Reading a Bank's Financial Statements

Why this matters

Everything in Part 3 assumed a company that makes or sells something. A bank doesn't fit. Its raw material and its product are both money. Its debts aren't a financing choice. They're the business. A reader who applies the usual tools to a bank will get answers that mean nothing, so this lesson builds a different set.

What's different

• Deposits are debt, and they're the point. A bank owes its depositors their money back. Collecting deposits cheaply and lending them out is how it earns a living. Debt-to-equity ratios that would signal distress elsewhere are normal for a bank.
• Interest is revenue and cost of sales. Measures such as operating income and EBITDA stop before interest, so they leave out the bank's main activity.
• Cash flow tells you little. Taking deposits and making loans are both movements of cash, so the cash flow statement doesn't separate operations from financing in a useful way. Free cash flow isn't meaningful.
• The biggest cost is an estimate. Nobody knows which loans will go bad until they do.

How a bank earns money

The core is net interest income: interest earned on loans and securities, less interest paid on deposits and other borrowing. Dividing it by the bank's average earning assets gives the net interest margin.¹ For all FDIC-insured banks together, it was 3.32% in the second quarter of 2026.¹

Banks also earn fees, called noninterest income, from things like account charges, card payments, and managing investments.

	Amount
Interest earned on loans and securities	55
Interest paid on deposits and borrowing	(20)
Net interest income	35
Fees and other noninterest income	10
Total revenue	45
Salaries, branches, technology, and other costs	(27)
Provision for loan losses	(4)
Profit before tax	14
Income tax	(3)
Net income	11

The bank has $1,000 million of earning assets: $700 million of loans, $200 million of securities, and $100 million of cash. Its net interest margin is $35 million ÷ $1,000 million, or 3.5%.

The margin moves with interest rates, and the direction depends on the bank. If its loans reprice quickly and its deposits are slow to follow, rising rates widen the margin. If it holds long-term fixed-rate loans and bonds funded by deposits that can leave or demand more interest, rising rates squeeze it. Banks describe this sensitivity in their filings.

Costs: the efficiency ratio

The efficiency ratio is operating costs as a share of revenue, with a lower number meaning a leaner bank.¹ This bank spends $27 million to produce $45 million of revenue, a ratio of 60%. It's best compared with banks of a similar size and type, since a bank with many branches has a different cost base from one that operates online.

Loan quality

Lending is easy. Getting the money back is the skill. Three figures track it.

• The allowance for credit losses. A reserve held against loans, representing the bank's current estimate of all the losses it expects on them. The estimate draws on past experience, current conditions, and reasonable and supportable forecasts, and the standard says it requires judgment.²
• The provision. The expense recorded each period to bring the allowance to the right level. It's the line in the income statement where expected losses reach profit.
• Noncurrent loans and net charge-offs. Noncurrent loans are those 90 days or more past due or no longer accruing interest. Net charge-offs are loans written off as uncollectable, less amounts recovered.¹ These are facts, not forecasts.

	Amount	As a share of loans
Loans	700
Allowance for credit losses	9	1.3%
Noncurrent loans	7	1.0%
Net charge-offs this year	3	0.4%

The allowance is 1.3 times the loans already in trouble, and three times this year's write-offs. Whether that's enough depends on what the loans are. An allowance of 1.3% is thin for credit cards and generous for well-secured home mortgages.

Because the allowance is an estimate, it's also where a bank's profit can be managed. A bank that grows its loans quickly while its allowance shrinks as a share of them is reporting profit that depends on nothing going wrong. Fast loan growth deserves caution in general, because the problems in a loan take time to appear.

Leverage and capital

Two returns describe a bank's profitability. Return on assets is net income as a share of average total assets, and return on equity is the same profit against shareholders' equity.¹

	Amount
Total assets	1,050
Deposits	880
Other borrowing	60
Shareholders' equity	110
Return on assets (11 ÷ 1,050)	1.05%
Return on equity (11 ÷ 110)	10%

The bank earns about one cent a year on each dollar of assets. It turns that into a 10% return for shareholders by holding $9.50 of assets for every dollar of equity. The same arithmetic works in reverse: a loss of 2% on its loans would be $14 million, more than a whole year's profit and about 13% of its equity.

That thin cushion is why regulators set minimum capital levels. For large US banks, the main measure compares common equity capital with assets weighted by their risk. The minimum is 4.5%, and each large bank must hold a further buffer on top that is at least 2.5% and is set partly by a yearly stress test.³ Banks report their ratios every quarter. How far a bank sits above its requirement shows how much room it has to absorb losses, keep lending, and pay dividends.

Funding

A bank's assets are mostly long-term and hard to sell quickly. Its deposits can leave in a day. That mismatch is in the nature of banking, and it's safe only while depositors stay put.

Deposit insurance is what keeps most of them calm: the FDIC insures deposits up to $250,000 per depositor, per insured bank, in each ownership category.⁴ Deposits above that limit are uninsured, and their owners have every reason to leave at the first sign of trouble.

Silicon Valley Bank showed how fast that can happen. According to the Federal Reserve's review, about 94% of its deposits were uninsured at the end of 2022. It had invested heavily in longer-term securities, which lost value as interest rates rose. On March 9, 2023, it lost more than $40 billion of deposits in a single day, and it failed on March 10.⁵

The case also shows a gap in the accounts. Securities a bank intends to hold until they mature aren't marked down when their market value falls. The fall has to be disclosed, but it doesn't change the value shown on the balance sheet.⁵ The loss is in the notes, and it becomes real if the bank is forced to sell. Comparing those unrealized losses with the bank's equity is a quick and important check.

What to check

• Net interest margin over several years, and what the bank says would happen to it if rates moved.
• The efficiency ratio against similar banks.
• Noncurrent loans and charge-offs, and whether the allowance is keeping pace with them and with loan growth.
• What the loans are. A book concentrated in one industry, one region, or one type of property carries more risk than the averages show.
• Capital ratios against the requirement.
• Deposits: the share that's uninsured, and how much comes from a few large customers.
• Unrealized losses on securities against equity.

For valuation, investors often compare a bank's share price with its book value per share, alongside its return on equity. Other Multiples: P/S, P/B, and EV/EBITDA introduced price to book.

Key takeaways

• A bank earns the gap between what it's paid on loans and investments and what it pays for deposits. EBITDA, free cash flow, and debt ratios don't apply.
• Net interest margin and the efficiency ratio show how much it earns and how much it spends to earn it.
• The allowance for loan losses is an estimate. Noncurrent loans and charge-offs show what has actually gone wrong.
• Banks are highly leveraged, so small losses on assets are large losses of equity. Capital ratios measure the cushion.
• Uninsured deposits and unrealized losses on securities are where a bank's funding can break.

Check your understanding

A bank has total assets of $2,000 million and equity of $160 million. It loses 4% of the value of its assets. What happens to its equity?

1. It falls by 4%, to about $154 million, in line with the fall in assets.
2. It falls by $80 million, which is half of the bank's equity.
3. It's unaffected, because losses on assets are borne by the depositors.

Two banks have the same return on equity. Bank A funds itself mainly with insured deposits from households. Bank B relies on large uninsured deposits from a few hundred companies. Which statement is most accurate?

1. They carry the same risk, since identical returns on equity mean identical businesses.
2. Bank B is safer, since large corporate customers are more loyal than households.
3. Bank B's funding is less stable, since uninsured depositors can leave quickly.

What's next

Insurers share one feature with banks: they hold other people's money and invest it. But they're paid first and learn their costs later. Reading an Insurer's Financial Statements explains what that does to the accounts.