Investing Basics. Making sense of a bank’s balance sheet

In the >previous article of this series we discussed some of the key ratios related to a bank’s profit and loss account. We take forward our discussion on how the accounts of financial organisations are different as compared to those of non-manufacturing organisations. In this article, we will discuss a bank’s other financial statement, the balance sheet.

The balance sheet of a manufacturing firm is broadly divided into two parts — ‘Sources of funds’ and ‘Application of funds’. For a bank these are termed as ‘Capital and liabilities’ and ‘Assets’ respectively.

We first discuss the ‘Capital and liabilities’ portion of the balance sheet.

Capital and Liabilities

The ‘capital and liabilities’ head, as the name suggests, is made up of the three portions — the net worth, which is the ‘capital’ and the ‘reserve and surplus’, the liabilities, which is the money that a bank owes. This money is in the form of ‘deposits and borrowings’. The third portion is the ‘other liabilities and provisions’.

Net worth: Net worth is made up of the ‘share capital’ and the ‘reserves and surplus’. While the net worth of banks is quite similar to that of a non-financial institution, there are some balances that a bank needs to maintain in its balance sheet, which one will not find in a non-financial institution. One such reserve is the ‘statutory reserve’, which is not a free reserve for the bank. Unlike this there are free reserves that banks maintain, but their proportions are quite subjective as they differ from bank to bank. Such reserves include ‘Investment Reserve Account’ and ‘Foreign Currency Translation Account’.

Liabilities: As it is a bank’s business to raise funds and lend the same, the debt to equity ratio is typically 10 to 20 times, much higher than that of non-financial firms. Banks also need funds for investing. The liabilities are usually in various forms. They can either be deposits or borrowings. Deposits are again broadly of three kinds — demand deposits (current accounts), savings bank deposits (savings accounts) and term deposits (fixed deposits).

As compared to the interest paid on fixed deposits (term deposits), the interest offered on demand and savings bank deposits (popularly known as CASA or current account and savings accounts) is very low. As such, when banks mention that they are trying to increase the share of low-cost funds, it means that they are trying to garner more funds in the form of CASA. This would eventually help them improve their net interest margins (NIMs).

As for borrowings, they are somewhat similar to the debt that non-financial companies take. Apart from deposits, banks can also borrow funds through loans from other sources. These can include the Reserve Bank of India as well as other institutions and agencies, be it domestic or foreign.

Other liabilities and provisions: This head is similar to that of a 'current liabilities' portion of a non-financial company. The items that can fall under this head are the short-term obligations of a bank during a particular year. The items that can fall under this category include bills payable, interest accrued, provision for dividend and contingent provisions.

In the next article of this series, we will continue our discussion on the financial statements of banks.

This article is authored by >Equitymaster.com , India’s leading independent equity research initiative

Disclaimer: The opinions expressed by Equitymaster are theirs alone and do not reflect the opinions of The Hindu Business Line or any employee thereof. The Hindu Business Line is not responsible for the accuracy of any of the information within the article.

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