The effectiveness of a company’s daily asset and liability management is frequently evaluated using the efficiency ratio.
An efficiency ratio can be used to determine the rotation of receivables, repayment of obligations, quantity and usage of equity, and general utilisation of assets and equipment. The performance of commercial and investment banks can also be gauged and examined using this ratio.
How Does an Efficiency Ratio Help You?
Efficiency ratios, also known as activity ratios, are used by analysts to evaluate a company’s short-term or present performance. These ratios all use data from a company’s current assets or current liabilities to quantify its activities.
A company’s ability to create income from its assets is evaluated by an efficiency ratio.
For instance, an efficiency ratio might take into account a number of things, such how long it takes to turn merchandise into cash or collect money from customers. This underlines the significance of efficiency ratios because rising efficiency ratios typically translate into rising profitability.
To identify businesses that are better managed than the others, these ratios can be compared to those of peers in the same industry. Popular efficiency ratios include sales to inventory, sales to net working capital, sales to accounts payable, fixed asset turnover, and stock turnover ratio.
Bank efficiency ratios
In the banking sector, an efficiency ratio has a unique significance. The efficiency ratio for banks is non-interest expenses/revenue. This shows how skillfully the bank’s executives control their overhead (or “back office”) expenses. Similar to the efficiency ratios mentioned above, analysts can use this to assess the performance of commercial and investment banks.
The Importance of the Efficiency Ratio
An institution’s profitability and level of financial stability are both indicated by a bank’s efficiency ratio. The more solid a bank or credit union is, the safer it is to entrust it with your money.
Losing banks are more likely to go out of business or merge, and they might also be unable to offer competitive prices on the goods you consume. Banks can reinvest their profits into their businesses and absorb economic shocks and loan losses.
Comparing Banks Using Efficiency Ratios
Efficiency ratios in banks do not exist in a vacuum. Due to variations in their architectural styles and operational procedures, banks’ efficiency ratios might vary significantly.
Because they don’t have to pay for real estate or tangible promotional materials, online-only banks, for example, have less operational costs. On checking and high-yield savings accounts, they do, however, typically offer higher interest rates.
A regional bank that promises high-touch, in-person service will have higher operating costs in a pricey real estate market. It might also process more high-interest loans, which would increase revenue.
When comparing efficiency ratios amongst banks, look for institutions with similar business strategies and client bases, and then aim to discover the institution with the best ratio in that sector.
Why Does the Efficiency Ratio of a Bank Change?
Efficiency ratios alter along with the economy.
Banks may reduce expenses or make investments in order to adapt to the competitive climate. Extreme cost-cutting can increase a bank’s efficiency ratio, but it can also have a negative impact on future profitability, client happiness, regulatory compliance, and other organisational areas.
If you’re going to analyse banks using the efficiency ratio, make sure to consider how the numbers change over time, what a certain bank does differently from its rivals, and how it compares to banks with similar size and operating practises.
Components of the Efficiency Ratio
The income statement of a bank contains the information required to calculate its efficiency ratio. It is possible to calculate a bank’s efficiency ratio by just copying and pasting certain statistics, but the final ratio will have more meaning if you know what’s going on in the background.
A bank’s operating income comes from a variety of sources. Interest and non-interest income are two subcategories of this revenue.
Banks make income through investing the money they have in checking and savings accounts, as well as through loans, mortgages, credit cards, and other financial products. While the majority of this interest is retained by the bank as profit, some of it is given to customers. Net interest income is the difference between interest earned and interest distributed to customers.
Fees are another source of income for banks besides interest. The fees that clients must pay include maintenance costs, low balance fees, overdraft fees, and service fees for wire transfers or ATM withdrawals. Others may be covered by retailers, including swipe fee profits on bank-issued cards.
Provision for Loan Losses
Financial organisations’ financial accounts commonly list anticipated losses as a cost category. Banks must prepare for the possibility that some borrowers would default on their loans. Banks write off bad debts and cover the expense of the loss when customers miss payments.