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Financial statements for banks present a different analytical problem than manufacturing and service companies. As a result, analysis of a bank's financial statements requires a distinct approach that recognizes a bank's somewhat unique risks. (To learn more about reading financial statements, see What You Need To Know About Financial Statements and our Advanced Financial Statement Analysis tutorials.)
Banks take deposits from savers, paying interest on some of these accounts. They pass these funds on to borrowers, receiving interest on the loans. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. This ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. By managing this flow of funds, banks generate profits, acting as the intermediary of interest paid and interest received and taking on the risks of offering credit.
Leverage and Risk
Banking is a highly leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. In the U.S., a bank's primary regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending on the charter of the bank. Within the Federal Reserve Board, there are 12 districts with 12 different regulatory staffing groups. These regulators focus on compliance with certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the banking system. (To read more about leverage, see When Companies Borrow Money.)
As one of the most highly regulated banking industries in the world, investors have some level of assurance in the soundness of the banking system. As a result, investors can focus most of their efforts on how a bank will perform in different economic environments.
Below is a sample income statement and balance sheet for a large bank. The first thing to notice is that the line items in the statements are not the same as your typical manufacturing or service firm. Instead, there are entries that represent interest earned or expensed as well as deposits and loans. (To find out more about balance sheets and income statements, see Find Investment Quality In The Income Statement, Understanding The Income Statement, Reading The Balance Sheet and Breaking Down The Balance Sheet.)
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| Figure 1: The Income Statement |
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| Figure 2: The Balance Sheet |
As financial intermediaries, banks assume two primary types of risk as they manage the flow of money through their business. Interest rate risk is the management of the spread between interest paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower will default on its loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements that need to be understood when analyzing a bank's financial statement.
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