There are as many ways to perform financial analysis as there are market analysts, and the time invested in it has an associated cost, regardless of whether you are aware of it. Therefore, the question is: What is the best way to carry out this process? One option is to use a principle that is used in rescue agencies, focusing first on key indicators that consider the critical areas to be assessed. In this way, the process becomes more efficient and effective.
The similarity between the ABC of rescue corps and CAMEL analysis
Methodologies that seek to define key indicators have been used in many professions. For example, in the world of medicine, rescue forces use what is known as the ABC’ (i.e. airway, breathing, and circulation) to care for a patient at first contact. These three initial steps seek to increase the chances of recovery for anyone in need of first aid. It would be very expensive for the patient to spend time taking his or her body temperature if he or she is not treated for respiratory distress first!
Similarly, methodologies have been developed in the financial world to optimize analysis and reduce the costs involved. For example, when evaluating companies, some analysts use the DuPont analysis to study the return on equity (ROE). This index focuses on net operating income, asset turnover, and financial leverage to assess the company’s performance.
But can we use the same variables in the analysis of financial institutions? The answer is no. The nature of the business is different, so it requires other indicators that allow “taking the patient’s pulse”.
CAMEL: a photograph of the financial situation of a bank
One of the traditional methodologies for the analysis of financial institutions is known as CAMEL (i.e. capital, assets, management, income, and liquidity). While this describes critical areas to consider, the tool is even more useful when associated with a simple structure of financial statements, as it helps to better identify some key indicators that explain profit generation.
This formula provides a quick snapshot of a bank’s financial situation by looking at five financial indicators that relate directly and indirectly to the critical areas of the CAMEL methodology, starting with: i) Net Income; ii) Provisions for Losses; iii) Administrative Expenses; iv) Interest Income and v) Financial Expenses.
While a complete financial analysis usually takes several hours, these financial ratios serve as a first step to getting an overview of the bank in a few minutes. It allows the analyst to focus his or her attention, in a first stage, on key indicators that explain the capacity to generate profits, in order to then investigate more deeply the areas that attracted his or her attention.
It is common to find analyses saturated with descriptions and explanations of the behavior of a large number of financial ratios, which can be confusing in the end. Also, there may be isolated cases, where a variable that escapes from the detailed analysis ends up explaining the significant change in profits.
Spending many hours on an analysis is no guarantee that everything relevant has been considered and it should be borne in mind that this has an associated financial cost. An alternative is to start with the financial indicators presented here and adjust them as experience shows others that better explain how the entity generates profits. Any effort to identify these key indicators, in the respective critical areas, will result in greater efficiency and effectiveness of the analyst, as well as improved diagnosis and prescription of the actions to be taken.