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Requirement
The DuPont model is commonly regarded as the fundamental tool for bank performance analysis. a. Provide a detailed diagram to illustrate all five components in the DuPont model. Each component must be defined and explained. (10 marks) b. Find data from Orbis or banks’ annual reports to calculate the components mentioned in part (a) for the four major Australian banks from 2013 to 2017. Your calculated figures are to be carefully tabulated. (10 marks) c. Based on the tabulated figures in part (b), generate a line graph for each component and conduct in-depth trend analysis and peer analysis for each component, highlighting their linkages, impact on the Return on Equity (ROE), as well as risk implications. You should present five graphs (one for each component). Your analysis must be supported with evidence from these banks’ real-word practice, actual regulatory changes, changes in market forces, etc. (15 marks) d. Forecast the trend for Australian banks’ ROE in the next few years. Provide reasons to support your arguments. (5 marks) Note: Approximately 200 words are recommended for introduction and conclusion together. Subheadings should be used to separate parts a, b, c, and d. Suggested data source for part b: Banks’ annual reports from their own websites, or Orbis Bank Focus database (access via Monash library database website, under the “Banking and Finance” tab).
Solution
Introduction
Return on Equity is one of the critical ratios that are keenly noticed by all investors who seek to invest in an organization. The paper aims to make a critical analysis of the big four banks ROE using the DuPont five-step model to have a thorough understanding of the major influencer of the ROE. A detailed five-year analysis for all the big four banks is made to understand the changes over the period and how they can be compared with their peers. Among the big four banks, CBA was generating consistent profit when compared to the peers. Besides the independent performance of the banks, external regulations play an important role and cause major influences in the business. Tightening regulations and speeding up technology innovation is causing trouble to the entire Australian banking sectors and that results in poor projections about the future ROE generating ability of the banks in the country (Global Banking Outlook, 2018). The paper makes a detailed analysis of the ROE of Australia and New Zealand Bank (ANZ), Commonwealth Bank (CBA), Westpac Group (WBC) and National Australia Bank (NAB). It focuses on the reasons that cause fluctuation to the entire banking industry.
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Body
a) DuPont Model
DuPont Model is essential and important to understand the main factor that is contributing to the ROE. DuPont model decomposes the ROE into either three parts or five parts (Ramesh, 2018). For obtaining a better understanding of the major influencing factor, the five-step model is useful. The below graph indicates the five-step DuPont model and the respective ratios and their impact on the ROE.
First important ratio is the operating profit margin. Operating profit margin ratio is determined by dividing Operating income by sales and to understand the operating profit-generating ability of the organization (Ramesh, 2018). For a good ROE, the contribution from the operating profit margin should be higher. It will indicate that profit-generating ability of the business is the main reason for higher ROE and it indicates the strong financial performance of the company. Asset turnover ratio is determined by dividing the sale by the total assets held by the organization. Asset turnover ratio indicates about the ability of the assets of the organization to generate sales. Higher asset turnover ratio is favorable for an organization because it is an indication that assets employment by the organization are good and they generate revenue which is essential for the investor to understand and evaluate. Next is interested burden ratio determined by dividing EBT by the EBIT and measures the effect of interest on the ROE. If this ratio is higher than it indicates that the borrowing costs of the company is higher and they are offsetting the ROE of the company (Ramesh, 2018).
Next is equity multiplier ratio that is determined by dividing total assets by the shareholder’s equity. It is the ratio that is mainly used for measuring the leverage of the company. Leverage is one of the important variable that results in improvement of the ROE that is higher leverage ratio increases the ROE. If the ROE is higher due to the leverage then it is not a healthy financial ratio and the company might face any solvency risks in the future. Tax burden is determined by dividing net income by the EBT to measure the impact of tax efficiency on the ROE. It will provide an outline as whether the company is paying more taxes that is resulting in lowering the ROE or less tax that results in higher ROE. Such analysis is essential for the investors to understand about the real contributor to ROE. If ROE of a company is higher due to operating profit and asset turnover ratio then it is considered to be healthy for the organization (Ramesh, 2018). If financial leverage is higher than it is considered to be risky for the company.
b) Ratio Table
Operating profit margin is the second ratio for determining the ROE. The following table outlines the operating profit margin for all the four banks from 2013 to 2017.
Panel A: Ratio 1 Operating Profit Margin = EBIT/Sales
2013 2014 2015 2016 2017
ANZ 80.46% 81.78% 80.13% 66.96% 72.79%
CBA 84.62% 85.52% 86.10% 83.29% 85.45%
WBC 82.83% 84.11% 85.29% 77.69% 79.71%
NAB 60.70% 58.05% 76.42% 69.50% 65.77%
Asset Turnover ratio is the second ratio for determining the ROE. Following table outlines the asset turnover ratio for all the four banks from 2013 to 2017.
