Community Chair

Top KPIs for Finance

 KPIs or key performance indicators are often quantifiable in the field of finance. They help a financial institution to design its strategic roadmap and push the company towards a direction it would like to move towards through giving it goals which can be achieved with the present resources- while at the same time planning towards acquiring the resources the company would like to utilize and invest in. According to CFO Key Performance Indicators (KPI) survey, done by PWC

28% of the companies which responded, track more than 20 or fewer than 5 KPIs.
Less than half of the respondents believed that KPIs help in monitoring the long-term
strategic goal of the company.
More than 1/3rd of the respondents reviewed their KPIs quarterly or more frequently.”

KPIs should be connected to a long-term strategy, and are essential to drive down a data-driven approach when it comes to decision making. Some business aspects can be difficult to quantify, but it is important to consider quantifiable indicators so that you can monitor and track your performance easily. The finance department has a significant influence over the growth and fall of the institution and can determine things like risk-taking capability, sustainability quotient only if he has some standard KPIs to follow through.

The four quarters of finance that need to be measured and monitored since they define the general health of a company are- profitability, activity, solvency, and liquidity. They need to be tracked at least quarterly so that you can avoid making decisions based on guts and uncertainties.

This article seeks to educate about the top 10 Key performance indicators in finance - namely, return on equity, return on assets, Net Interest Margin, Efficiency Ratio, Non-performing Loans Ratio, Net charge-off ratio, Loan to Deposit Ratio, Tier 1 Common Capital Ratio, Churn Rate and Cost of funds.

Every institution has a different reality, and you should be able to determine the indicators that will adapt to your business strategy so that it is possible to track, monitor and perform effectively.

1. Return on equity

      If you want to monitor the profitability of your institution, calculating and tracking return on equity is what helps to ensure and justify whether you will able to honor your shareholders or not. Return on equity is the ratio of net income to shareholders equity, and hence it determines the profits which can be made from shareholder investments and also indicates how efficient is your institution in utilizing investments of shareholders in growth and operations and most importantly it attracts investors by acting as a reliability factor.

A high return on equity ratio is preferable as it means that the institution can use the invested funds wisely and is able to generate more returns.  It also helps in the interpretation of the annual income statement. Tracking the change of equity, by calculating once at the beginning of the year and then once at the end of the year.

RETURN ON EQUITY = NET INCOME
 
SHAREHOLDER EQUITY

2. Loan to Deposit Ratio

Loan to deposit ratio, as the name indicates is the ratio of investment of a bank to its depositors. It indicates the ability of a bank to cover the withdrawals made by its depositors.  It is a liquidity ratio which helps the investors to analyze the short time viability of the lending functions i.e. to ensure that if they need immediate money, it is readily available. A low loan to deposit ratio is not as preferable to a high loan to deposit ratio since it indicates that the bank is not viable in the short run.

LOAN TO DEPOSIT RATIO = TOTAL LOAN
 
TOTAL DEPOSITS

3. Non-performing Loans Ratio

A non-performing loan is the sum of money on which the debtor has not made any return on the payment within 90-180 days. It is the ratio of the bank’s non-performing loan to the total loans. The more the ratio of non-performing loans, the more they will hurt the standing of a bank as a borrower. Ideally, a non-performing ratio should be less than 1% in one credit cycle.

NON-PERFORMING LOANS RATIO = NON-PERFORMING LOANS
 
TOTAL LOANS

4. Net charge-off Ratio

To understand the general financial health of the institution, you should be calculating and monitoring net charge-off ratio monthly/quarterly. Net charge-off ratio indicates the ratio of debt that a bank believes that it will never get back when compared to the average receivables. Net charge-off ratio should preferably be smaller than the net performing loans ratio. A lower net charge-off ratio will indicate that the bank needs to focus more on account receivables.

NET CHARGE-OFF RATIO = NET CHARGE-OFF
 
TOTAL LOANS

5. Efficiency Ratio

Efficiency ratio indicates the ability of a bank/institution to utilize its assets and liabilities to generate revenue. For any institution which wants to stay sustainable keeping a weekly/monthly track of efficiency ratio is the best way to compare growth and move towards the desired results. When institutions can maintain efficiency in their operations, that is when they gradually become profitable too.

Efficiency ratios include accounts receivable ratio, total asset turnover ratio, inventory turnover, working capital ratio. It is the ratio of these non-interest expenses to net revenue. A ratio below 60% is the desired efficiency ratio for most institutions.

EFFICIENCY RATIO = NON INTEREST EXPENSES
 
NET REVENUE

6. Net Interest Margin

A profitability ratio which helps to analyze how efficiently a company or bank is investing by calculating profits on investment operations. Hence a favorable ratio will indicate that the investment decisions are efficient and contributing to profitability, and a negative ratio will indicate areas of improvement. It is the ratio of net interest to the average earnings on assets.

