Presented By:

August 16, 2016

FINANCIAL STATEMENT AND RATIO ANALYSIS

Kevin Kirksey

Principal, Strategic Solutions Group

Agenda

• Depository trends

• Strategic initiatives

• Integrated reporting

• Review financial statements

• Cover financial statement analysis– Key ratios

– Risk exposures

2

Depository Trends

• Since 1990:– Including failed banks, M&A activity has been consistent since

1990 at 3-4% per year

– Overcapacity and regulation will fuel continued consolidation

– Deal multiples have been the lowest since the credit crisis began in late 2007

– Depressed earnings at targets have created abnormalities in pricing statistics (buyers focus on tangible book value)

• From early 2013 to present:– Increasing volume of loans to assets

– Average loan yield continues to roll-down

– Declining volume of other investments and securities to assets

– Increasing volume of NMD to total liabilities

– NIM maintained through rock-bottom deposit rates

– Capital raising is expensive, buyers are reluctant to dilute their equity, and sellers do not trust distressed loan valuations

– Technological advances should improve efficiency and customer experience above competitive lending landscape

3

Depository M&A Trends – Annual M&A Volume

4

0

50

100

150

200

250

300

350

266 293 279 143 109 175 145 217 224 280 280

Bank M&A Deals

10 Yr. Average = 224

Depository M&A Trends – Industry Profitability

5

0.88% 0.94%0.85%

0.48%

-0.81%

-0.48%

0.01%

0.35%

0.53%

0.53%

0.61%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Return on Average Assets

10 Yr. Average = 0.53%

9.03%9.66%

8.06%

4.52%

-9.06%

-5.36%

0.09%

3.61%

5.27%5.23%

5.62%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Return on Average Equity

10 Yr. Average = 5.53%

Depository M&A Trends – Bank Equity Values

6

0

0.5

1

1.5

2

2.5

3

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Median Price/Tangible Book

10 Yr. Average = 1.38

0

5

10

15

20

25

30

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Price / LTM EPS

10 Yr. Average = 22.64

Dealmakers and Auditors Focus on Different Metrics?

• During the credit crisis, P / TBV became the most important metric in valuing banks as earnings were volatile, and balance sheet strength was paramount to a bank’s survival

• As we have witnessed recently, earnings have become a more important driver of bank value due to the general recovery of the banking industry

• Eventually, forward-looking earnings and earnings growth will become the dominant driver of M&A value

• We are not at that point in the cycle yet because it is still so difficult for banks to grow earnings, but if interest rates rise and the macro-economic picture brightens, forward earnings will come to the forefront of valuation

• New normal not for all sellers despite internal headaches

7

Depository M&A Trends – Core Deposit Intangible

8

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Core Deposit Intangible/Core Deposits

10 Yr. Average = 1.33%

M&A Pricing Stats – Current Market Update 2015 YTD

9

Deals By Seller's Assets # of Deals Total Assets

Tangible Equity/ Assets

LTM ROAA

LTM ROAE

NPAs/ Total

AssetsPrice/ Book

Price/ Tg Book

Price/ LTM EPS

> 1.0 Billion 23 1,814,122$ 9.38% 0.85% 8.18% 1.19% 175.25% 191.27% 22.72%$500 Million - $1.0 Billion 27 646,899$ 9.74% 0.77% 6.91% 1.32% 156.46% 154.08% 24.20%$100 - $500 Million 131 205,096$ 10.15% 0.61% 5.76% 1.30% 133.00% 131.93% 22.61%<$100 Million 99 47,496$ 10.63% 0.35% 3.07% 0.79% 109.23% 129.06% 20.99%

Deals by Seller's ROAE> 10% 57 252,328$ 9.96% 1.34% 12.85% 0.84% 154.84% 177.07% 14.92%5% - 10% 94 203,428$ 10.29% 0.74% 6.94% 1.05% 144.77% 158.91% 22.67%0% - 5% 75 145,565$ 10.65% 0.30% 2.55% 1.18% 120.20% 125.86% 42.08%< 0% 46 66,576$ 8.15% -0.62% -8.65% 3.79% 93.62% 120.53% NA

Deals by Seller's NPAs/Total Assets< 1% 121 136,243$ 10.29% 0.73% 6.76% 0.32% 146.77% 168.37% 23.29%1% - 3% 86 177,245$ 10.40% 0.60% 5.77% 1.67% 140.20% 144.82% 22.23%3% - 5% 30 126,716$ 10.06% 0.39% 3.16% 3.88% 117.79% 172.63% 25.11%> 5% 23 123,101$ 7.77% -0.72% -11.15% 8.04% 89.67% 104.01% 31.85%

