The balance sheet of a bank is quite different from that of other companies and businesses. Some elements that make up a company balance sheet, such as accounts receivables, accounts payable, and inventory, will not be seen in a bank’s balance sheet. Rather, you will come across things like investments and loans, deposits, and borrowings.
A bank’s balance sheet, which sums up the financial balances, is prepared and tailored to reflect the mandate put in place by a bank’s regulatory authority. A bank’s mandate reflects the relationship between the profit made by the bank, its risk levels, and its financial health.
Importance of balance sheet
Balance sheets play several vital roles in ensuring the financial health of a business. Some of the importance of balance sheet are as follows:
- It helps individuals gain an understanding of the financial standing of a company.
- Through the balance sheet, stakeholders can project the company’s current liquidity position and overall performance.
- Balance sheets help to determine the growth rate of a business over time.
- The balance sheet is important to document investors’ looks at making investment decisions.
- A balance sheet serves as a tool for determining a firm’s ability to expand its operations per time.
Things that make up a Bank’s Balance Sheet
The balance sheet of a bank has several components that distinguish it from the balance sheet of other companies. Though the terms may defer, the purpose is still the same- showing the bank’s financial position per time. So what are these components?
#1. Cash and its equivalent
Other businesses consider holding cash as a loss because it could be invested in other areas or reinvested into the business. But for banks, it’s a different story. Cash is considered a source of income and is kept on deposit. Banks may also keep cash for other banks. The reason is that the services rendered by banks to their customers are such that banks need to have cash on demand.
Banks are also mandated to hold a percentage of their assets as liquid cash. Excess reserves are sometimes also kept by banks for safety purposes. These excess cash reserves make it possible for banks to buy into great investment opportunities and make more money.
#2. Securities
Securities are one of the instruments banks use in generating income within a short time. Many banks buy treasury bills and municipal bonds. These securities have a short maturity period and are very liquid. The liquidity of these securities makes it possible to sell off at the money market within short notice. These securities are often referred to as secondary reserves and are a good way banks invest their cash reserves. These securities are also captured in the bank’s balance sheet.
#3. Loans
To many businesses, loans are a major liability, but that is not so for banks. This is because money lending and interest generation through money loaned out are major sources of a bank’s income. Therefore, a loan is an asset to a bank and therefore appears as an asset on the bank’s balance sheet.
When the balance sheet of a bank shows an increase in deposits and loans, it is usually an indicator that the bank is experiencing growth. However, an increase in loans alone may not be an accurate indicator of growth, except the creditors are credible. If the quality of creditors is low, the level of default will be high.
On a general scale, there are two types of loans banks provide- mortgage loans and personal loans. Personal loans are given out to the individual after checking the creditworthiness of an individual. Personal loans are issued to individuals without any form of securities, making the interest rate high.
On the other hand, mortgage loans are issued to individuals to enable them to purchase a house. The security for the mortgage loan is the property it was bought with. Therefore interest is lower than that of personal loans. If at any point the borrower defaults in paying back the money loaned to them, the bank reserves the right to sell the property and recover the money.
Aside from loans given to individuals, banks provide loans to businesses for different purposes, including startup, business expansion, procurement of assets, and others. Other forms of loans banks give out are interbank loans, commercial loans, home equity loans, and residential loans.
#4. Deposits
When banks receive deposits from individuals and businesses, it is recorded as a liability in a bank’s balance sheet. This is because this money has to be given back to the depositor. Deposits are the most significant liability a bank has. Deposits include interest and non-interest accounts such as savings accounts, money markets as well as current accounts.
Though deposits are considered a liability, they are also vital as they determine the ability of a bank to maintain a good cash reserve. If a bank’s deposit drops at any point, it will hamper its ability to give out loans. This will consequently lead to a rise in loan growth. To meet up with an increased loan if a situation arises, the bank may need to borrow from other sources which are not cost-effective.
Borrowing from other sources to meet up with loan demands does not work out well for a bank and may eventually lead to its crash. Deposits are, however, a different kind of liability to a bank. This type of liability enables banks to earn more money from the interest that borrowers will pay. There is also a section in the bank’s balance sheet that creates allowances to cover losses. The amount set aside for this is dependent on the prevalent economic condition per time.
Vital indicators in the Banks Balance Sheet Analysis to take note of
Default
The default means the inability to fulfill loan payments or interest obligations. Banks generally set aside a particular percentage known as the “non-performance ratio” to show the number of creditors that are most likely not going to meet up with their loan obligations. The default analysis shows a bank’s financial capacity in meeting up with contingencies in the future. The commonly used ratio in most banks include:
- Non-performing loans/customer loans
- Non-performing loans/average total assets
- Non-performing loans/customer loans + collateral
- Own resources/average total assets
The non-performing loan/ loan ratio is used to measure how good a bank’s loan book is. A loan is considered to be non-performing if the payment of interest on the loan becomes overdue for three months or more.
The non-performing/ customer loans + collateral is very significant, especially when the bank is already in a bad place financially. This ratio can be considered an indication of insolvency if it passes a specific benchmark.
Conclusion
The balance sheet of a bank is a vital analytical tool that aids in determining a bank’s financial position. Though the components and their significance may differ from that of other businesses, the purpose is still the same- showing the organization’s financial position at a glance.
