For a software engineer like me it has been a constant struggle to understand the financial statements of lending businesses like banks and NBFCs. Early this year, I came across this book which improved my knowledge on lending businesses leaps and bounds. Few days back my friend Vishal analyzed the annual report of a lending company. You can find his analysis here.
By reading these excellent resources one can attain 70% knowledge on lending businesses. Knowledge is cumulative and attaining the remaining 30% takes hard work and time. In the quest of attaining the remaining 30%, I will be writing several posts whenever I learn something new about lending. In this post I will be writing about (1) how to find out asset-liability mismatch (2) difference between net interest margin (NIM) and spread.
1. How to find out asset-liability mismatch
Lending companies borrow money (its liabilities), at one rate and lends it out (its assets) to borrowers at a higher interest rate. The interest and principal paid back by the borrowers is used to payback its lenders. What happens when it funds its long-term assets by using short-term liabilities? The outflows to its lenders will be much higher than the inflows from its borrowers. In such a scenario the only way for it to service its liabilities is to borrow more money. Most of the times the company can get away by doing that. But once in a while that doesn’t happen.
Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job. Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees. – Buffett
Many lending companies believe that they can fund the asset-liability mismatch (ALM) by borrowing more funds. This kind of thinking is akin to jumping out of a plane with a parachute that opens 99% of the time. The image shown below is borrowed from Prof. Bakshi’s presentations.
How do you find out if the lending company you are interested in has an ALM? In India all lending companies have to disclose the asset-liability maturity pattern in their annual report. With few additions and subtractions we can easily check if the company has an ALM. Take a look at the table given below for Shriram City Union Finance (SCUF). You can download their annual report from here. The rows with bold texts are mine and the rest are obtained from the annual report. Spend some time to go through the table and it’s self explanatory.
From the table we can see that SCUF has an ALM of 381.46 crores between 3-5 years. This is minuscule compared to the cumulative surplus it was running in the previous years. So if you’re an investor with SCUF you can sleep peacefully. SCUF lends money to micro-small-and-medium enterprises, two-wheelers, auto, gold, and personal loans. Majority of its loans are short term in nature. And it funds them using long term borrowings. This is the reason why they don’t have a lot of ALM.
2. Difference between NIM and spread
Sometime back I studied the business model of Repco Home Finance and I wrote about it here. In FY2015, Repco had a net interest margin (NIM) of 4.50% and a spread of around 3%. I couldn’t understand why should NIM and spread differ by over 1%. Upon further digging I came across an excellent explanation which is given below.
NIM and spread are the two key parameters that give an indication of a bank’s operational efficiency. As a concept, NIM and spread are similar, but there is a subtle difference between the two. While NIM is arrived at by dividing a bank’s net interest income by its average interest-earning assets, spread is the margin between the yield on assets and the cost of liabilities, or the difference between interest income and interest expense as a percentage of assets. NIM can be higher or lower than the net interest spread. – A Bank For The Buck
The table given below contains the details of Repco’s assets, liabilities, interest income and expense. Using this information let us calculate the NIM and spread for FY2015 and understand why they differ.
NIM2015 = (Interest Income / Average Assets) - (Interest Expense / Average Assets) NIM2015 = (Interest Income - Interest Expense) / Average Assets NIM2015 = (Net Interest Income) / Average Assets NIM2015 = 237.3 / 5273.33 NIM2015 = 4.5% Spread2015 = (Interest Income / Average Assets) - (Interest Expense / Liabilities) Spread2015 = (692.2 / 5273.33) - (454.9 / 4738.54) Spread2015 = (13.12%) - (9.6%) Spread2015 = 3.52% -- My calculations slightly differs from the reported spread of 3.0%
For calculating NIM we used assets in the denominator. But for calculating spread we used both assets and liabilities in the denominator. All else being equal if (interest-earning-assets > liabilities) then your interest expense as a percentage of interest-earning-assets will be lower resulting in higher NIM. And this is the reason why Repco had higher NIM than its spread. On the other hand if (interest-earning-assets < liabilities) then your interest expense as a percentage of interest-earning-assets will be higher resulting in lower NIM.