Loan Loss Reserve Ratio (Definition, Formula, Example, And Analysis)

Definition:

Loan Loss Reserve Ratio is described as the ratio that is used in the bank in order to represent the reserve that the company has in percentage terms in order to cover the estimated losses that they would have suffered as a result of defaulted loans.

The nature of the Loan Loss account is described as a contra account to gross loan outstanding. This particular ratio is used to identify and measure the performance of the existing loan portfolio of the company, as a comparison to other players in the market.

The Loan Loss Reserve Ratio basically shows the probability of debtors failing to settle their debts in due time. This basically reflects the company’s position in terms of the collection rate.

A higher Loan Loss Reserve Ratio means a lower collection (from the total loans issued), whereas a Lower Loan Loss Reserve Ratio means a higher collection.

Formula:

Loan Reserve Ratio is calculated using the following formula:

Loan Loss Reserve Ratio = (Loss Loan Reserves) / (Gross Loan Portfolio)

Therefore, this calculation describes the overall probability of customers defaulting, as a percentage of the overall gross loans that are withdrawn on the company.

Additionally, it can also be seen that the lower ratio indicates that the bank or the financial institution is a safer institution to invest in, from the investors’ perspective.

On the other hand, if the bank or the financial institution has a higher loan loss reserve ratio, it means that the organization has a higher risk profile, and therefore, it might not be a suitable investment for risk-averse investors.

Example:

In order to further explain the concept of Loan Loss Reserve, the following illustration is given:

Metro Bank has made around $200,000 in loans to various other institutions and individuals. The managers at Metro Bank only lend out loans to individuals that have a low and medium-low risk profile.

Therefore, they only handpick individuals they know are going to pay back those loans in time. However, they can still never be certain if all the debtors are going to pay back the amount they had drawn as loans.

Therefore, they are supposed to create a loan loss reserve in order to be prudent that the net receivables might not necessarily be equal to the actual amount of loan that was outstanding.

In this regard, Metro Bank assumes that the arbitrary percentage that they need to account for around 1% of the total amount of the loans that have been drawn.

In the example mentioned above, it can be seen that the total amount of loan reserves for the company amounts to $2000.  This means that out of $200,000 that the organization has given out in loans, Metro Bank expects $2000 to not be recovered at all.

Analysis:

Loss Loan Reserves are mentioned in the balance sheet. They are used to show the amount that is parked as a provision for these loans not being honored by the company.

In this regard, it is imperative to recognize the fact that are considered as provisions that are in place to reflect for circumstances, that might reduce the total collectibles.

Hence, the impact of the loan loss reserve ratio is seen as increasing the amount of loan loss provision, or a decrease in the amount of net-charge offs for the respective year.

Loan Loss Reserve Ratio is created based on the historical default rates of the company, and the statistics that are mentioned for the customer defaults existing within those banks.

Hence, it is a multitude of a number of factors that are based on credit losses existing within the bank, as well as other different factors that impact the collection of the business.

Loan Loss Reserve Ratio, is often used alongside Loan Loss Provisions in order to estimate the existing risk profile of the bank, or the financial institution.

However, it must be noted that loan loss provision is also expensed in the Income Statement, and therefore, it reduces the net income of the organization.

The main usage of this ratio is mainly from a stakeholder perspective. It shows the existing risk profile of the business, and the ability of the business to successfully manage all the due collections.

When the financial statements are issued, investors, as well as the board of directors gauge the risk profile by directly comparing the loan loss reserve ratio of the bank with other competitors.

Having a lower loan reserve ratio is favorable, but it should not come at a cost of compromising on the prudence principle in accounting.

Financial Self-Sufficiency (Definition, Formula, Example and How to Calculate?)

Definition:

Financial Self-Sufficiency is a ratio that is used in order to evaluate if the company is able to generate enough revenue to cover its costs while ensuring that the equity value is sustained, after incorporating inflation, and another cost of capital.

This particular ratio is considered to be a very useful metric in terms of assessing long-term measurement.

