Financial ratios are widely used to analyze a bank's performance, specifically to gauge and benchmark the bank's level of solvency and liquidity. A financial ratio is a relative magnitude of two financial variables taken from a business's financial statements, such as sales, assets, investments and share price. Bank financial ratios can be used by the bank's clients, partners, investors, regulators or other interested parties.

Place the financial data you'd like to analyze in a spreadsheet application such as Microsoft Excel. Calculating ratios on a spreadsheet is much easier than on a piece of paper, even with the help of a financial calculator.

If you are not sure which data to input into the cells, limit yourself to the most important variables such as the number of shares outstanding, their current market price, total assets and liabilities, current assets and liabilities, number of bad debts and annual income (net income and earnings before interest payments, taxes, depreciation and amortization-EBITDA). You can add other financial data later.

Calculate solvency ratios. Solvency ratios are ratios that tell us whether the bank is a healthy long-term business or not. A good ratio here is the Loans to Assets ratio. It is calculated by dividing the amount of loans by the amount of assets (deposits) at a bank.

The higher the loan/assets ratio, the more risky the bank. The Loans to Assets ratio should be as close to 1 as possible, but anything bigger than 1.1 can mean that the bank gives more loans than it has in deposits, borrowing from other banks to cover the shortfall. That is considered risky behavior.

Another ratio to be considered here is the Non-Performing Loans to All Loans Ratio, or, more simply put, the Bad Loans ratio. The Bad Loans Ratio indicates the percentage of nonperforming loans a bank has on its books.

This ratio should be about 1 to 3 percent, but a figure of more than 10 percent indicates the bank has serious problems collecting its debts. A nonperforming loan is a loan the bank says will not recover. Banks use a pretty sophisticated methodology to calculate the number of those loans.

Calculate and analyze liquidity ratios. Liquidity ratios are ratios that reveal whether a bank is able to honor its short-term obligations and is viable in the short-term future.

The primary ratio here is the Current Ratio. The Current Ratio indicates whether the bank has enough cash and cash-equivalents to cover its short-term liabilities.

Current Ratio = Total Current Assets / Total Current Liabilities

The current ratio of a good bank should always be greater than 1. A ratio of less than 1 poses a concern about the bank's ability to cover its short-term liabilities.

Calculate and analyze the Return to Shareholders Ratio and the Price to Earning Ratio.

To calculate the Return to Shareholders Ratio, divide the dividends and capital gains of a stock by the price of the stock at the start of the period being analyzed, usually a calendar year.

For example, if the stock on Jan. 1, 2010, cost $10, dividends per share were $1, and on Jan. 1, 2011, the stock cost $11, then the Return to Shareholders Ratio will be as follows: [($11-$10)+$1] / $10 = 0.2 or 20 percent.

The return to shareholders should be at least the interest rate paid on a bank term deposit. Otherwise shareholders would be better off having their money in a safe bank deposit, guaranteed by the government.

The Price to Earning Ratio is calculated by dividing the bank's share price by the earning per share: P/E = price of one share / earnings per share. The P/E ratio typically varies in the 10 to 20 range.

Things You Will Need

  • Income Statement

  • Balance Sheet

  • Cash Flow Statement

  • Spreadsheet application (e.g. Microsoft Excel)