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Liquidity and profitability ratios are used by managers, investors, creditors where multiple techniques are used to reveals the company and its operations.
Several banks and lending firms use the statistical procedures to analyze firms’ financial ratios and based on the analysis that tells about profitability and risk of financial distress, they can classify them.
PPOP provides the estimation related to the capital the bank expects to have left for the operating profit once the cash outflows to defaulted loans are estimated.
The pre-provision operating profit or PPOP will be less once the bank deducts the dollar amount of bad debts provision.
The ratio analysis method is extremely useful for narrowly focused organizations having large multidimensional setup.
It is useful in situations when inflation distorts the firm’s balance sheets.
There are a few things one needs to keep in mind about such ratios. The comparative analysis of the different firms should be interpreted carefully to conclude.
A ratio is just a number that is divided by another and is considered unreasonable to expect the mechanical calculation of one ratio or several, which will automatically provide insights into the firm.
These ratio analysis methods can be misleading unless appropriately combined with other knowledge related to the company’s management and economic situations.
It can be used by large companies to operate several different activities in different industries and develop a meaningful set of industry averages for comparison purposes.
Provisioning for loan losses goes into the bank’s profit. During the 2008 -2009 financial crisis, the banks did not see the major crisis.
RBS reported a loss in 2008 due to impaired securities and the total impairment charges jumped from 6% of pre-provisioning income in the previous year to 29% in 2008 and it continued to increase in the next two to three years.
Banks perform portfolio asset management by evaluating loans outstanding with different customers at one time and it is a matter of time before the customer defaults on their loans.
It will be inaccurate for banks to consider the entire operating profit as income, hence, they report the operating income as PPOP to allow investors to get a better insight about bad debts that are still to be incurred and reduced from the bottom line profits.
Provisioning, capital needs, and liquidity risk for banks can be ascertained through the bank by bank quality review that looks into individual bank loan portfolios and the account provisions and the capital held by each bank.
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