In this regard, it is also important to highlight the fact that this specific metric is used by investors, as well as other financial stakeholders, in order to calculate the overall financial standing of the company in terms of its ability to meet its expenses and ensure that they are able to sustain themselves in the longer run.

Formula:

Financial Self-Sufficiency is calculated using the following formula:

Financial Self-Sufficiency = Operating Income / (Operating Expenses + Financial Cost + Loan Loss Provision + Cost of Capital (imputed))

In the formula above, it can be seen that operating income includes interest, fees, and other relevant commission income that the company has earned over the course of time.

In the same manner, operating expenses mainly include administrative expenses, and the costs that are incurred to make sure that company is able to sustain itself in a positive manner.

In the same manner, it can also be seen that financial cost includes interest that are paid by the company against the financial instruments that they have drawn on, as well as the fee expenses that are incurred on financing.

As far as the imputed cost of capital is concerned, it can further be seen that it is the figure that can be calculated using metrics like inflation, and the market rate of equity in the discussion.

Example and How to Calculate?

The calculation of financial self-sufficiency can be calculated using the following example:

Elgar Co. has the following finances from the year ended 31st December 2020.

INCOME STATEMENT2019 ($)
Financial Income400,000
Interest Income300,000
Fees Income50,000
Commissions Earned50,000
Financial Expenses200,000
Interest Expenses150,000
Fees Expenses50,000
Financial Margins200,000
Loan Loss Provision40,000
Operating Expenses50,000
Administrative Expenses50,000
Net Profit Before Tax110,000
Tax on Profit10,000
Net Profit After Tax100,000

Furthermore, the imputed cost of capital calculated was 40,000 based on the inflation rate of 5%.

Depending on the following information mentioned above, it can be seen that following:

Operating Income: Financial Income = 400,000

Operating Expenses = 50,000

Financial Costs = 200,000

Loan Loss Provision = 40,000

Cost of Capital (Impute) = 40,000

Financial Self-Sufficiency = Operating Income [400,000] / (Operating Expenses [50,000] + Financial Cost [200,000] + Loan Loss Provision [40,000] + Cost of Capital (imputed) [40,000])

Financial Self-Sufficiency = 400000 / 330000 = 121.2%

The Financial Self-Sufficiency Ratio mentioned above is proof of the fact that the company is doing well enough to earn its self-sufficient operating revenues in order to meet its expenses. Therefore, this is a positive sign and shows that the company would be fine in the short run.

 Advantages

Financial self-sufficiency is something that is really integral for the very survival of the business. As a matter of fact, it can be seen that financial self-sufficiency results in businesses and companies being able to meet their expenses, and cover all the liquidity-related expenses.

In the same manner, it having a clear idea about financial self-sufficiency somewhat ensures that businesses can keep their investors and their investment on board.

In retrospect, financial self-sufficiency can also help businesses save considerable money by avoiding costly finance charges, which would otherwise be substantial because of the existing high level of risk for the company.

Therefore, this particular metric can act as a signaling effect, which goes in favor of the business.

Disadvantages

Regardless of the fact that financial self-sufficiency is considered a very useful tool for gauging the operational efficiency of the firm, yet there is no doubt to the fact that it has certain implications that also need to be accounted for when using this matrix.

In certain cases, for example, a higher self-sufficiency ratio is also indicative of the fact that the organization can further expand its operations and resources in order to get a better return.

In the same manner, it can also be seen that as far as financial self-sufficiency is concerned, there might be a tradeoff between growth, and self-sufficiency.

A business with limited growth and sustained operations might be self-sufficient in terms of operations, but it might not always hold a promising future for the people. Hence, this opportunity cost needs to be accounted for, so that companies can decide what is better for them, strategically.

Current Cash Debt Coverage Ratio

Definition

Current Cash Debt Coverage Ratio is categorized as a liquidity ratio that is used to measure the effectiveness with which cash is managed within the company.

It basically is a metric that depicts the company’s relation to the operating cash flow that is received by the company over the respective period, along with the current liabilities that needs to be settled by the company.

