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Solvency and Liquidity Ratios in Banking sector
Now that we have learned all the financial ratios & their types, let's see how we can apply them. In this unit, we will discuss the importance of solvency & liquidity ratio, especially in the banking sector.
What does Solvency and Liquidity ratio mean for a bank?
- Solvency ratios are analysed to determine the long-term ability of the bank to meet its obligations
- Liquidity ratio are analysed to determine the short-term ability of the bank to meet its obligations
- Banks are a leveraged business and hence both liquidity & solvency must be carefully analysed. Liquidity and Solvency play an imperative role in the smooth survival of the bank.
- This position of the bank should be analysed both on a standalone basis and also in comparison to its peers to have a better understanding of the current situation as well as the market cycle.
Financial ratios are widely used to analyse a bank’s performance specifically to gauge and benchmark the bank’s level of solvency and liquidity.
Solvency ratio measures the long-term ability of the bank to meet its obligations. This involves understanding the capacity of the bank to meet its obligations. These include:
1. Debt to Equity Ratio: Discussed earlier
2. Financial leverage: Discussed earlier
3. Capital Adequacy Ratio:
The higher the CAR, the better the bank is insulated from any business shocks. As per regulatory standards in India, Private Banks are required to maintain a minimum CAR of 9% whereas the number stands at 12% for Public Sector Banks and 15% for Small Finance Banks.
1. Credit to Deposit Ratio:
This ratio is also known as the Loans to Deposits Ratio (LDR)
This measures the bank’s total credit in relation to its total deposits in the bank. This helps in analysing the bank’s liquidity position.
A reading greater than 100 indicates that the bank has lent more than the amount of deposits available with it.
2. CASA Ratio:
CASA stands for Current Account and Saving Account.
CASA Ratio measures the ratio of deposits in current and savings accounts as a percentage of total deposits.
Higher the ratio, lower is the cost of funds for the bank which significantly helps the banks (since interest paid on current & savings account is lower than time & fixed deposits) in reducing operating expense.
3. Interest Expended to Total Funds:
The interest expense is the amount paid on the deposits accepted by the bank. It tells us about the cost of funds with respect to deposits.
Interest expense is a non-operating expense shown in the income statement. It represents interest payable on any borrowings such as bonds, loans, convertible debt or lines of credit.
4. Current ratio : Discussed earlier
5. Cash ratio : Discussed earlier
Besides this, we have a bunch of other modules on ELM School for all who are willing to learn in greater detail on financial analysis and the stock market. Be sure to check them out.