Since banks make profits by borrowing funds at a low-interest rate and then investing the funds at higher rates, these decisions need comparisons and calculated processes. The Margin can always be affected by charging higher return from debtors or paying low returns to creditors, but this decision can reach only if the net interest margin ratio is interpreted effectively.

NET INTEREST MARGIN = NET INTEREST INCOME
 
AVERAGE EARNING ASSETS

7.Capital Ratio

A ratio to determine the general efficiency and profitability for your institution. It compares the bank’s equity capital to the total risk-weighted assets. The size of capital it has assesses a bank. This ratio determines the solvency of the bank. To be regarded as a well-capitalized institution, a bank should have a capital ratio of 7% or more. The minimum regulatory requirement is 4.5 %.

CAPITAL RATIO = COMMON CAPITAL
 
RISK-WEIGHTED

8. Return on Assets

To measure the performance of banks, return on assets is a significant factor. Return on assets is the ratio which determines an institution’s profitability at the most basic level since it explains the relativity of the institution with respect to its total assets. The ratio indicates the efficiency of management in utilizing the assets; hence it is the ratio of net income to the total assets.

A higher return on asset ratio will be preferable as it will indicate a better utilization of assets. Financial institutions can thrive only when at the end of the fiscal year they have enough funds remaining as profits to invest back in the institution or further expand their commercial market.  This ratio not only shows the profitability but also indicates the feasibility of the institution in the long run.

RETURN ON ASSETS = NET INCOME
 
TOTAL ASSETS

9. Churn Rate

Churn rate is used to determine the rate at which members or employees are leaving the institution. It is calculated by comparing the numbers of members who left in a particular period to the total number of active members in that duration.

The growth rate i.e. the rate at which new members are joining the institution should always be higher than its churn rate. It helps to analyze the hiring and retention patterns of the institution, the factors which lead to the same, and on what factors the institution needs to focus so that the employees can be retained and a low ratio can be maintained.

CHURN RATE = NO. OF MEMBERS LEFT AT A PARTICULAR TIME
 
NO. OF ACTIVE MEMBERS IN THAT DURATION

10. Cost of Funds

It is the rate at which the financial institutions pay the interest for the assets that are utilized in the business. A low cost of funds indicates that better returns are being generated since lesser costs are incurred for long-term loans, and funds are getting used for short-term expenses. It is the ratio of annual interest to the total of interest-bearing deposits.

CONCLUSION

As mentioned earlier, every business has its reality, and you need to determine what indicator is suitable for your institution, according to the sector of finance you wish to prioritize. For example- if you want to focus and monitor profitability more - then you should be tracking gross and net profit ratios frequently. Having the right information at the right time will help you in making a more calculated decision.

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Comments

  • Vendor

    Let me add a few "tip of the spear" or leading indicators that are important to the finance function.  1) Weighted average rate on loan originations (measured monthly or weekly).  If it is higher than the current yield, then loan yield will increase in the future, and vice-versa.  2) Weighted average cost on new time deposits (measured monthly or weekly).  If higher than the current cost of time funds, then overall cost of time funds will increase in the future and vice-versa.  3) Weighted average loan to value on new loan originations (measured monthly).  Leading indicator of risk in portfolio on balance sheet.  4) Weighted average FICO on new loan originations (measured monthly).  Leading indicator of quality of portfolio on balance sheet.  5) Weighted average duration of new loan originations.  Leading indicator of interest rate risk in loan portfolio.  Lastly, on the Cost of Funds measure in the article, my preference is to include noninterest bearing funds as part of the calculation; they have an interest rate of zero and are arguably of the highest strategic value to any financial institution.

    • CU Employee CULytics Founder

      Hi Mike,

      Thanks for your comments. I agree that the Weighted Average on loan originations, LTV, FICO, duration makes a lot of sense.

      Can you please elaborate on Cost of New Time Deposits? 

      Thanks,

      -Naveen

    • Vendor

      The Cost on New/Renewal Time Deposits is used to montior that aspect of funding cost.  It might have looked out of place among the other "lending related" metrics.  As quick aside, the Top 10 measures include a lot of duplication ... for example: Non-performings are in Margin, Efficiency and ROA/E.  Margin in is Efficiency and ROA/E.  I tend to prefer more balance sheet mix measures; the composition, and therefore, strength (or lack of) on the balance sheet.  I did not see anything for non-interest (capital independent) income.  Most of the measures are profit driven, when the objective of credit unions are more member focused (optimal profit, not maximizing profit).  Just my two cents here.  I've been in the KPI business for over 20 years now.  Don't ever hesitate to reach out if you want to expand on this topic a bit.

    • CU Employee CULytics Founder

      Good observations Mike. I am setting some time to discuss this further.

This reply was deleted.

 

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