How to Analyze a Bank’s Balance Sheet

The Straits Times Index (SGX: ^STI), Singapore’s stock market representative index, has been on a roll this year, gaining 12% since January. Interestingly, more than 20% of that gain has come from its three bank components. In light of this, I have decided to write a three-part series on the basic steps to assessing a bank.

They will be broken down into:

1) assessing a bank’s balance sheet;

2) assessing their profitability; and

3) valuing its stock.

How does a bank make its money?

Banks, or prototypes of banks have been around for thousands of years. The very first forms of banks appeared in Assyria and Babylon 4000 years ago, where grain loans were offered to travelling merchants in exchange for services or goods. The essence of a modern bank’s business has not changed much since then.

A bank’s main revenue model is providing loans in exchange for interest. They gain liquidity by deposits, which are in essence how banks “borrow” money at a cheap. Modern banks may also offer additional services such as credit cards, financial advice, distribution of insurance and other investment products, or underwriting. All of which they collect fees from to boost their revenue.

Having said that, the bulk of most banks’ profits and revenue still comes from loan interest.

What to look out for on the Balance Sheet

Now that we know the gist of a bank’s business model, we can start to look at what makes a bank a good investment. And the first thing we need to assess is its balance sheet. There are four key areas of a balance sheet we will be focusing on.

The first and most fundamental metric to introduce is the Debt-to-Equity ratio.

This ratio measures the amount of debt that a bank takes against its equity. Because of the way a bank works, this ratio usually tends to be much higher than other industries. Generally, a ratio less than 10 is considered safe. This means that the bank will have enough capital to tie it through most exigencies.

The next part of the balance sheet we will need to look at is the composition of loans. A bank may break down the kind of loans into commercial, mortgage, construction, etc. Different types of loans command different interest rates but also pose varying risks of default. For example, a bank whose loans are mostly to construction businesses will be more at risk than banks whose loans are mostly mortgage loans.

We also need to assess how a bank is obtaining the money to loan out. As mentioned earlier, banks loan out the money that is deposited. Deposits are a very cheap way for banks to obtain liquidity to offer loans. Therefore a bank with a high deposit-to-liability ratio means that it is able to attract deposits, which is cheaper than obtaining money from other means.

The next important metric we can use is the loan-to-deposit ratio (LTD), which is the total loans divided by total deposits. Ideally, a bank will have an LTD of between 80% and 90%. Banks that are below this ratio may not be maximising the capital they have. Whereas banks that have an LTD above this range are at risk when there is a surge in withdrawals.

The Foolish bottom line

Banks in Singapore are highly regulated by Monetary Authority of Singapore to ensure they can withstand any stresses in the economy. Despite this, retail investors should familiarise themselves with the ins and outs of analysing a bank.

Banks can be very complicated stocks to assess because of their complex balance sheet and sometimes intentionally vague terms that financial experts use. But if we are able to break down their financial statements and know what we are looking for, we can get to the bottom of them quite easily.

To summarize, when we assess a bank’s balance sheet, we will need to look at the (1) debt-to-equity ratio, (2) composition of loans, (3) deposit-to-liability ratio, and (4) loan-to-deposit ratio.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.