Checks to perform before investing in bank FD
When we start earning, most of the parents and grand-parents advise to open a PPF account and Fixed Deposit (FD) with banks. No doubt, they are fascinated with investment in FDs as in their time FDs were able to beat inflation. However, in our age, with the falling interest rates, it is not possible to beat inflation with post-tax returns on FDs.
These days, we have seen even institutions filing for bankruptcy. In order to boost a confidence among retail investors, Finance Minister in the Union Budget increased the depositor’s insurance amount from Rs 1 lakh to Rs 3 lakh. One thing to remember is that, this coverage is across bank FDs and not for each bank FD. Therefore, if you wish to invest in bank FDs then, here are a few checks that you need to do before investing in it.
Profitability Ratios
Profitability ratios help to understand the ability of the bank to generate revenue in order to cover their costs. If the bank is consistently failing to cover its cost, then it’s an alarming sign. Following are the profitability ratios to check:
1. Return on Asset (ROA) is calculated as net income (loss) divided by the total assets. This ratio helps us to understand how profitable are the total assets of the bank.
2. Return on Equity (ROE) is calculated as net income (loss) divided by equity. This ratio shows how profitable is equity of the bank.
3. Interest income on loans is calculated by dividing interest income on loans by gross loans. This ratio helps to understand how profitable are gross loans of the bank.
Capital Adequacy Ratio
This is one of the key ratios to check before investing in bank FDs. Capital Adequacy Ratio (CAR) measures the capital available with the bank. This is usually used to protect depositors. It is calculated by dividing the sum of Tier 1 and Tier 2 capital by risk-weighted assets.
Tier 1 capital is something that can absorb the losses without a need for the bank to cease its operations. Tier 2 capital is something that can absorb the losses in an event of a winding-up and thus, provide a lesser degree of protection to depositors. Risk-weighted assets help to determine the minimum amount of capital that a bank must hold to reduce the risk of insolvency.
As per Basel III, the minimum CAR that bank must maintain is eight per cent. The minimum CAR including the capital conservation buffer is 10.5 per cent. Reserve Bank of India (RBI) prescribes minimum CAR of nine per cent.
Liquidity Ratios
At any point in time, liquidity is one of the major things that banks should maintain in order to provide for any withdrawals. These ratios examine the ability of the banks to meet its short-term obligations. Following are the liquidity ratios that you should check before investing in bank FDs:
1. Short-term funding ratio is calculated by dividing liquid assets by short-term funding. This answers the question of whether the bank has sufficient liquid resources to face short-term debt.
2. Loans to deposit ratio is calculated as loans divided by deposits. This ratio must be lower than 100 per cent.