In simpler terminology, it basically reflects the company’s ability to settle its current liabilities from the operating cycle over the respective period.

Formula

Current Cash Debt Coverage Ratio is calculated using the following formula:

Current Cash Debt Coverage Ratio = (Net Cash provided by Operating Activities) / (Average Current Liabilities)

How to Calculate Current Debt Coverage Ratio?

The calculation of Current Debt Coverage Ratio can be explained using the following illustration:

Jardin Co. was able to generate $26,250 from its operating cycle in the Financial Year ended Dec 31 2019. Jardin Co. had current liabilities of $20000 and $30000, on 1st January 2019, and 31st December 2019, respectively.

In the illustration given above, the Current Debt Coverage Ratio of Jardin Co. can be calculated as follows:

Current Cash Debt Coverage Ratio = 26250 / (Average Current Liabilities), where

Average Current Liabilities = (20,000 + 30,000) / 2 = $25,000. Therefore,

Current Cash Debt Coverage Ratio = 26,250/ 25,000 = 2

Interpretation: The Current Cash Debt Coverage Ratio of 1.05 means that for every $1 of Current Liability that the company has, it also has $1.05 from its Operating Cycle to fund that particular Current Liability.

A high Current Cash Debt Coverage Ratio is indicative of a better liquidity position of the company. Generally, a Current Cash Debt Coverage Ratio of 1:1 (or higher) is considered as very comfortable from the standpoint of the company.

Advantages

Current Cash Debt Coverage Ratio tends to be a highly important metric that helps companies, as well as their stakeholders in the decision-making process. Here are a few reasons why this particular ratio is considered to be a really important ratio:

  • Current Cash Debt Coverage Ratio includes thee holistic performance of the year, because it includes the amount that has been raised from Operating Cycle of the company across the year. In the same manner, it incorporates ‘average liabilities’ across the year, which means it inculcates the holistic performance of the company and not just standalone figures.
  • This ratio also allows the investors of the company to identify the standing of the company, and how likely is it that they will get dividends on time, and the company is not going to face a liquidity issue. This ratio can be a very quick source to extrapolate the future liquidity position of the company.

Limitations

Regardless of the usefulness of the Current Cash Debt Coverage Ratio, it can also be seen that there are a couple of drawbacks and disadvantages associated with this particular ratio. They mainly include the following:

  • This ratio calculates the ability of the company to be able to pay their current liabilities based on the amount generated from the operating cycle. However, it ignores the fact that average liabilities, as well as incomings from operating cycle are not spread evenly across the year. It gives a generic idea, which cannot be considered concrete in terms of absolute surety that the company will not face a liquidity issue in the coming years.
  • In the same manner, Current Cash Debt Coverage Ratio fails to incorporate the fact that there are other expenses and obligations (which are non-current liabilities), that the business has to honor. It is also important to ensure that those particular cash flows are incorporated. Therefore, this particular ratio cannot be relied upon in isolation.

How can Current Cash Debt Coverage Ratio be improved?

Current Cash Debt Coverage Ratio is considered to be a very important ratio, and hence companies should actively make an effort to improve this ratio. This can be done using either of the following:

  • The easiest way to increase this ratio is to increase the net operating income. This can either be done by increasing sales, or reducing the expenses. By increasing the net operating income, the funds that the company would have at their disposal are likely to increase, hereby resulting in a better current cash coverage ratio.
  • Paying off existing debts can also improve the Current Cash Debt Ratio, since this would directly reduce the liabilities of the company at the given time.
  • Decreasing the amount that the company borrows can also positively impact the Current Cash Debt Ratio, because this is the amount that would directly impact the liabilities of the business, hence improving the ratio.

Delivery Cycle Time: Definition, Formula, and How to Calculate It?

Definition

Delivery Cycle time is considered to be a highly important metric when it comes to internal business performance. It is described as the amount of time from when the order is received to when the order is finally shipped.

This tends to be an important factor for businesses, as well as the customers, because timely order processing is a feat that almost every business, as well as customer tends to appreciate.