Deals by RegionMid Atlantic 35 226,893$ 9.96% 0.56% 4.16% 1.26% 129.53% 146.91% 23.17%Midwest 104 122,367$ 10.15% 0.62% 5.75% 0.94% 129.55% 147.04% 19.08%Northeast 13 44,651$ 10.07% 0.33% 2.83% 0.14% 131.64% 131.64% 26.12%Southeast 62 162,792$ 10.02% 0.66% 6.53% 1.26% 129.97% 135.41% 22.12%Southwest 38 157,669$ 9.80% 0.61% 4.74% 1.37% 121.98% 158.91% 19.68%West 28 128,572$ 10.28% 0.71% 6.97% 0.34% 143.12% 147.04% 24.29%

Source: SNL Financial

Note: Based on median statistics; ex cludes priv ate equity and terminated deals

Markets and Geography Matter?

• Historically, P / TBV multiples peak just prior to a peak in the S&P 500 Index

• This M&A cycle is different with deal pricing lagging the S&P 500’s performance

– Likely due to a combination of factors, including buyer weariness of target asset values, as well as the Fed’s bond buying program, which has artificially inflated the value of equities

• Since 2000, sellers over $1 billion in assets have commanded a 40% premium over those sellers less than $1 billion

• Since 2000, sellers in MSAs have commanded a 16% premium over those banksthat were not located in a metropolitan area (i.e., rural banks)

– The difference between metro and rural banks has diminished since the credit crisis,” presumably because urban banks were hit harder by the downturn and rural banks remained more insulated

• GA, FL, and IL have been the epicenters of US bank failures, accounting for ~45% of all failures since January 1, 2008.

• The Southeast’s pricing fell particularly hard due to the housing crisis, but is slowly recovering

• The Midwest has led the way in the number of M&A transactions since January 2007 due primarily to the large number of small, community banks located in the Midwest

10

620 612 598 597 604 594

1355 1329 1304 1302 1286 1273

2083 2068 2057 2031 2014 1999

737 740 752 754 741 755

979 1007 1031 1036 1051 1055

382 402 420 442 469 488

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2010 2011 2012 2013 2014 2015Q3

# of Credit Unions Trend by Asset Class Peer Groups

Under $2M $2M-$10M $10M-$50M $50M-$100M $100M-$500M $500M+

Credit Unions by Asset Class

11

P&L Basics For Depository Institutions

• Depository institutions vs. industrial companies– Balance sheet vs. income statement

– Tangible book vs. pro forma EBITDA

• How depositories make money:– Interest spread

– Fee income

– Gain on sale of loans and securities

• How depositories lose money:– Loan and security losses

– Rate and index exposure

– Overhead

12

Strategic Initiatives

• Footprint expansion

• Market share augmentation

• Product and service enhancement

• Human capital synergies / talent addition

• Economies of scale / operational redundancy reduction

• Management succession

13

Integrated Reporting

• Peer comparisons– Capital-to-assets (surplus?)– Operating expense ratio– Cost to acquire borrower / depositor– Wallet share

• Historical trends– Normalized ROA and ROE– Loan quality

• Loan loss reserve / gross loans• NPAs / assets• Net charge-offs / assets

• Branch maps and accounting• Culture perception

– Special dividends– Corporate charity

14

Questions Directors Should Be Able To Answer

15

What does this line item mean?

Why is this item important?

Are there inherent risks in

the line item?

What is the trend of the line item?

Is this trend the intent of the

financial institution?

Accounting Methods

• Cash-basis method – record all transactions when cash actually changes hands– In order to record a transaction, payment must be received in the

form of cash, check, credit card, electronic transfer

– Does not allow credit transactions to be recorded

• Accrual method – record all transactions when they occur– Can record a transaction even if no cash changes hands, as

long as there is an agreement that cash will be transferred at a later date

– Allows credit transactions to be recorded

– Trade date versus settlement date accounting

16

Financial Statements

• We follow the “accrual method”

• Statements:– Balance sheet

• Financial position at a point in time

– Income statement • Financial performance over a period of time

– Statement of cash flows• Shows change in cash

• Sources and uses of cash

• Ties the income statement and balance sheet together

17

Balance Sheet

Assets = Liabilities + Equity

• Assets – what the financial institution is financing– Consumer and mortgage loans, investments, other assets

• Liabilities – how the financial institution is financing the assets– Deposits, borrowings and other liabilities

