World over, to remain in business, both profitability and growth are important for a company to attract investors.
A commercial bank makes its profit by paying interest to people who keep money there and charging a higher rate of interest to borrowers who borrow money from the bank.
In Uganda, the aggregate banking sector profitability improved for 2019, net after-tax profits increased by 22.8 per cent from Shs691.8 billion in 2018 to Shs849.8 billion in 2019.
Banks registered growth in customer deposits by 18.4 per cent from Shs19.6 trillion in December 2018 to Shs23.2 trillion in December 2019. Shilling deposits stood at Shs14.2 trillion, which translates in 62.8 per cent while Foreign Exchange (FX) deposits were recorded at Shs8.7 trillion, representing 37.2 per cent.
The industry average loan to deposit ratio was recorded at 61.4 per cent, down from 68 per cent in 2018. The average industry non-performing loan ratio moved from 4.2 per cent in December 2018 to 5.2 per cent representing Shs749.2 billion in December 2019.
In an interview on July 1, the director standards and regulation at the Institute of Certified Public Accountants of Uganda, Mr Mark Omona explained that whereas banks usually focus on driving growth, not all growth creates sustainable value or profits for banks.
“An analysis of some of the banks’ customers would suggest an estimated 42 per cent of a bank’s customers not being profitable to their institutions,” he said.
Mr Omona added: “This seeks to underscore the value of customers and other non-financial parameters like channels of distribution, branches, product portfolio, quality of staff play in managing a bank’s profitability overall.”
Profitability measures the financial performance of a bank over a period of time, usually one year, as a result of the decisions made regarding the use of all resources in the institution.
“Bank profitability commonly measured by the return on assets (ROA) and/or the return on equity (ROE) is usually expressed as a function of internal and external determinants. Internal determinants are factors that are mainly influenced by a bank‘s management decisions and policy objectives such as the level of liquidity, provisioning policy, capital adequacy, expense management and bank size,” Mr Omona said.
Mr Omona said on the other hand, external determinants, both industry-related and macroeconomic, are variables that reflect the economic and legal environment where the banking institutions operate. Below is further explanation of the key profitability metrics as they apply to banks.
He said bank profitability tends to go hand-in-hand with economic activity. Slower growth prospects may dent bank profitability through a reduction in lending activity and a possible increase in credit impairments/losses.
“Automatically, all banks will measure their performance based on the above parameters. The only difference will be in the result as some will be seen to be performing while others are not.
The performance will highly be driven by forces that are both internal/ external and financial/non-financial, thereby branding some banks as profit-making while other banks are loss-making,” he said.
In 2019, the total assets of the banking sector increased by 16.7 per cent from Shs28.1 trillion at the end of December 2018 to Shs32.8 trillion as at December 2019, which signifies how asset quality in banks in Uganda have improved overtime.
Yield on Earning Assets
The Yield on Earning Assets (YEA) ratio accounts for the interest income relative to the total or average of the assets utilised during the same period. The YEA is calculated by dividing interest income on earning assets by the average value of these assets during the period.
The principal source of most banks’ revenues is interest-earning assets (loans, short-term money, market investments, lease financing and investment securities). Furthermore, as banks can achieve their target profit level in a variety of ways, the components affecting net income must be considered when evaluating the quality of earnings.
Return on Equity
In 2019, commercial banks Return on Equity (ROE) improved from 16.3 per cent in 2018 to 20.5 per cent in 2019.
Mr Omona explains that Return on equity (ROE) ROE reflects management’s ability to generate profits from using shareholders’ equity as one of the sources of finance. A bank’s ROE is calculated by dividing its net income by the average shareholders’ equity.
The ROE is the measure that shareholders/ owners of the bank would be most interested in. This is the return that they earn on their investment, and it depends not only on the return of assets but also on the total value of the assets that earn income.
The 2019 results show banks had good Net Interest Margin. Net interest margin (NIM) is the difference between YEA and RPF is the net interest margin. A widening net interest margin is a sign of successful management of assets and liabilities, while a narrowing net interest margin indicates a profit squeeze.
“A NIM of less than 3 per cent is generally considered low, and more than 6 per cent is very high. This range, however, should be used only as a rough guideline, because net interest margin can vary with the particular business mix of individual banks as well as the specific economic conditions in the country.
Adding, “If the bank is able to raise funds with liabilities that have low-interest costs and acquire assets with high-interest income, the NIM will be high indicating that the bank is likely to be highly profitable. However, if the interest cost of its liabilities rises relative to the interest earned on the assets, the NIM will fall and consequently, profitability will suffer.”
While the financial results for 2019 show that most banks were able to make profits and the number of loss-making was 8 in 2018 and stayed at 8 banks in 2019.
“Eight banks made losses in 2019 largely brought about by provisions for non-performing loans,” said Uganda Bankers Association (UBA).
Mr Omona said when evaluating a bank performance, however, ―due consideration needs to be given to not only its profitability but also its financial condition. Thus, the management of profitability and risks is closely related, because risk-taking is a necessary condition of future profitability. Each bank makes trade-offs between the profitability level it is striving to achieve and the risks it is willing to take.
“Therefore, other than the measure of profitability discussed above, Banks equally need to take into consideration the following: Risk – Provision for loan losses and debt-to-asset are the two ratios employed to measure a bank’s risk. The debt-to-asset ratio indicates the financial strength of a bank to pay its debtors,” he said.
The provision for loan losses is an amount reserved by a bank to cover possible loan losses. The provision, which appears on the income statement, is a charge taken against earnings; the charge then goes into a cumulative reserve to cover possible loan losses.
This provision should be considered along with the net interest margin when evaluating a bank’s financial performance. The level of provisions as a percentage of total loans reflects the success or failure of the bank’s credit evaluation procedures and the risks inherent in the bank’s loan portfolio.
Efficiency ratios relate physical output to selected physical inputs and help evaluate whether or not firm assets are being used efficiently to generate income.
Bank efficiency has been measured using non-interest income, the expense to income and expense ratios.
Non-interest income indicates the proportion of a bank’s total income accountable to non-interest sources of income. This reflects the banks’ involvement in other activities, which may include currency and bond trading, asset management services, corporate finance, and other fee-based financial services applicable to its services.
Non-interest expenses ratio indicates the relationship between all expenses incurred in the bank’s other operations and its operating income. A rising cost to income ratio (non-interest expenses relative to net operating revenues) can signal inefficient operations.
While expense to income ratio assesses the efficiency of the bank in utilizing its assets to generate income. This takes into consideration Operating income and Operating Expense. Operating income is the income that comes from a bank’s ongoing operations. Most of a bank‘s operating income is generated by interest on its assets, particularly loans.
Banks in Uganda over the years have faced the problem of high operational costs. However, this time around, Uganda Bankers Association says “industry average cost to income ratio improved from 73.9 per cent in 2018 to 61.4 per cent in 2019.