Analyze the financial ratios of investment banks

For ordinary investors, properly assessing an investment bank can be tricky. The general rules for stock selection apply-profitability is good, dividends rise better, and cash flow should be sustainable-but there are some additional indicators that are particularly relevant to investment banks. These include stockholder equity indicators, liability composition, debt as a percentage of total capital, return on capital used (ROCE), and return on assets (ROA).

Successful investment bank

Investment banking accounts for a large part of the entire economic and financial sector, especially in the capital and credit markets. Successful investment banks will discover opportunities to help promising companies grow faster and create liquidity in the stock market.

At a basic level, investment banks cooperate with larger organizations or institutional investors. They provide advice, investment services, help raise or manage new capital, and sometimes act as principals.

These are often large financial institutions with strong ties to Wall Street. Investment banks earn most of their income through fees or commissions. They also have their own investment portfolios and can profit from their holdings.

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To analyze an investment bank, you need to understand its efficiency in acquiring assets, making investments, managing risks, and subsequently generating profits for shareholders.

P/E ratio

Think of the price-to-earnings ratio (P/E) as the price you must pay to get the company’s earnings. The price-to-earnings ratio is calculated by dividing the price per share by the earnings per share (EPS). Every major investment website or publication should provide this information.

Return on Assets

The ROA indicator reveals the ratio of the profitability of an investment bank to its total assets. Use it to measure how management effectively utilizes the bank’s existing asset base to create profits for shareholders. ROA is calculated by dividing the investment bank’s net income by its average total assets. Since income is in the numerator, the higher the return on assets, the better.

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Return on equity

The return on equity (ROE) ratio may be second only to the price-to-earnings ratio, which helps express the effectiveness of the company’s return on investment to shareholders. For example, suppose that a company’s net income is 500,000 U.S. dollars, and the average shareholder’s equity is 10 million U.S. dollars. You can calculate ROE by dividing USD 500,000 by USD 10 million to get 0.05 or 5%. This means that every dollar of shareholder equity becomes a profit of 5 cents. Like ROA, ROE prefers higher numbers.

Debt as a share of total capital

The debt-to-total capital ratio describes how much debt is used to bring investment banks together. This ratio is calculated by dividing total debt by total capital. A higher number means that there is a higher risk in the company’s financial structure. Analysts similarly apply this ratio to the debt/equity ratio.

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Return on capital used

ROCE is another ratio that emphasizes efficiency, but it is particularly suitable for investment banks. Investment banks bring in a lot of service income, but they often hold a lot of assets and are tied to a lot of liabilities. ROCE is calculated by dividing profit before interest and taxes by the total capital used. The higher numbers reflect a profitable and efficient capital strategy.

Current ratio

Think of the current ratio as a correction of debt to total capital. If they have strong, stable cash flow to finance their debt, even a highly leveraged investment bank may be safe. The current ratio is equal to current assets divided by current liabilities. This directly measures the company’s ability to use current assets to repay short-term debts and payables.

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