In the same manner, it can also be seen that shorter delivery cycle times can potentially act as a competitive advantage for the company, and in most cases, it tends to be critical for their survival and sustenance.

Formula

Delivery Cycle Time is calculated using the following formula:

Delivery Cycle time = Wait Time + Throughput Time

Throughput Time is referred to as the time which is taken to prepare the product, and finalize it, so that it is ready to be dispatched. Throughput time is calculated using the following formula:

Throughput time = Processing Time + Quality Inspection Time + Queue Time + Moving Time

How to calculate Delivery Cycle Time?

Calculation of Delivery Cycle Time is illustrated via the following example:

Feliz Inc. needs to determine if their delivery cycle time has improved in comparison to the last quarter. Last quarter, the delivery cycle time was 20 days. For the current quarter, the have the following details available:

Wait time: 9

Quality Inspection Time: 0.3

Processing Time: 3

Moving Time: 0.7

Queue Time: 4

In order to calculate the delivery cycle time, there is a need to calculate the throughput time first. Throughput time is calculated using the following formula:

Throughput Time = Processing Time (3) + Quality Inspection Time (0.3) + Queue Time (4) + Moving Time (0.7)

Therefore, throughput time in the current quarter is 8.

Now, in order to calculate the delivery cycle time, the following formula is used:

Delivery Cycle time = Wait Time (9) + Throughput Time 8)

Therefore, delivery cycle time now is 17 days.

In comparison to the last quarter, delivery cycle time has reduced by 3 days, and therefore, the delivery cycle efficiency for Feliz Inc. is said to have improved.

Advantages

Delivery Cycle Time is a highly important metric that directly reflects how the company handles and processes orders, once a sale is made. Therefore, this important metric should be analyzed properly, because it holds the following upsides, from the perspective of the company:

  • Delivery Cycle Time is considered to be an efficiency related metric. It shows how quickly the company responds, to fulfill orders. In the case where the company has a shorter delivery time as compared to other players in the market, it can be marketed as a unique selling proposition, which gives company a competitive edge on numerous grounds.
  • Delivery Cycle Time can be broken down into several different components. In case of variance, it can easily be identified which production aspect went wrong, and how can it subsequently be fixed in the next cycle.
  • Shorter delivery cycles might also mean shorter cash conversion cycles for the company. It means that the turnover would be higher, since processing is fast, and hence, cash would be converted at a faster pace too.

Disadvantages

On the contrary, if delivery cycle time is not managed properly, it poses a number of threats for the company. Some of the following examples are:

  • Longer delivery times disincentives sales. It gives the customers and clients time to think over their purchase, and they might look for alternates that can fulfill the orders relatively quickly.
  • Poorly managed delivery cycle times might also take an uncalled for toll on the product quality. If crucial components within the throughput time are compromised upon (for example, processing time, or inspection time), it might eventually lead to quality degradation, that would be detrimental for the business in the longer run.

How to improve Delivery Cycle Time?

However, there is no doubt to the fact that delivery cycle time is a metric that should continually be improved over the course of time.

As a matter of fact, it is important to ensure that those areas within the formula are identified, which can make the process efficient, without compromising on quality. These may include the following:

  • Focusing on areas that prolong the waiting time within the company. This can be done by reducing waiting time before the order is received, and the time when it starts to get processed.
  • Adopting a Just-In-Time Policy – In cases where the company waits for inventory stock-ups, they can ensure that they are able to adopt Just-In-Time policies to ensure that there are no delays because of inventory mismanagement.

Equity Vs. Debt: 6 Difference

When it comes to the sources of financing, companies or businesses have two primary options. These are equity and debt. Both of these types of finance have their advantages or disadvantages. However, companies use a combination of both to reap the maximum possible benefits from them. That is why a company’s capital structure will include both of them.

However, to use both these sources of finance properly, companies need to understand the differences between equity and debt. While there are many differences between them, the top 6 differences are as below.

1) Meaning

Equity is a type of finance that companies generate from their shareholders. In the case of different forms of businesses, equity comes from owners. However, apart from capital, equity also has other components, such as retained earnings, reserves, etc. Therefore, equity can come from external sources, primarily through shareholders and owners, or internal sources, such as profits.

