NBFC Compliance

NBFC Evaluation: Key Performance Metrics to Check in an NBFC

Both NBFCs and Banks are involved in the business of lending and makes profit through lending. Compared to any other financial institution’s evaluation, an NBFC^[1] Evaluation is considered most technical. Various tools like CAGR (Compound Annual Growth Rate), DuPont Analysis,PEG Ratio (Price Earnings to Growth Ratio), Enterprise Valuation Model and other ratios are used for NBFC evaluation.

What is NBFC Evaluation?

NBFC valuation is carried out to access the financial performance of the NBFCs on a sustainable basis as potential investors have aversion towards investing in NBFCs due to their fear on the quality of the lending book.

Key Metrics for NBFC Evaluation

Some of the key metrics discussed in the blog for NBFC Evaluation are following:

Asset Quality

RBI introduced the asset quality review to recognise stressed assets on books of account. This review applies to both Non-banking Financial Companies and Banks.The quality of credit risk management system presents an accurate picture and analyses the quality of assets (maturity profile of an asset).An asset consists of loans, advances and purchased bonds through investments etc. In a highly competitive market, some NBFC dilutes the underwriting and standard collaterals; hence the quality of the assets decreases steadily. The factor contributing to the maximum growth potential of the Return of Equity is identified by DuPont Analysis.

Revenue

NBFC borrows money from one institution (generally banks) and lend it to other businesses/NBFCs at a higher interest rate. NBFCs earn interest-based and non-interest income; the interest income is significantly higher than non-interest income (from loan processing fees). If Return on Assets improves significantly, revenue generation improves at the same rate. Revenue are calculated when lending rate (portfolio yield) is multiplied by the size of the assets under NBFC’s management.

Liquidity Profile

A liquidity deficit can lead to the company’s failure. In adverse times, NBFCs having strong liquidity can easily absorb the risk of a finance crunch.NBFCs use internal and external sources to meet the requirements of funds. NBFC faces a higher risk of liquidity crunch due to their association with poor quality of assets and asset-liability mismatch. The maturity profile of assets and liabilities is a significant factor in a company’s liquidity, and a prolonged mismatch in the maturity of respective assets and liabilities can create big problems. The liquidity risk is examined by reviewing the NBFCs liquidity policy, recovery efficiency, and the assets and liabilities maturity profile (ALM) and estimating the proportion of liquid assets to total assets.

Net Interest Margins

A net profit margin ratio is a ratio that measures profitability to the amount of net income earned with each rupee of sales executed. The Net profit margins present the cost efficacy of an NBFC, and a higher net profit margin will indicate that sales are converting into actual profits.

Gross Non-Performing Assets (NPA)

This matrix tell us about how well the books of account are maintained and performing. It illustrates the NBFC’s lending eligibilities and standard of loan recovery mechanism. Any default in payment of interest and principal which remain overdue for 90 days is considered Non-Performing Assets (NPA). It reflects the condition of the bank’s loan books. Banks have further classified NPAs into Substandard Assets(≤ 12 months), Doubtful Assets (remain substandard for 12 months) and Loss Assets.

Capital Adequacy

An NBFC’s capital provides protection to borrowers (earnings being the first), and therefore, its capital adequacy which consists risks related to credit, market, and operations are an essential consideration for evaluation ratings. The product riskiness and classification of the portfolio has a significant impact on the amount of funds required to achieve the desired degree of protection to NBFCs’ borrowers.

Profitability

The NBFCs profitability gives an accurate picture of NBFC’s financial health. The evaluation is based on the extent of interest based income which is calculated with the amount of yield on the product and cost of funds. To increase the profitability ratio strategic changes are to be made in the liquidity position, regulatory framework and financial flexibility of an NBFC.

Strength of NBFC

NBFC’s strength lies in its capacity to grow while maintainingrisk-adjusted returns and continuous earnings, thereby facilitating the projection of NBFC’s future financial performance. NBFC has a significant market share in the financial sector, which could be beneficial in the long run.

Adaptability

Changes in the business environment always lead to changes in the functioning of the organisation. The assessment of adaptability involves NBFC’s financial position, dependence on the outsourced services and management restructuring, and market change (demand and supply) regarding the growth plan and future projects.

Risk Management

Here VCFO analyses the risk management structure of the company and different policies framed to mitigate the risk. A standard examination of the debt recovery framework, prudential lending standards, interest rates, and foreign exchange risk is executed to evaluate credit risk management. The interest rate risk arises from different assists and liabilities and an imbalance between fixed and floating assets and liabilities. A foreign risk results from the difference in the currency denomination of assets and liabilities. Virtual Chief Financial Official keeps a consistent check on compliance, and guidelines issued by RBI are adhered to in letter and spirit.

Benefits of NBFC Evaluation

Some of the following benefits of NBFC Evaluation are:

• Better Knowledge and Understanding of Company Assets;
• Understanding of Company Current Valuation and Projected Valuation;
• Assistance during a takeover of an NBFC and Merger & Acquisitions and;
• More Access to Potential Investors
• Fundraising

Conclusion

From the above, we can state that these different performance metrics are significant in evaluating NBFC. These NBFC evaluation reports are crucial for NBFCs to raise capital through various institutions. The potential investor takes this evaluation report very serious in terms of asset quality and revenue generation. However, an investor who is not risk averse can prefer NBFC with better performing key markers.

Read our Article: What is a Non Banking Financial Company (NBFC)?