Panel B: Ratio 2 Asset Turnover = Sales/Total Assets
2013 2014 2015 2016 2017
ANZ 0.0181 0.0179 0.0164 0.0165 0.0166
CBA 0.0185 0.0191 0.0181 0.0182 0.0180
WBC 0.0183 0.0176 0.0176 0.0181 0.0182
NAB 0.0165 0.0152 0.0130 0.0166 0.0167
Interest burden ratio is the third ratio for determining the ROE. Following table outlines the interest burden ratio for all the four banks from 2013 to 2017.
Panel C: Ratio 3 Interest Burden = EBT/EBIT
2013 2014 2015 2016 2017
ANZ 0.8843 0.9127 0.8993 0.8091 0.8893
CBA 0.9028 0.9289 0.9274 0.9110 0.9272
WBC 0.9202 0.9429 0.9381 0.9045 0.9310
NAB 0.9980 0.9992 0.9992 0.9991 0.9990
Equity multiplier is the fourth ratio for determining the ROE. Following table outlines the equity multiplier ratio for all the four banks from 2013 to 2017.
Panel D: Ratio 4 Equity Multiplier = Total Assets/Shareholders Equity
2013 2014 2015 2016 2017
ANZ 15.4365 15.6662 15.5162 15.7935 15.1896
CBA 16.5548 16.0382 16.4823 15.4052 15.3238
WBC 14.7484 15.6240 15.0636 14.4240 13.8873
NAB 19.3554 18.4374 17.2041 15.1361 15.3619
Tax burden ratio is the second ratio for determining the ROE. Following table outlines the tax burden ratio for all the four banks from 2013 to 2017.
Panel E: Ratio 5 Tax Burden = Net Income/EBT
2013 2014 2015 2016 2017
ANZ 69.63% 70.65% 71.27% 69.94% 66.70%
CBA 71.71% 72.10% 72.03% 71.94% 71.37%
WBC 69.84% 71.00% 70.67% 70.09% 69.45%
NAB 66.31% 68.08% 67.18% 3.98% 61.06%
ROE of All the Four Banks:
ROE: (Net Income/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Total Assets) x (Total Assets/Shareholders Equity)
2013 2014 2015 2016 2017
ANZ 13.88% 14.78% 13.09% 9.87% 10.87%
CBA 16.76% 17.53% 17.14% 15.26% 15.62%
WBC 14.36% 15.45% 14.96% 12.82% 13.04%
NAB 12.82% 11.06% 11.51% 0.70% 10.30%
c) Analysis
The operating profit margin of ANZ was fluctuating between 2013 and 2015, but there was a sudden fall in the margin in 2016, and there is a slight improvement during 2017. The main reason for the decrease in the operating income during 2016 decreased in other operating income which is mainly due to impairment of an investment in the AMMB Holdings, Berhad, as an initiative to make a strategic repositioning in the industry (ANZ, 2016). CBA’s operating profit margin is maintained stably by the bank as there was continuous improvement in the sales and profitability of the business without more fluctuation. The inclusion of some positive infrequent items in 2015 boosted the profit for WBC, and that disclosed a sharp decline in the profit during 2016 (Westpac, 2016). There is no significant reason for the fluctuation in WBC over the period. In case of NAB, similar to CBA there is consistency in the ratio. Except ANZ other banks were stable over the period CBA is highly profited generating bank.
The asset turnover ratio for ANZ was higher during 2013 and 2014 when compared to the other period. There was a significant decrease in the asset turnover ratio of the company during 2015, and the bank maintains at the stable level from that period. Changes in the minimum total capital to a minimum of 4.5% in CET 1 capital and there is an additional Tier 1 capital with a minimum of 1.5%. Tier 2 capital requirement’s minimum requirement is about 2% that has an impact on the overall return generating ability of the bank (Majcher, 2015).It is one of the main reason for all the banks to have lower asset turnover ratio. In case of CBA, the asset turnover ratio is maintained almost stable over the period. There is a continuous and slight improvement in the asset turnover ratio of WBC. Due to discontinuation of operations for NAB, there were fluctuations in this ratio during 2015. Overall regulations have a strong impact on this ratio.
Operating expenses increased by $1,044 million during 2016 for ANZ that is due to repositioning and restructuring expenses, which results in lower earnings before taxes and operating profit for the company resulted in a decrease in interest burden during 2016. CBA is making their interest burden ratio stable over the entire period. WBC change in interest burden is due to the inclusion of abnormal items during 2015 in the financial statement. NAB has stable interest burden and is comparatively higher than the peers followed by WBC and CBA. ANZ has fewer interest burdens.
As per the Basil III requirement, there are more changes and restrictions brought to the capital requirement and level of leverage held by the banks. According to Basil III, bankers should report about the financial leverage to the public and the regulators. Restriction in the financial leverage from 2013 over the banks has resulted in almost stable or even decreasing trend noticeable for all four banks (Majcher, 2015). Due to the changes in regulation all the banks disclosed similar fluctuation in the financial leverage over the period and for WBC and NAB there is a reduction in the leverage. WBC has the least leverage when compared to other peers, and financial leverage is the major driver of ROE for all banks.
