Here Are 4 Numbers That Can Help Investors Better Understand Hong Leong Finance Ltd

When investors in Singapore’s stock market talk about financial institutions, the focus is likely to be on the three big banks, namely DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39) and United Overseas Bank Ltd (SGX: U11).

That’s due partly to their size; the trio have market capitalisations of at least S$34 billion each.

Shadowed by these behemoths with a market cap of just around S$970 million, the much smaller financial institution Hong Leong Finance Ltd (SGX: S41) will probably not appear on the radar of most investors.

But, Hong Leong Finance’s business model has some similarities to the three big banks and it is currently valued at just 0.6 times book value, which is much lower than the price-to-book ratios of 1 that the three banks all carry.

Here are four numbers to help give investors a better of understanding of Hong Leong Finance. I will also be comparing Hong Leong Finance’s numbers to DBS Group in order to provide some perspective.

The cost to income ratio

The cost to income ratio measures the percentage of a financial institution’s income (income here is analogous to revenue) that is expensed by the company to run its business.

What we need to understand is relatively straight forward: The lower the expenses, the higher a financial institution’s profitability. In other words, the lower the cost to income ratio is, the better it could be.

In 2015, Hong Leong Finance recorded a cost to income ratio of 52.5%, up slightly from 51.8% in 2014. Comparatively, the cost to income ratio of DBS Group for the same period is 45.4%. The higher cost to income ratio of Hong Leong Finance when compared to DBS Group could be a result of the former’s smaller customer base to spread out its expenses, which tend to be largely fixed in nature.

Non-performing loans

Non-performing loans relate to loans on which a financial institution’s borrowers have failed to make the required payments. Lending money entails risk, so having borrowers default on loans is part and parcel of a lender’s business – it is simply a lender’s cost of doing business.

But, it is also important for a lender to be taking on sensible risks. So, taking all things equal, it is preferable for investors to see low incidences of non-performing loans in a lender.

In the case of Hong Leong Finance, its non-performing loans as a percentage of its total loans (this is known as the non-performing loans ratio, or NPL ratio) in 2015 is 0.7%. This is down slightly from the 0.8% seen in 2014 and also lower than DBS Group’s 2015 NPL ratio of 0.9%.

At first glance, it seems that Hong Leong Finance has been more prudent in its lending activities as compared to DBS Group, thus resulting in the lower NPL ratio. But, investors may also want to dig further and look at the type of loans made by Hong Leong Finance to ensure there are no hidden risks that could blow up.

The return on assets

The return on assets metric measures the ability of a financial institution to utilise its assets to generate a profit. The more profit generated per dollar of assets held by a financial institution, the higher its return on assets is.

Hong Leong Finance’s return on assets in 2015 was just 0.6%, though it is an improvement from 2015’s 0.5%. But, DBS Group had a stronger return on assets of 0.96% in 2015.

The capital adequacy ratio

A financial institution’s ability to absorb losses from its loans can be gauged by its capital adequacy ratio, or CAR.

You can think of the CAR as being the airbag installed in cars to protect passengers in the event of an accident; the higher the CAR, the more cushioning effect there is. Put another way, the higher the CAR is, the lower the risk of a financial institution becoming insolvent when things go wrong.

For Hong Leong Finance, its CAR in 2015 and 2014 was 15.1% and 16.4%, respectively. DBS Group on the other hand, had a similar CAR in 2015 of 15.4%.

A Foolish conclusion

What we have above are four important numbers for investors to better understand Hong Leong Finance’s business.

When it comes to financial risks Hong Leong Finance is taking on (seen from the NPL ratio and CAR), it appears that the company is doing a job on par with – or even better than – Singapore’s largest bank, DBS Group.

But, Hong Leong Finance loses out when it comes to profitability (the cost to income ratio and return on assets). Size matters in the operations of a lender, since it allows fixed costs to be efficiently spread out over a larger base. As such, having a smaller scale means that Hong Leong Finance’s cost to income ratio is higher, resulting in a lower return on assets.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of United Overseas Bank. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.