On the other hand, debt represents liabilities taken from other parties, usually financial institutions. These include loans and debt instruments, such as bonds, that companies use to generate funds. Debts can either be short-term or long-term.

2) Returns

When it comes to equity, the primary return that companies provide to its shareholders comes through the profits it generates in its operations. Shareholders receive a percentage of the earnings of a company through dividends.

However, shareholders also get another type of return from investing in a company’s shares, which comes in the form of capital gains. If the company makes losses, however, it does not have to pay anything to its equity holders.

For debts, the primary source of returns provided by the company is interest payments. Every debt instrument carries terms that allow the debtholder to receive interest on their funds. Companies must pay interest on debts regardless of whether they make profits or losses.

3) Dilution of control

When a company generates equity finance, its control gets diluted. What this means is that the more equity a company generates, the more shareholders it will have with associated voting rights.

However, in case the existing shareholders contribute more equity, a dilution of control may not occur. Nonetheless, a dilution of control is considered bad for companies.

On the other hand, debts don’t usually cause a dilution of interest. It is one of the reasons why companies prefer debt finance over equity finance. Similarly, debt doesn’t come with any voting rights, which allows the company to receive finance without any interference from the debtholders.

4) Cost

The cost of equity finance is generally higher compared to the cost of debt. It is because equity finance comes with a higher risk for shareholders and, therefore, they expect higher returns in exchange.

Similarly, equity finance is, theoretically, forever. Hence, in the long run, companies end up paying more to equity holders for their investments.

On the other hand, debt finance comes with lower costs. As mentioned, the only cost it usually comes with is the interest payments made on it. Similarly, debt finance has a finite life, depending on whether companies obtain short- or long-term loans. Therefore, debt finance is substantially inexpensive.

5) Payment timing

When it comes to the timing of their payments, equity holders usually get paid last. It is because equity holders receive a percentage of the profits of a company to calculate which, companies need to deduct all their expenses first, including any interest payments.

Once the company meets all its other obligations, it can pay the remaining amount to equity holders.

Debt holders, on the other hand, are priority payments for companies. Almost all types of debt require companies to pay them on time regardless of profits or other factors. That places debtholders first on the list of payments made by a company.

6) Usage

As mentioned, equity remains with a company for almost forever. That is why it is a long-term type of finance. Therefore, equity is best for when a company needs to finance long-term needs rather than short-term ones.

If a company uses equity for short-term needs, the costs will exceed the benefits and end up harming the company.

On the other hand, debt comes in short-term or long-term durations. The short-term debt usually lasts up to 1 or 2 years, while long-term debt is for five years or more. Based on the needs of a company, it can choose whether it wants short- or long-term finance. Usually, debt finance is best for short-term usage but can also help with long-term needs.

Summary

Key differentEquityDebt
MeaningEquity is finance generated through shareholders.Debt is finance that comes with liability, usually financial institutions.
ReturnsEquity holders can get dividends or capital gains.Debt holders usually gain through interest income.
Dilution of controlEquity causes a dilution of control and comes with voting rights.Usually, debt doesn’t cause dilution of control or come with voting rights.
CostEquity is considered more costly.Debt is relatively inexpensive.
Payment timingCompanies pay their equity holders last.Debt holders get paid first.
UsageEquity is best for long-term needs.Usually, debt is great for short-term needs but also helps with long-term financing.

Cost to Income Ratio: Meaning, Example, Formula, Calculation, and More

Cost to Income Ratio Meaning

The cost to income ratio is one of the efficiency ratios which is used to gauge the efficiency of an organization. It is used to compare the operating expenses of a bank vis-à-vis its income. The lower the cost to income ratio, the better the company’s performance.

The cost to income ratio is primarily used in determining the profitability of banks. It depicts the efficiency at which the bank is being run. The lower ratio the better and it indicates more profitability of banks. There is an indirect relationship between the cost to income ratio and the bank’s profitability.

