Banks being specialized enterprises are not distinct from any business form except for their roles as financial intermediaries.
Underlying their unique functions, and behind their secured bricks and mortar infrastructures, banks operate as strategic enterprises navigating the same principles that underpin businesses across all industries.
They share a common essence with other businesses – the pursuit to generate profit, promote operational efficiency, and maximize customer satisfaction. And in performing their critical roles, a bank’s balance sheet (now commonly referred to as a “Statement of Financial Position”) remains a good reference point for any assessment of a bank’s financial performance and business viability.
It is essential to note that the effective operation of a bank is subject to its ability to adjust to market dynamics, comply with regulatory requirements, and build resilience to withstand the varied economic cycles. While at it, it has become necessary for banks to measure their performance while seeking to drive growth, remain stable, and survive difficult economic times. And in this article, I shall seek to uncover the essential meanings banks must ascribe to the numbers on their statements of financial positions in evaluating their own performance.
WHAT IS A STATEMENT OF FINANCIAL POSITION?
A “Statement of Financial Position” is a periodic financial statement that seeks to provide an accurate, comprehensive, and up-to-date financial position of a company reflecting its assets, liabilities, and capital positions. It reflects mostly what the company has or owns (assets), what or who it owes (liabilities), and how much the owners have invested into the business as capital (equity). In the ordinary sense, it is synonymous with preparing your personal financial statement, to determine what you own, who owes you, and how much money have put up towards your financial life.
Frank Wood in his book titled, Business Accounting 1 (Twelfth Edition) seeks to explain this concept as follows; “The statement of financial position shows the financial position of an organization at a point in time. In other words, it presents a snapshot of the organization at the date for which it was prepared.”
We can draw from this definition that a Statement of Financial position is used for evaluating the performance of a business. It serves as a tool that records the operations of organizations for assessing their financial health at the end of each reporting period, such as a month, quarter, or year.
Also, it serves as a reference document for investors and other stakeholders. It enables them to compare current assets and liabilities to determine the business’s liquidity or calculate the rate at which the company generates returns among others.
EXPLORING THE KEY ELEMENTS OF STATEMENT OF FINANCIAL POSITIONS
A statement of financial position is prepared on the basis of a structure that provides detailed information about the financial health of a company to its stakeholders. This structure is concerned with classifying and recording actual transactions relative to assets, liabilities, and capital in monetary terms. It is noteworthy that, the importance of certain items on statements of financial position could vary depending on the industry. Often these variations may be due to adopted accounting practices and standards.
However, a standard structure comprises the following items:
- Assets: Assets are valuable resources owned by an organization from which future economic benefits are expected to flow. They are like the money you have in your wallet, plus any other valuables you have, such as your phone, house, or your car.
Assets do not only showcase a company's resource base but also its ability to generate cash flows, meet obligations, and invest in growth. They are a testament to a business's capacity to leverage its resources effectively and capitalize on opportunities.
Assets on a statement of financial position are categorized by liquidity. They are grouped according to the headings, current assets like cash, accounts receivable, and short-term investments, and non-current assets (also called “fixed assets”) like buildings, equipment, long-term investments, and intangible assets like patents, goodwill, and trademarks. Current assets deal with listed items that are easily accessible and could be sold and/or converted to raise immediate cash for the business operations while fixed assets concern themselves with listed items that provide benefits over a long period of time and are permanent in nature.
- Liabilities: Liabilities are non-negotiable obligations of organizations owed to external parties. It must be considered carefully by every practice, as they represent debts and can include loans, accounts payable, wages, taxes, and other significant debts. Similar to assets, it is essential to categorize these debts based on their due date to ensure timely repayment. Every organization first lists its current liabilities which are generally due within a year of the date of the statement of financial position, followed by a list of non-current liabilities - those obligations that will not become due for more than a year. Common liabilities which fall under current liabilities include bank loans and overdrafts, deposits from customers, accruals (unpaid expenses), etc. while non-current liabilities include, long-term loans, etc.
- Equity: Equity is the residual interest in the assets after deducting liabilities. It measures an organization’s financial strength and becomes a determinant of economic growth or failure in an organization. An owner becomes better off when the scales tip in favor of profitability and efficiency. This is demonstrated when net assets are increasing. The reverse paints a picture of a loss. Largely, equity represents the fund or capital contributed or deemed to be contributed by the owners of the related company.
WHAT THE NUMBERS MEAN TO BANKS
Navigating the perspective of a bank’s statement of financial position can be a complex endeavor for those unfamiliar with its operations. To demystify this complexity, it is important to embark on a succinct journey in understanding the key constituents of the key elements of a bank’s statement of financial position and what they mean to the running of the bank. Akin to any other business, a bank's statement of financial position is composed of three fundamental components. “The assets side” which serves to showcase the bank's possessions, “the liabilities side” which lays bare its debts, and in between, “the equity” side, which reflects the difference between assets and liabilities, generally.
A look at some listed items and their respective figures
- Cash: Undoubtedly, one of the paramount roles a bank undertakes is to provide immediate access to cash as needed. This service unfolds in various scenarios: depositors withdrawing money or writing checks, bank customers tapping into credit lines, or even routine business expenses that require immediate settlement.
Cash withdrawals from customers are unpredictable, unlike regular bills. Consequently, a bank must meticulously balance its liabilities with a prudent level of cash reserves. This entails holding a portion of its funds in reserve. These reserves serve as a buffer for unexpected withdrawals.
Banks are expected to adopt a cash management strategy that involves collecting funds efficiently. In the past, presenting physical checks to the issuing bank for payment was the norm, which took a considerable amount of time. However, with the advancements in technology, electronic processing of checks and transactions has become the standard. Therefore, banks must keep up with the changing times and adapt to the new norms which means having adequate cash available at all times to meet customer withdrawal and payment demands as well as the bank’s own operational activity requirements.
