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.

Related article  Return on average assets

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 expenditure of 40.64% to generate operating income. However, for actual comparison we need to compare with 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.
Related article  Equity Vs. Debt: 6 Difference

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.