The decrease in the earnings of the company will reduce the overall tax burden, and it will reduce the implication of tax on the ROE similar to that of ANZ during 2016. CBA does not disclose more fluctuation in the tax burden ratio over the period similar to WBC. NAB’s tax burden has decreased mainly due to the fall in the net income during 2016 mainly due to discontinued business operations (NAB, 2016). CBA and WBC has stable tax burden due to stable net income generation when compared to ANZ and NAB.
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There is a transition in the entire banking industry that reduces the reliance on market power and housing price to financial stability and addressing community issue will decrease the ROE for banks. Increasing price competition in the housing market requires Australian banks to be prepared for facing those challenges (Jacobs, 2018). Disruptive innovation in managing the payment and other financial transactions will build up the pressure on bankers in the country and will have an adverse impact on the ROE. There is an increase in the increased scrutiny provides downside risks related to legal and regulatory requirements for the banks affecting their strategic focus from generating revenue. According to Morgan Stanley’s report, Westpac bank has a lower level of executive risks and uncertainty which will provide an advantage to them in managing the ROE when compared to the peers (Jacobs, 2018).
Change associated with the innovation that is 70% of the banks will be forced to invest in innovative technology to retain their competitiveness which will pull down the ROE of the banks (EY, 2018). There will be a deviation in the investment made by the banks towards technology which may or may not generate a required return is resulting in poor ROE projections for the banks. Changes in regulatory priorities and handling reputation risks is a major challenge for the banks, and it is expected to have a negative impact on the future ROE. Thus, future banks ROE is projected to decrease
Conclusion
Analyzing various factors contributing to the ROE is essential to ascertain whether the financial performance and position are good for the banks are not. There are changes in the regulatory requirements. Especially, after the introduction of various restrictions in the liquidity and capital maintenance by Australian Prudential Regulatory Authority (APRA), there is an increase in the level of capital, but there is no complementing return on equity because of various restriction to the bankers (RBA, 2017). It has eventually increased the level of capital in the balance sheet with very slow movement into profitability resulting in decreasing trend in the ROE for all the banks and higher fluctuation in the ROE during the last few years. Operating profit margin and financial leverage is the dominant contributor to the increase in the ROE for the banks. But overall ROE of all the banks are better and among all CBA generate higher ROE when compared to their peers. There are changes in the regulatory requirement and growth in the technology that are causing challenges to the banking operations and posing a threat to them. It is resulting in challenging the future performance of the bank. In Australia, the short-term prediction about the banking sector is negative.
Reference
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ANZ (2016). Annual Report. [online] Available at: http://shareholder.anz.com/sites/default/files/anz_-_annual_report_2016.pdf [Accessed 22 Apr. 2018].
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EY (2018). EY Global Banking Outlook. [online] Available at: http://www.ey.com/Publication/vwLUAssets/ey-global-banking-outlook-2018/$File/ey-global-banking-outlook-2018.pdf [Accessed 22 Apr. 2018].
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Global Banking Outlook (2018). Global banking outlook 2018 Pivoting toward an innovation-led strategy. [online] Available at: http://www.ey.com/Publication/vwLUAssets/ey-global-banking-outlook-2018/$File/ey-global-banking-outlook-2018.pdf [Accessed 22 Apr. 2018].
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Jacobs, S. (2018). 5 challenges facing the big four Australian banks in 2018. [online] Business Insider Australia. Available at: https://www.businessinsider.com.au/5-challenges-facing-the-big-four-australian-banks-in-2018-2018-1 [Accessed 22 Apr. 2018].
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Majcher, P. (2015). Increased Bank Capital Requirements: Neither Panacea nor Poison. Procedia Economics and Finance, [online] 25, pp.249-255. Available at: https://www.sciencedirect.com/science/article/pii/S2212567115007352.
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NAB (2016). Annual Report. [online] Available at: https://www.nab.com.au/content/dam/nabrwd/About-Us/shareholder%20centre/documents/2016-annual-review.pdf [Accessed 22 Apr. 2018].
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Ramesh, M. (2018). DuPont Analysis of Axis Bank. Asian Journal of Management Research. [online] Available at: http://ipublishing.co.in/ajmrvol1no1/volfive/EIJMRS5233.pdf [Accessed 22 Apr. 2018].
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RBA (2017). How Have Australian Banks Responded to Tighter Capital and Liquidity Requirements? | Bulletin – June Quarter 2017 | RBA. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/publications/bulletin/2017/jun/5.html [Accessed 22 Apr. 2018].
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Westpac (2016). Annual Report. [online] Available at: https://www.westpac.com.au/content/dam/public/wbc/documents/pdf/aw/ic/2016_Westpac_Annual_Report [Accessed 22 Apr. 2018].
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