Today, the need to have available a pool of cash is crucial for any seamless operation of a bank and indicative of its liquidity position. A high cash position is a strong signal of a bank’s ability to meet its immediate cash demands and the reverse is true of its inability to do same.
- Loans: Banks heavily rely on loans as a crucial asset base that generates substantial interest and revenue. They generate more interest than banks have to pay on deposits, and, thus, are a major source of revenue for a bank. Although lending is a core activity for banks, it is associated with risks, particularly the risk of customers defaulting on their loan repayments. When a customer defaults, it leads to financial losses for the bank. A high loan portfolio with a high default rate is equivalent to potential future financial losses.
- Investments (short-term): These short-term assets mirror the essence of cash. Cash equivalents encompass investments with minimal maturity periods – typically three months or less – that can be swiftly converted into cash without incurring a substantial loss. These include demand deposits, Treasury bills (T-bills), and commercial paper. Notably, they bear minimal interest rate risk due to their short maturity and boast high credit ratings. Government-issued securities, such as T-bills, form the crux of this category, engendering minimal credit risk due to their association with a government empowered to print currency. Investing in government bills, despite being perceived as low-risk, can lead to unexpectedly high risks. Relying highly on government investments may expose banks to unforeseen dangers, as was the case with the recent Domestic Debt Exchange Program that resulted in a hold on government-acquired bonds.
- Property, Plant, And Equipment: Fixed assets, despite their nature, stand as essential pillars in a bank's portfolio. While seemingly non-liquid and less conducive to immediate transactions, these tangible entities wield profound significance as valuable assets. Unlike cash or easily tradable securities, these assets don't effortlessly transition into currency. Instead, they yield value over an extended timeframe, contributing to an organization's profitability through operational efficiency, increased productivity, and even brand recognition. Having a substantial amount of fixed assets can lead to difficulties in conducting business smoothly due to the lack of easily accessible cash. This situation can pose a significant operational disadvantage for the bank.
- Liabilities: They represent the financial commitments that a bank holds to external parties. This spectrum spans from the deposits entrusted by customers to the funds procured from external sources. These funds are akin to debt which are repayable by the debtor (in this case, the bank).
- Equity: Equity not only signifies ownership but also serves as a cushion to absorb losses. It is a measure of a company's net worth and its ability to withstand financial setbacks. Changes in equity over time capture the impact of profits or losses, additional investments, dividends, and other equity transactions. This element is categorized into;
(a) stated capital: This reflects the owner’s contribution or amount injected into the setup of the bank.
(b) retained earnings: These earnings are the profits garnered by the company that hasn't been distributed as dividends to shareholders. Instead, they are maintained for the purposes of reinvestment into the company to fuel growth, innovation, and expansion.
(c) Reserve: This is like an emergency fund saved for unforeseen events. They serve as a well you fall on when there is no general supply of water.
Holistically, these components of equity act as cushions during uncertainties. In such a situation, stated capital may increase through additional investments, retained earnings swell with each profitable endeavor, and reserves are replenished to safeguard against uncertainties. situations. [Include an assessment of the effect of low or high positions of these discussed items]
THE INTERPLAY OF FINANCIAL STATEMENT’S POSITIONS TO THE BANK
The correlation between assets, liabilities, and equity is the heartbeat of a bank's financial stability. Changes in any of these components set off a ripple effect that reverberates throughout the entire financial system.
Consider a scenario where a bank extends a substantial number of loans to various clients. While loans constitute assets for the bank, they also introduce an element of risk. If a significant portion of these loans become irrecoverable due to economic downturns or resulting from other default factors, the bank's assets decrease, leading to potential instability. To address this, a bank might tap into its capital reserves, reducing equity and potentially affecting its ability to attract investors or respond to unforeseen opportunities. It is prudent a well-diversified loan portfolio is maintained to ensure balanced management of risk.
The assets, liabilities, and equity together constitute the essence of banking. Remember, the balance sheet follows a simple equation: Assets = Liabilities + Equity. This means everything the company owns is either paid for by the money it owes (liabilities) or by the investment of its owners (equity).
Understanding the interplay between these key elements is paramount for banks to ensure financial stability, liquidity, and sustainable profitability. An equilibrium is sought wherein the funds procured through liabilities are prudently deployed to fund assets that yield revenue.
The composition of assets can give a sense of the bank's risk profile. Higher proportions of liquid assets and low-risk investments indicate careful liquidity management. The presence of liabilities on a bank's statement of financial position doesn't necessarily paint a negative picture, as these liabilities often encompass deposits from clients. These deposits stand as a testament to a dependable funding source and the confidence clients have in the bank.
On the other hand, higher equity and retained earnings compared to liabilities suggest a stronger capital base, which enhances the bank's ability to absorb losses. From the regulatory perspective, minimum requirements are set by central banks to ensure the stability and resilience of the banking system. This protects customers from the potential negative consequences of a bank's insolvency and fosters public confidence.
While other assessments could be made of the statement of financial positions of banks, the discussed listed items and their relative numbers give a strong indication of how banks see and respond to same given their influence on the measure of a bank’s financial health and its ability to provide its primary service as a bank. I am confident you will appreciate what banks make of what represents numbers on their statement of financial position – as they mean and represent more than just numbers to them.
ABOUT THE AUTHOR
ADWOA BIRAGO NYANTAKYI is an Associate at SUSTINERI ATTORNEYS PRUC (www.sustineriattorneys.com). Adwoa specializes in Banking and Finance, Green Financing, Capital Markets, Projects, Infrastructure, and Construction, as well as Property and Land related legal matters. She welcomes views on this article via birago@sustineriattorneys.com.