The cost-to-income ratio is one of the efficiency ratios used to gauge an organization’s efficiency. 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 the cost to income ratio with the following formula:
Cost to Income ratio = Operating cost/Operating income
Operating expenses of banks include:
- Professional services
- Sales and marketing
- Office supplies
- 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 banking stocks. There exists an 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 the cost to income ratio of Sinra Inc., a small bank.
As of 31st Dec. 2019
|Income from financing||85,234|
|Income from Portfolio||546,892|
|Income from investment||253,648|
|Expense from financing||123,457|
|The expense for client deposit||128,989|
|The expense for borrowed loan||235,465|
|Foreign exchange gain/loss||56,898|
|Operating income after LLP and forex adjustment||248,195|
|Income before tax||73,195|
|Income after tax||68,695|
Calculate the cost to income ratio for Sinra Inc
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
This ratio of 40.64% implies that Sinra Inc. made an expenditure of 40.64% to generate operating income. However, we need to compare with the bank’s past figures or its peers in the industry for actual comparison. 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 the previous year, the company is not performing properly than the previous year.
The following steps can compute the cost to income ratio:
- 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.
Let us understand this ratio with another detailed analysis of an example:
|Amount||FY 2019||FY 2018|
|Other operating expenses||8||14|
|Net interest income||60.25||44.89|
|Cost to income ratio||100%||96.97%|
Here, the cost to income ratio is very high in both years, which is not a good indicator of the 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.
|Amount||FY 2019||FY 2018|
|Other operating expenses||3||3|
|Net interest income||23||20|
|Cost to income ratio||81.81%||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.