Bank Efficiency Ratio Formula

 

Bank Efficiency Ratio Formula (Table of Contents)

• Formula
• Examples

What is the Bank Efficiency Ratio Formula?

There are multiple types of ratios Operating Margin Ratio, Return on Asset, Return on Equity, Debt to Equity Ratio, Asset Turnover Ratio, Account Receivable Turnover Ratio, Working Capital Ratio, and each ratio indicates the various aspect of the business.

The efficiency ratio is also known as the Activity ratio indicates how effectively, the company is performing currently by using its internal resources. The efficiency ratio is used by banks as it helps the analysts to examine how well the bank is performing its operations overhead to generate revenue. The lower the ratio the better it is, 50% is considered to be an ideal ratio

Examples of Bank Efficiency Ratio Formula (With Excel Template)

Let’s take an example to understand the calculation of Bank Efficiency Ratio in a better manner.

Bank Efficiency Ratio Formula – Example #1

 Let us take the example of a Local Bank A it’s Non-Interest Expenses is $1,050,000 and its Net Revenue is $2,200,000. Using this data we need to calculate the Bank Efficiency Ratio for Bank.

Solution:

Bank Efficiency Ratio is calculated using the formula given below

Bank Efficiency Ratio = Non-Interest Expenses / Net Revenue

• Bank Efficiency Ratio = $1,070,000 / $2,200,000
• Bank Efficiency Ratio = 48.6%

To calculate Efficiency Ratio we need to divide Non Interest Expense $ 1,070,000 by Revenue $ 2,200,000. Using the above-explained formula we have got value 48.6%, which means the company spent $ 0.486 to generate a dollar.

Bank Efficiency Ratio Formula – Example #2

Let us take another example of the same Bank A who has recently started and they want to identify the efficiency ratio of the bank to analyze how well the company is using its resources to generate revenue. Bank’s Provision for credit losses is $ 9000.

Solution:

Net Interest Income is calculated using the formula given below

Net Interest Income= Total Interest Income  – Total Interest Expenses

• Net Interest Income = $215000- $67500
• Net Interest Income = $147500

Bank Efficiency Ratio is calculated using the formula given below

Bank Efficiency Ratio = Non-Interest Expense / (Net Interest Income + Non-Interest Income -Provision for Credit Losses)

• Bank Efficiency Ratio = $ 73000/ $ 198500
• Bank Efficiency Ratio = 36.8%

From the above calculation, it can be concluded that this bank is working very efficiently with a ratio of 36.8%.

Bank Efficiency Ratio Formula – Example #3

Let’s take one more example of Green Bank Corp. Below is the historical data of the bank

Solution:

Bank Efficiency Ratio is calculated using the formula given below

Bank Efficiency Ratio = Non-Interest Expense / (Net Interest Income + Non-Interest Income -Provision for Credit Losses)

For 2017

• Bank Efficiency Ratio = $55,608 / ($52,245 + $44,012 – $3,697 )
• Bank Efficiency Ratio = 60.08%

For 2018

• Bank Efficiency Ratio = $53,205 / ($51,945 + $45,455 – $2,500)
• Bank Efficiency Ratio = 56.06%

For 2019

• Bank Efficiency Ratio = $52,168 / ($51,600 + $44,569 – $1,495)
• Bank Efficiency Ratio = 55.10%

Following are observations of the above case –

• It is interesting to see that the bank efficiency ratio is significantly reducing for the last three years. From an investor’s or a business manager’s perspective, this is a great thing that the bank is improving its performance over the years.
• The efficiency ratio is reducing because of multiple factors here, as you can see there is a downward trend in Non-Interest expenses, that means the bank is managing its business very well with low operation cost and this will leads to increase the profitability in future.
• On the other hand, the provision for credit losses is also reducing, which can be interpreted in multiple ways. First, this means that the bank is having high loan recovery rate which is a positive side. On the other hand, the bank might face big issues related to credit losses in the future.  Then it would be a big challenge for the banks to recover the losses.

Explanation

The formula for Banking Efficiency Ratio can be derived by using the following steps:

Step 1: Firstly, figure out the Non-Interest Expense of the Bank. Some examples of Non-interest expenses are Rent, Salary, Administration cost, etc. Non-Interest Expenses are the fixed operating cost of the bank.

Step 2: Next, figure out the Net Interest Income of the bank which can be calculated as interest earned less interest Paid by the bank).

Step 3: Identify the Non-interest Income of the bank. A few Examples of Non-interest Income are loan processing fees, deposit charges, Credit card fees, Income earned from capital market by selling their products like mutual funds, insurances, etc.

Step 4: In the fourth step, subtract “Provision for credit losses” from Net Interest Income and Non-Interest Income.

Step 5: Finally, Banking Efficiency Ratio can be derived by dividing Non-Interest Expense from Step one with the value we have calculated from Step 4.

Relevance and Use of Bank Efficiency Ratio Formula

The Bank Efficiency ratio is used by an analyst to determine insights of the business and it provides awareness about the efficiency of the different areas of business. Analysts also use this ratio to measure banks with the peer company within the same industry. It helps banks to identify the businesses that are managed well in comparison to others.

This Ratio used by higher Managements to know how well they are operating their business and gives a clear picture of whether they have met the set goals or not. Using this they can change their strategies to operate the business activities and utilization of resources in a better manner to reach the predetermined goals.

This ratio is also used by the investors as well as the management. Investors use this ratio to determine whether the business is a good investment or not because a better efficiency ratio means that management is operating the business efficiently and this could lead to good returns in the future.

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