. For example, taking the previous example of your mother lending Rs 1,000. You profited Rs 400 from giving out the loan of Rs 1,000. Thus, your margin is 40%. This is quite a high amount. In reality, banks rarely have margins higher than 3%, in India at least. This is because a lot of loans turn non-profitable.
- Grapes can turn sour: So what happens if you borrow from a bank, but you are unable to pay? The bank can seize your assets like your house and sell it to recover its loan amount. This may not always be possible. The loan then becomes a non-performing asset for the bank. This is written down in the balance sheet as a loss. Since we now know banks earn from its loans, an NPA eats into banks’ profitability. Understanding the trend in NPAs can help you forecast the bank’s profitability in the near-term. NPAs too are measured as a percentage of the total loans.
As the Indian economy slowed down after the 2008 financial crisis in the US, banks were hit. Bad loans started rising, reducing banks’ profitability. However, a lot of factors suggest the economy is on the way back up. As a result, the non-performing assets too are reducing. The worst is over, ICICI CEO Chanda Kochhar said in a press conference. This is a good signal for banks.
- Provisioning: Who knows the business better than those in business? Similarly, banks have a tendency of forecasting which loans are likely to turn bad. The RBI rules that banks have to set aside money for loans that may turn non-profitable. This is called provisioning. For example, suppose you realized that your friend may not be able to pay you back in time. So you kept aside Rs 1,100 from your salary to pay your mother back. You are simply budgeting for a future loss. This is the same way banks set aside money to provision loans. It also acts as a good indicator of future profitability. If a bank increases provisioning, then it expects more loans to turn bad, thus leading to a fall in profits. IndusInd set aside Rs 73.2 crore in the quarter as provisions, lower than the Rs 88.86 crore it set aside last year. This is a sign of an improvement in the quality of its loans.
- Where is the data? Do these numbers sound like a lot? It may, as numbers always do. But, these are simple calculations that the companies mention in the balance sheet, profit and loss accounts or even press conferences. They are not that hard to find. You can also find these details on the stock exchange websites or on the bank’s investor relations website page. Here is a link to IndusInd’s financial statement:
In the next section, we will look at the pharmaceutical industry in the same way, and understand the key metrics involved.
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