• Equity – what the members / shareholders own

18

Balance Sheet Example – Purchasing A Home

19

$100,000 House

$80,000 Loan

$20,000 Down Payment

Assets = Liabilities + Equity

Common Asset Types For A Financial Institution

• Cash and cash equivalents

– Cash on hand and investments with original maturities of 3 months or less

• Investments

– Brokered CDs

– Treasuries

– Agency debentures

– Agency pass-throughs

• Loans

– Credit cards

– Auto loans

– Secured and unsecured lines of credit

– Mortgages

– Commercial 20

Fixed and Other Assets

• Land

• Buildings and equipment– Depreciation expense is contra account used to allocate the cost

of the asset over the years of usage

• Other Assets– Prepaid expenses – operating cost paid for a service that will

occur in the future

– NCUSIF / FDIC

– MSR

– OREO

21

Contra Account – Allowance For Loan Loss

• Management’s estimate of probable loan losses

• Based on historical losses and analysis of loan products

Allowance for loan loss (beginning of period)

Minus Loans charged off

Plus Recoveries of past loans charged off

Plus Provision for loan loss

Allowance for loan loss (end of period)

22

Investment Security Classifications

• Trading– Intent is to hold only for the near term

• Available-for-sale (AFS)– May consider selling before maturity to meet liquidity needs or

respond to a change in market conditions

• Held-to-maturity (HTM)– Intent and ability to hold from purchase to maturity date

23

Investment Reporting

• Realized gain / loss is the gain or loss that results from selling a security

• Unrealized gain / loss is the gain or loss that results from a change in market value

• Amortized cost is the purchase price + / - premium or discount

24

Trading Available for Sale Held to Maturity

Balance Sheet Fair ValueAmortized CostUnrealized Gains / Losses flow into Equity

Amortized Cost

Income StatementRealized Gains / LossesUnrealized Gains / Losses

Realized Gains / Losses Realized Gains / Losses

Liabilities

• Deposits and borrowings– Non-maturity deposits

– Time deposits • Retail

• Wholesale

– FHLB advances / repo

– Uninsured deposits

• Accrued expense – an expense incurred but not paid– Salaries

– Benefits – 401k, life insurance

25

Equity

• Regular reserves– Minimum required reserves each financial institution must retain

• Undivided earnings– Cumulative net income that has not been distributed

• Other comprehensive income– Unrealized gains / losses on AFS securities

– Gains and losses on derivatives used as hedges

– Actuarial gains and losses on defined benefit plans recognized

26

Income Statement

Income – Expense = Net Income

• Income– Interest income

– Other income

• Expense– Interest expense

– Other expense

27

Income Sources

• Consumer and mortgage loan income (interest paid)

• Investment income

• Late fees

• Overdraft fees

• ATM fees

• Gain on sale of fixed assets

28

Expense Sources

• Interest expense on non-maturity deposits and certificates

• Interest on borrowings

• Salaries

• Employee benefits

• Building expenses– Taxes, cleaning fees, utilities

• Legal fees

• Operating fees– Advertisements, postage

• Loan loss provision expense

29

Income Statement Equation For A Financial Institution

Interest income

- Interest expense

Net interest income

- Provision for loan loss

+ Other income

- Other expense

Net income

30

Provision For Loan Loss

• Current period provision set aside for probable loan losses

• Used to transfer funds to the allowance for loan loss account on the balance sheet

• If asset quality declines and an increase in provision for loan loss is warranted, this will have a negative impact on net income

31

Financial Statement Analysis

• Financial statements– Record the financial data quickly and clearly

• Financial statement analysis– Process of reviewing the financials to gain an understanding

of the financial performance of an institution• Ratio analysis

• Peer analysis

• Trend analysis

– Supplement with narratives / footnotes

32

Key Ratio Categories

• Capital adequacy

• Asset quality

• Liquidity

• Earnings

• Operating

33

Capital Adequacy Ratio

• Net worth ratio = total net worth / total assets– Regulatory limit excludes OCI and treats mergers unfairly

– Average is ~ 9%

• Tier 1 capital ratio– (Total shareholders’ equity – goodwill – non-MSR intangibles +

qualifying hybrid securities) / risk-weighted assets (RWA)

– ≥6% = well capitalized

• Tier 1 common capital ratio– (Common shareholders’ equity – goodwill – non-MSR intangibles) / RWA

– ≥4.5% = well capitalized

– 2.5% conservation buffer and 2.5% countercyclical buffer

• Tier 1 leverage ratio– Tier 1 capital ratio / average tangible assets

– ≥5% = well capitalized

34

Asset Quality Ratios

• Delinquency ratio = delinquent loans / average loans– Delinquent loans are over 60 days past due

– Indicates potential loan losses or loan quality

– Low ratio could indicate too restrictive underwriting standards

– An increasing ratio could be an indication of a future impact to earnings

• Coverage ratio = allowance for loan loss / delinquent loans– How much does the allowance for loan loss cover the current

delinquent loans?

