Capital Adequacy Ratio (CAR)
The Capital Adequacy Ratio (CAR) is a measure of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures.
The Capital Adequacy Ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world.
☑ How the Capital Adequacy Ratio Is Calculated
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets.
It is measured as
Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets.
▪ Tier-One Capital
Tier-one capital, or core capital, is comprised of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-one capital is used to absorb losses and does not require a bank to cease operations.
▪ Tier-Two Capital
Tier two capital comprises unaudited retained earnings, unaudited reserves and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating.
The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans, evaluating the risk and then assigned a weight. When measuring credit exposures, adjustments are made to the value of assets listed on a lender’s balance sheet. All the loans the bank has issued are weighted based on their degree of credit risk.
▪ Tier-Three Capital
Tier 3 capital is tertiary capital, which many banks hold in order to support their market risk, commodities risk, and foreign currency risk.
Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capitals.
Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves as compared with tier 2 capital.
To qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1 capital, be unsecured, subordinated, and have a minimum maturity of two years.
☑ What are the norms of CAR under Basel 3
The capital norms recommend Capital Adequacy ratio (CAR) be increased to 8 per cent internationally, while in India it is 9 per cent. CAR is a ratio of a bank’s capital to its risk.
This capital is further classified into two – Tier 1 (the main portion of the banks’ capital, usually in the form of equity shares) and Tier 2 capital.
Out of the 9%of CAR, 7% has to be met by Tier 1 capital while the remaining 2 per cent by Tier 2 capital.
So, if the bank has risky assets worth Rs 100, it needs to have Tier 1 capital worth Rs 7. This capital can be easily used to raise funds in times of troubles. In addition, banks also have to hold an additional buffer of 2.5 per cent of risky assets.
☑ High capital adequacy ratio indicate?
It measures a bank's financial strength by using its capital and assets. It is used to protect depositors and promote the stability and efficiency of financial systems around the world. Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.
☑ Usage of CAR
Capital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities and other risks such as credit risk, operational risk etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk.
Statutory Liquidity Ratio * *(SLR)
SLR defined as ‘the share of bank’s total deposit that it needs to maintain itself as liquid assets’.
Banks required to maintain a minimum portion of their Net Demand and Time Liabilities (NDTL) in the form of gold, cash, govt approved securities before providing credit to the customers. The ratio of these liquid assets to the demand and time liabilities is referred to as the Statutory Liquidity Ratio.
The Reserve Bank of India has the authority to increase this ratio up to 40% The increase in this ratio constricts the ability of the bank to inject money into the economy.
The Reserve Bank of India raises the SLR to control the bank credit during the time of inflation and inversely it decreases the SLR during the time of recession to increase the bank credit
In order to determine the base rate, SLR acts as one of the reference rates
*Current SLR rate is 19.5% * and
The SLR has an upper limit of 40% and a lower limit of 0% in India
Coverage Ratio
✍ A Coverage Ratio is any one of a group of financial ratios used to measure a company’s ability to pay its financial obligations.
✍ A higher ratio indicates a greater ability of the company to meet its financial obligations while a lower ratio indicates a lesser ability.
✍ A Coverage ratios are commonly used by creditors and lenders to determine the financial standing of a prospective borrower.
Most common coverage ratios are:
✍ Interest coverage ratio: Ability of a company to pay the interest expense(only) on its debt
✍ Debt service coverage ratio: The ability of a company to pay all debt obligations, including repayment of principal and interest
✍ Cash coverage ratio: The ability of a company to pay interest expense with its cash balance
✍ Asset coverage ratio: The ability of a company to repay its debt obligations with its assets.
While comparing the coverage ratios of companies in the same industry or sector can provide valuable insights into their relative financial positions, doing so across companies in different sectors is not as useful, since it might be like to comparing apples and oranges.
Information Ratio
Information ratio shows the consistency of the fund manager in generating superior risk adjusted performance. A higher information ratio shows that fund manager has outshined other fund managers and has delivered consistent returns over a specified period.
Information ratio is useful in comparing a group of funds with similar management styles.It is calculated by dividing the active return of a portfolio by the tracking error. The tracking error is calculated as the standard deviation of the difference between fund return and index return.
The formula for calculating Information Ratio is R-BR/w
R: Portfolio Return
BR: Benchmark Return
w: Standard deviation of the active return. This is also called tracking error.
The information ratio (IR) is a measure of portfolio returns above the returns of a benchmark, usually an index, to the volatility of those returns. The information ratio (IR) measures a portfolio manager's ability to generate excess returns relative to a benchmark, but it also attempts to identify the consistency of the investor.
The information ratio identifies how much a manager has exceeded the benchmark. Higher information ratios indicate a desired level of consistency, whereas low information ratios indicate the opposite.
Treynor Ratio
Treynor ratio is also known as reward-to-volatility ratio, Treynor ratio is the excess return generated by a fund over and above the risk free return (government bond yield). It is similar to Sharpe ratio though one difference is that it uses beta as a measure of a measure of volatility. The ratio is named after Jack L. Treynor.
The higher the Treynor ratio, the better the performance of the portfolio under analysis.
Calculated as follows:
(Average Return of a Portfolio – Average Return of the Risk-Free Rate)/Beta of the Portfolio
For example Your investor gets 7% return on her investment in a scheme with a beta of 1.0.
We assume risk free rate is 5%.
Treynor Ratio is 7-5/1.0 =2 in this case.
Leverage Ratio
Leverage ratio is the relation between the amount of equity that a company has and the amount of debt that it is carrying in its books. It is a measurement of the capacity of the company to meet its financial obligations.
A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.
Types of leverage ratios are as follows
?Debt-to-EBITDA
?Debt-to-Capital
?Debt-to-Equity
?Debt-to-Asset
Debt to Capital Ratio
The debt-to-capital ratio is a measurement of a company's financial leverage. The debt-to-capital ratio is calculated by taking the company's interest-bearing debt, both short- and long-term liabilities and dividing it by the total capital. Total capital is all interest-bearing debt plus shareholders' equity, which may include items such as common stock, preferred stock and minority interest.
The formula to calculate Debt to Capital is as follows
= Total Debt / (Total Debt + Total Equity)
P/E Ratio -(Price to Earning Ratio)
P/E Ratio calculates the market value of a stock relative to its earning by comparing the market price per share by earnings per share.
It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company.
Formula of P/E RATIO
P/E = Stock price per share/ Earnings Per Share
Price-To-Book Ratio - P/B Ratio:
Price-to-book value (P/B) is the ratio of market value of a company's shares (share price) over its book value of equity. The book value of equity, in turn, is the value of a company's assets expressed on the balance sheet.
It is calculated as:
P/B ratio = Market price per share/book value per share
Book value per share = (total assets - total liabilities) / number of shares outstanding
A lower P/B ratio could mean that Stock is undervalued.
Note: All information provided in this blog is for educational purposes only and does not constitute any professional advice or service. Readers are requested to consult a financial advisor before investing as investments are subject to Market Risks.
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