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Tim’s Financials Decoding Manual

And Now for Something Completely Different!

From Kevin Smith and Tim Harrington

You’ve gotten used to the fact that this blog space has consisted mostly of musings about governance from me, Kevin Smith. But this month we’re going to do something completly different. Not too long ago, Tim sent me a document that encompassed many of his cheat codes for understanding credit union financials at the board of director’s level. He wanted to share it with me (since I don’t speak CPA and have to practice) and to see what I thought we could do with it. So we’re going to share it here! It’s a tremendously helpful resource for any credit union director, but it may be just the ticket for newer directors still trying to get their feet under them in terms of reading the financials.

Not only will be post this below for your perusing but at the bottom there will be a link to a downloadable version for you to save and treasure forever. (And maybe you can bring it to the next conference you’re at with Tim and have him autograph it! :lol:)

FINANCIAL DECODING MANUAL.

IMPORTANT FORMULAS



Exercise: Using the Balance Sheet and Income Statement above, you can caluculate the following important ratios. In this exercise, we are NOT using Average Assets, but to keep it simple (and slightly inaccuate), we are using Total Assets: $227,000. To calculate Average Assets, you would need the Total Assets from the previous year end Balance Sheet. To calculate the Average, you simply add the Total Assets from the end of the previous year to the Total Assets from the most recent Balance Sheet, and divide by two.

Yield on Assets

Interest Income from loans and investments / Average assets

$____________ / $227,000 x 100 = ______%

 

Cost of Funds

Dividends and Interest paid / Average assets

$____________ / $227,000 x 100 = ______%

 

Net Interest Margin (Spread)

Yield on Assets less Cost of funds

_______% less _______% = ________%

 

Operating Expense Ratio

Total operating expenses (excluding Provision for Loan & Lease Losses) / Average asset

$___________ / $227,000 = ______%

 

Provision for Loan and Lease Losses Ratio

PLLL / Average assets

$________ / $227,000 = ______%

 

Non-Interest Income (NII) Ratio (Fees, Service Charges, etc.)

Total NII / Average assets

$___________ / $27,000 x 100 = _____%

 

Return on Average Assets (ROA)

Net income / Average assets

$___________ / $227,000 x 100 = _____% 

 

Your answers (our answers are at the end of this manual)

                                                                               Your Calc.    Nat. Avg. (12/31/22)

Yield on Assets                                                   ______            3.38

Less: Cost of funds                                            ­­______            (0.52)

            Net Interest Margin (Spread)                 ______             2.86

Less:  Operating costs                                       ______            (2.85)

Less: Provision for loan losses                         ­­­­­______            (0.25)     

    Net loss before other income                        ______             (0.24)

 Plus:  Non-Interest Income                                            

            (Fee income, Service Revs, etc.)           ______              1.13  

Equals: Net Profit or Loss                                  ­­­­______              0.92

 


Some Important Explanations

Capital
Capital can be called Capital, Equity, Net Worth or Reserves.

Formula:  [All Reserves + Undivided Earnings] ¸ Total Assets

Industry Standard:  Depends on amount of RISK at your credit union. Prompt Corrective Action (PCA) considers a credit union with capital of 7% or higher as ‘Well Capitalized’.

How to Improve:
Since profits increase Capital and losses decrease Capital AND this is a ratio of Capital to Assets:

  1. Increase Profits faster than Assets are growing
  2. Decrease Assets and make a Profit
  3. Hold assets steady and make a Profit

Generally, the higher the percentage the better. But too much capital can create some issues


Asset Quality
(aka: Net Interest Margin Analysis)

This is actually two ratios: Delinquency Ratio and Net Charge-Off Ratio

A. Delinquency Ratio

Delinquency Measures:  Quality of Loan Portfolio based on what percentage is currently late by 60 days or more

Formula:  Dollar Amount of Delinquent Loans (60+days) ¸ Total Loans

Industry Standard:  Somewhere in the 0.50% to 1.50% range, depending on strategy. Credit Unions that lend to members of modest means will often have a much higher delinquency ratio than lenders who favor A and B credit rated borrowers.