– Consider potential changes in accounting regulations

35

Asset Quality Ratios (continued…)

• Charge-off ratio = net charge-offs / average loans– Net charge-offs are total charge-offs minus loan recoveries

– Annualize by multiplying the charge-off ratio by 12 and divide by the months reported

– Measures net charge-offs in relation to average loans

– Indicates the effectiveness of lending / collection practices or a change in liquidated asset value

– The lower the ratio, the lower the amount of loan losses were realized on loans

– While NPAs / assets average below 2.0%, charge-off ratio average is < 0.5%

36

Liquidity Ratios

• Loans-to-assets– This measures total loans outstanding as a percentage of assets

• Loans-to-deposits– This is the ratio of total loans outstanding to total non-maturity

and time deposits

– If deposits are increasing faster than loans, this ratio would decline

• Cash + short-term investments / assets– Cash on deposit at other financial institutions

– Short-term investments is the sum of investment cash flows in the next 12 months

37

Liquidity Ratios (continued…)

• Liquidity coverage ratio (LCR) ≥ 100%– High quality liquid assets (HQLA) / projected net cash out flow

during a 30-day stress period

• Net stable funding ratio (NSFR)– Available stable funding (ASF) / required stable funding (RSF) ≥

100%

– One-year horizon with factors applied based on projected cash flow length

38

Earnings Ratios

• Total yield on earning assets = Interest income / average interest-earning assets– This calculation can be used for loans and investments– Keep in mind the loan and investment portfolio composition– Will be impacted by the market rate environment

• Earnings per share (EPS) = Net income / number of outstanding shares– How much of a company’s earnings are allocated to the

company’s outstanding equity– Historical (noise) versus estimates (fiction)

• Price-to-earnings (P/E) =Average stock price / earnings per share– How much investors are willing to pay per dollar of earnings– High multiple indicates expected future growth

39

Earnings Ratios (continued…)

• Total cost of funding =

Interest expense / average interest-bearing liabilities

Keep in mind the following:

40

Deposit Composition

Borrowings/

SwapsRate

Environment

Earnings Ratios (continued…)

• Net interest spread

Total yield on earning assets – total cost of funding– Critical to manage this spread

– A wider spread allows management to operate with more flexibility

• Net interest margin (NIM)

Net interest income / average interest-earning assets– Indicative of lending, investing and deposit cost strategies

– 3.3% is average now whereas historically > 4%

41

Earnings Ratios (continued…)

• Return on assets (ROA) = Net income / total average assets

– 1.00% used to be a benchmark, but it is likely closer to 0.85% in the current environment

• Return on assets (ROE) =

Net income / total equity– LTM, YTD, Quarterly?

– How efficiently is the institution operating?

– How much income is balance sheet generating from each dollar worth of assets?

42

Operating Ratios

• Efficiency ratioNon-interest expense / (net interest income + non-interest income)

– Measures the cost to generate each dollar of income

• Operating expenses to average assets Operating costs / average assets

– How efficiently is the financial institution using funds to provide services

• Net cost ratio(Total expense – fee income) / average assets

– Measures the cost to generate each dollar of income

43

Gauging Ratios – Is It Good Or Bad?

• Trends – Are the ratios increasing or decreasing over time?

– More importantly WHY are they increasing or decreasing?• Is it because the institution made a strategic decision

• If not, further investigation is warranted

• Peer groups– FDIC and NCUA websites

– Software available

• Look beyond ratios– Spending for future growth, e.g. human and intellectual capital

– Spending for sustainability, e.g. social capital

– Spending for customer experience, e.g. technology platform

44

Conclusion

• Basic financial skills will enable a Director to be positioned to govern the best interests of the financial institution, and therefore the institution’s customers / members

• When analyzing financial statements ask yourself:– What interest income or expenses are tied to these activities?

– Equally important, what risks accompany these activities?

– Associated risks:• Credit

• Liquidity

• Interest rate

• Reputation

– How are these risks managed?• Internal controls

• Policy limits

45