Purpose of selection- We selected the method of ratio analysis because it would give us a quantitative analysis of the performance of two banks over a period of 5 years. And the analysis of the performance with the ratios will lead us to a meaningful conclusion.
Profitability Ratio - It tells us that how well the bank has been in generating profit through its operations.
Asset Utilisation - It shows the expertise of the banks in generating sales through the use of its assets.
Leverage Ratio- It gives an idea of the capital mix of the banks i.e. the extent to which they have used debt and equity in their capital structure.
Liquidity Ratio - Provides an idea of the liquidity position of the banks i.e. their ability to meet the short term commitments.
We calculated individually all these ratios for the two banks over a period of 5 years to see how well have they been performing. Based on the ratios we would make our conclusion on the performance of the banks. The key ratios that we would compare are
Get your grade
or your money back
using our Essay Writing Service!
Return on Equity = Net Income/ Average total equity
Return on Asset = Net Income/ Average total asset
Asset Utilisation Ratio = Net Sales/ Average total assets
Leverage Ratio = Assets/ Equity
The ratios for the banks are
RATIOS OF THE TWO BANKS
These ratios help us in making a conclusion about the performance of the two banks.
As can be seen from the Profitability ratios, over the period of last five years Lloyds banks has a greater Return on equity which suggests that they have been able to generate more value for the shareholders than Royal bank of Scotland. Also clear from the ratios is the fact that the profitability of both the banks has decreased over the last five years. RBS was in loss for last two years but Lloyds managed to maintain a small profit margin. We will further investigate the reason for this difference through our DuPont analysis.
We decided to calculate the asset utilisation ratio to see how efficient has the banks been in utilising their assets to generate sales. It can be clearly seen from the ratios that Lloyds bank has been more efficient over the years, however the efficiency for both the banks have been going down which can be attributed to the recent financial crisis.
Leverage ratio is to find the capital mix of both the banks i.e. what is the proportion of debt and equity in the capital structure. We calculated the leverage ratios and found that both the banks are highly geared with a leverage ratio between 20 to 30. However over the last five years Lloyds has been more geared than RBS.
We calculated the liquidity ratio to have an idea of what is the liquidity position of these banks. We found that Lloyds has maintained a better liquidity position and is in a better position to meet its short term commitments.
To make things more clear we drew some graphs of the key ratios to come up with the trends.
By our analysis using the ratios we found that though the performance of the two banks has gone down over the period, Lloyds has been able to generate more profit than RBS by utilising its asset better. In their performance there is also a role played by leverage which we will discuss in the DuPont analysis.
As we know that ROE measures the return that a bank generates on its equity for its shareholders. We apply the DuPont analysis to understand what drives the ROE i.e. which factors affect the ROE by decomposing it in some basic ratios. By doing this we can understand what brings the difference in ROE of the two banks. The DuPont analysis is based on-
-RETURN ON EQUITY = NET INCOME/ SHAREHOLDERS EQUITY
-RETURN ON ASSET = NET INCOME/ TOTAL ASSET
-LEVERAGE= TOTAL ASSET/ SHAREHOLDERS EQUITY
-NET PROFIT MARGIN= NET INCOME/ REVENUE → An indicator of gow much a company derives per one money unit of sales.
Always on Time
Marked to Standard
-ASSET TURNOVER = REVENUE/ TOTAL ASSET
-TAX BURDEN= NET INCOME/ EARNING BEFORE TAX → Effect of taxes on ROE. It shows how much of a company's pretax profit it gets to keep.
-INTEREST BURDEN= EARNING BEFORE TAX/ EARNING BEFORE INTEREST AND TAX → It measures the effect of interest on ROE. Higher borrowing cost reduces ROE.
-EBIT( Earning befor interest and tax) MARGIN= EBIT/ REVENUE → It measures the effect of operating profit on ROE.
This basically shows that ROE is directly affected by ROA and Leverage. ROA in turn is affected by net profit margin and asset turnover. If net profit margin is positive,higher the asset turnover higher is the ROA and if its negative, higher the asset turnover lower would be ROA. Net profit margin is affected by EBIT margin, Interest burden and Tax burden. If all these ratios are posive higher they are better is the ROE.
We analysed the ROE using DuPont analysis for the last five years but have shown the flowchart for the last year to show how it works.
LLOYDS DuPont ANALYSIS (2009)
ROYAL BANK OF SCOTLAND DuPont ANALYSIS(2009)
By doing this analysis we can understand what affected the ROE for the banks. The breakdown of ROE indicates that RBS lower profitability was due to a lower ROA which can be further investigated. The roots of a low ROA for RBS goes down to its negative interest burden, which basically reflects that the Earning before tax for RBS was in negative i.e. there was a loss. This loss is reflected in net profit margin and return on asset. Because of the high leverage the loss in ROA of -.16% is multiplied and is reflected as -2.82% in ROE. The opposite happens for Lloyds bank. Lloyds has a ROA of .28% but because of the equity multiplier of 20.96, the ROE becomes 5.77% which is a good return in the present conditions. A point to notice is the role of leverage in determining the ROE. It increases both profit and loss and that's why it's said a double edged sword which should be used carefully. For both banks equity is just a small portion of total capital.
If we look at the DuPont analysis of RBS for a period of 5 years, we can conclude that the performance of the bank has been deteriorating with a negative effect on nearly all the elements, but the bank has recovered well over the last year where it improved its performance from -29.45% ROE to -2.82% which can be seen as a result of reduction in its leverage. Sales have been adversely affected in the recent year which is evident from the low asset turnover ratio which has reduced over the years.
For Lloyds bank the ROE has gone down to nearly 5% for last 2 years from nearly 25% for the period of 2006- 2007. The major difference in the ROE can be seen at tax burden and interest burden. Interest burden drastically decreased showing earning before tax is a little fraction of earnings before interest and tax. This is because EBIT was small which made interest expense a large portion of EBIT therefore reducing EBT drastically. The other factor, Tax burden drastically increased showing that Net income was a large portion of EBT. This is because due to low profit there was no tax charges rather there was a tax rebate which made Net income more than earning before tax for some years.
To support our claim we present the five years breakdown of the ROE for the two banks in the following tables-
ROYAL BANK OF SCOTLAND
This Essay is
a Student's Work
This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.Examples of our work
Overall Lloyds bank managed their resource which is why it managed to keep its ROE positive and way above RBS over the last 5 years. So based on DuPont time series and cross section analysis Lloyds bank is the winner.
As we based our analysis on ratios, there are some limitations inherent to ratio analysis which is the limitations of our performance analysis. They are-
-Banks may use alternative accounting methods which will have an effect on their ratios.
-Ratio analysis is based on the person judging it.
-This analysis may be misleading if the accounts are wind dressed.
-It only takes into account the quantitative characteristics and ignores the qualitative point of view.