How to Improve:  Tighten underwriting standards (higher credit scores, Lower debt ratio, more disposable income, etc.); higher risk loans can be discontinued or curtailed; collections can be strengthened.

B. Net Charge-offs Ratio

Measures:  Quality of Loan Portfolio based on the percentage of loans removed from the books (so far this year) as non-performing.

Formula: [Charge offs – Recoveries] ¸ Average Loans (Charge-offs and Recoveries must be annualized)

Industry Standard:  Somewhere in the 0.25% to 0.75% range, depending on strategy. Credit Unions that lend to members of modest means will often have a higher net charge-off ratio than lenders who favor A and B credit rated borrowers.

How to Improve:  Tighten underwriting standards (higher credit scores, higher debt ratio, more disposable income, etc.); higher risk loans can be discontinued or curtailed; collections can be strengthened.


Spread Analysis
(aka: Net Interest Margin Analysis)

Measures: Profitability and how it was attained

Formula:  Each of the key balances on the Income Statement is divided by Average Assets (for simplicity, we used Total Assets in our example instead of Average Assets)

The Spread Analysis is a ratio of key balances on the Income Statement compared to the credit union’s asset size. This allows a comparison between periods and between financial institutions based on their asset size. You can look at the Spread Analysis for any bank or credit union of any size and compare your results with theirs. The tool gives you an apples-to-apples comparison. It is considered a “Common Sizing” tool.

Since credit unions earn most of their revenue from their major assets (Loans and Investments) and their highest expense is often from their major liability (Deposits), measuring the effect of the Income Statement against the size of the Assets makes sense. This is a standard ‘banking’ measure.


Loan to Share Ratio

This is a measuring of lending efficiency. It measures how well a credit union loans out its deposits. Deposits is the main source of funds, and they cost money to borrow from members. Therefore, it is important to utilize the deposits in the most lucrative way possible, that is to loan them out to other members.

Measures: Percentage of deposits (shares) actually loaned out

Formula:  Total Loans ¸ Total Deposits (Shares)

Industry Standard:  The industry average changes with economic conditions but generally runs in the range of 70% to 80%

How to Improve:  Increase loans or decrease deposits.

Loans can be increased by loosening underwriting standards (lower credit scores, lower debt ratio, less disposable income, etc.); make more higher risk loans; market more; add new loan types


Answers to Sample Credit Union Financials

Yield on Assets

Interest Income from loans and investments / Average assets

$12,500 / $227,000 x 100 = 5.51%

 

Cost of Funds

Dividends and Interest paid / Average assets

$4,200 / $227,000 x 100 = 1.85%

 

Net Interest Margin (Spread)

Yield on Assets less Cost of funds

5.51% less 1.85% = 3.66%

 

Operating Expense Ratio

Total operating expenses (excluding Provision for Loan & Lease Losses) / Average assets

$7,800/ $227,000 = 3.44%

 

Provision for Loan and Lease Losses Ratio

PLLL / Average assets

$1,000 / $227,000 = 0.44%

 

Non-Interest Income (NII) Ratio (Fees, Service Charges, etc.)

Total NII / Average assets

$1,900 / $27,000 x 100 = 0.84%

 

Return on Average Assets (ROA)

Net income / Average assets

$1,400/ $227,000 x 100 = 0.62%

 

 

In a Spread Analysis Format

                                                                                 Your Calc.    Nat. Avg.

12/31/22

Yield on Assets                                                           5.51               3.38

Less: Cost of funds                                                  ­­­­   1.85             (0.52)

            Net Interest Margin (Spread)                          3.66              2.86

Less:  Operating costs                                          ­­­     (3.44)           (2.85)

Less: Provision for loan losses                                 ­­­­­  (0.44)            (0.25)     

    Net loss before other income                                  (0.22)           (0.24)

Plus:   Non-Interest Income                                   

            (Fee income, Service Revs, etc.)                       0.84               1.13  

Equals: Net Profit or Loss                          ­­­­­­                     0.62               0.92


If you’d like a downloadable version of this material to use and share go here and scroll down to the Financial Decoding Manual, check the box next to it and click “Submit” at the bottom of the page. Make sure you take a look around those free downloads; there may be other things that you can’t do without!

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