We calculate cost to income ratio with the following formula:

Cost to Income ratio= Operating cost/Operating income

Operating expenses of banks include:

  • Professional services
  • Rent/Lease
  • Sales and marketing
  • Telecommunications
  • Office supplies
  • Utilities
  • Salary to staffs
  • Interest expense

   Operating income of banks include:

  • Interest income
  • Fees and commission
  • Brokerage charges
  • Discounting charges

The same ratio can be written for banks as Operating costs/ Financial margin

It is useful in analyzing the banking stocks. There exists inverse relationship exists between the Cost Income ratio and bank profitability. Banks use this ratio to track the movement of costs vis-à-vis its income for the same period. It can be computed on a yearly basis and compared year on year and with another bank too. High cost to income ratio may indicate multiple things:

  • Bank is not managed in an efficient manner
  • Too much of competition in the banking industry

To reduce this ratio the company either needs to increase its operating income or decrease its operating expenses. Employee expenses and administration expenses come under the operating expenses.

Let us take the following example to calculate cost to income ratio of Sinra Inc. a small bank.

Sinra Inc

Income statement

As of 31st Dec. 2019

Particulars2019 (USD)
Income from financing85,234
Income from Portfolio546,892
Income from investment253,648
Other income156,324
Total income1,042,098
  
Expense from financing123,457
Expense for client deposit128,989
Expense for borrowed loan235,465
Other expenses123,659
Total expense611,570
  
Financial margin430,528
Loan/loss provision125,435
Foreign exchange gain/loss56,898
Operating income after LLP and forex adjustment248,195
  
Operating expenses175,000
Employee expenses85,000
Administration expenses90,000
  
Income before tax73,195
Taxes paid4,500
Income after tax68,695

Calculate cost to income ratio for Sinra Inc

Solution,

Operating costs             = 45,000

Financial income           = 1,042,098

Financial expense         = 611,570

Operating income        = 1,042,098- 611,570 = 430,528

Cost to income ratio    = operating cost/ Operating income

                                    = 175,000/430,528*100

                             =40.64%

This ratio of 40.64% implies that Sinra Inc. made an expenditure of 40.64% to generate operating income. However, for actual comparison, we need to compare with the bank’s past figures or its peers in the industry. Here, the costs seem to be lower so the bank is performing efficiently.

Lower the ratio, better profitability the company may achieve. When the ratio is higher vis-à-vis previous year, then it means the company is not performing properly than the previous year.

The cost to income ratio can be computed by the following steps:

  • Deduct interest income and interest expenses to arrive at net interest income.
  • Add commission and discount income to net interest income (income from financing, income from portfolio, income from investment
  • Add other income to get total income.
  • Deduct operating expenses and financing expense to get net income.
  • Adjust for LLP and foreign exchange gain/ losses.
  • Deduct operating expenses to get net income before taxes
  • Deduct taxes paid and we get net income after taxes.
  • Cost to income ratio is obtained by dividing operating expenses to operating income.

Operating expenses don’t include loan write-offs.

Example:

Let us understand this ratio with another detailed analysis of an example:

AmountFY 2019FY 2018
Interest earned90.2570.21
Other income4065
Total income130.25135.21
Interest expenses3025.32
Operating expenses2032
Employee cost1218
Other operating expenses814
Computation  
Net interest income60.2544.89
Operating income2033
Cost to income ratio100%96.97%

Here, the cost to income ratio is very high in both the years which is not a good indicator of efficient performance of the company. They are spending what they are earning from operations. They must look at options to reduce their operating expenditure. 

Let us take the final example of ABC Bank ltd.

AmountFY 2019FY 2018
Interest earned4135
Other income2018
Total income6153
Interest expenses1815
Operating expenses98
Employee cost65
Other operating expenses33
Computation  
Net interest income2320
Operating income1110
Cost to income ratio81.81%80%

Here, the cost to income ratio is again very high for both years. This ratio can be acceptable at the initial years of operations only. Else, the management needs to take a serious note of higher operating expenses and lower operating income.