How Do You Analyze a Bank's Financial Statements?

Just like a nonfinancial service company, a bank has to manage the trade-off between its profits and risks. However, two distinct characteristics for banks pose challenges in analyzing their financial statements. The first relates to defining debt and reinvestment needs for banks, making it difficult to calculate cash flows for investment analysis. The second difficulty has to do with regulation, which became especially burdensome after the 2009 financial crisis.

In the financial statement analysis for a typical nonfinancial service company, capital is calculated as the sum of debt and equity. The company borrows funds and issues equity to invest in property, plant and equipment. With banks, the capital definition becomes blurrier. For banks, debt is like a raw material that is turned into other more profitable financial products. For example, a bank raises funds from bondholders and invests these proceeds into foreign bonds with a yield above its borrowing rate. For this reason, the definition of banks' capital used by regulatory and investment professionals focuses on banks' equity.

The problem of defining debt for banks is especially evident when considering customers' deposits in checking and savings accounts. Since banks pay interest on savings accounts, such deposits should be considered debt and all interest expenses must be excluded in calculating free cash flow to the firm. However, this poses a problem since interest expense is one of the largest components on banks' financial statements. In some sense, interest expense to banks is similar to a cost of goods sold to nonfinancial service companies.

Another problem that financial institutions' business nature poses is how to measure banks' reinvestment needs. For a manufacturing company such as Boeing, the reinvestment need can be easily calculated by taking capital expenditures, subtracting depreciation and adding back changes in working capital.

Consider one of the largest U.S. commercial banks, Wells Fargo. Other than leasing buildings, Wells Fargo does not have to invest in property and its fixed assets are a very small fraction of its total assets. A quick look at the cash flow statement for Wells Fargo shows very small capital expenditures and depreciation that bear very little relation to its profitability. On the other hand, Wells Fargo heavily invests in its brand name and its employees, who are one of its most valuable assets.

Consider changes in working capital for Wells Fargo. Working capital is ordinarily defined as the difference between current assets and current liabilities. Looking at Wells Fargo's recent balance sheet reveals it does not break down its assets and liabilities by their maturity or expected use. If an investment analyst still categorizes Wells Fargo's assets and liabilities, most of them fall into one or the other category, and calculated changes in working capital have little relationship with reinvestment needs.

Finally, consider the regulatory burden. Regulatory requirements have a profound effect on banks' financial statements in the form of higher capital requirements, smaller payouts, additional expenses and other constraints. For example, due to the inability to pass stress tests conducted by the Federal Reserve, banks such as Citibank and Deutsche Bank were constrained in their ability to pay out dividends and repurchase their stocks. Regulation also imposes high compliance costs for the banks, reducing their profitability.