Financial Services Glossary
Amortization of Goodwill
This is an expense associated with acquisitions a company has made. Goodwill is an asset that needs to be expensed off (or written off or charged off) the balance sheet just as other assets do. Goodwill arises from the difference in market value paid for an acquired company and the appraised net asset value of that company (which falls in the neighborhood of the company's book value, or shareholders' equity).

Goodwill arises from purchase method accounting, in which a company acquires another company in a transaction other than a pooling of interests. In a pooling of interests, which is usually the accounting method chosen when two companies enter into a stock swap merger, the balance sheets of the two companies are combined with no adjustments for the value by which the merger price exceeded the appraised net asset value of the subsumed company.


In texts, a pooling of interests is sometimes described as the method used in a merger of equals, but outright acquisitions often use this accounting methodology because acquirors want to avoid goodwill amortizationexpenses in the future, which makes the income statement look better but makes no difference to actual cash flows.

Warren Buffett has said that the securities analyst and investor can live a long and fruitful life without paying attention to, or understanding, goodwill or the amortization thereof. This is especially true in the banking industry when talking about amortization expense. Most purchases of companies in the banking industry are financed with debt. The debt that is issued to cover the purchase price of acquisitions turns up on the income statement of the acquiring company in the form of interest expense. When the income statement shows the interest expense from that debt as well as amortization of goodwill, the acquirer's net income is understated and the expense of past acquisitions is overstated.

The asset of goodwill and the amortization thereon was supposed to account for the expenditure of capital to buy a set of customer relationships and assets. We want to identify how well a company has expended its resources, but we also want the financial statements to portray economic reality. As we point out above, though, the expense of buying versus building can be double-counted, which is surprisingly misunderstood by even professional investors. In addition, the level of expenses depends completely on the amortization schedule chosen by the acquiring company.

If a company has $1 billion in goodwill on the balance sheet, 100 million shares outstanding, and chooses to amortize the goodwill over 10 years, then the annual charge to earnings will be $1.00 per share. Done over 40 years, though (the maximum allowable goodwill amortization schedule according to Generally Accepted Accounting Principles (GAAP) and the Securities and Exchange Commission, the annual charge to earnings will be $0.25 per share. At 20 times earnings, that's a $15 per share difference in share prices if the market does not price the companies properly, which does happen. It doesn't make a whit of a difference on the cash flow statement of either company, though. In both cases, the net cash inflow (or outflow) of the companies in any given accounting cycle is no different, all other things being equal.

Since goodwill is not an asset against which banks can make loans or use as collateral in taking on debt themselves, it is also not a useful balance sheet account when assessing the capital strength of a company. International banking convention dictates that goodwill be entirely deducted from elements of capital for regulatory purposes. Investors would be well advised to follow the same dictum when assessing the capital strength of a company they're looking at. Market value and multiples to invested capital, earnings, tangible shareholders' equity, and other financial statement items will indicate to what degree investors believe the goodwill on the balance sheet is a worthwhile asset.

Cash Efficiency Ratio
Some banks identify amortization of goodwill expense and pull it out of their noninterest expense to calculate their efficiency ratio. Cash efficiency ratio is noninterest expense minus goodwill amortization expense divided into revenue.

Efficiency Ratio or Overhead Efficiency Ratio
A bank's efficiency ratio is the percentage of revenue that goes to all noninterest expenses. The ratio is calculated as noninterest expense divided into revenue. The calculation -- 1 minus the efficiency ratio -- is analogous to operating margin for manufacturing or services companies.

Goodwill
Goodwill arises from the difference in market value paid for an acquired company and the appraised net asset value of that company (which falls in the neighborhood of the company's book value, or shareholders' equity). See Amortization of Goodwill for a more comprehensive discussion.

Interest and Fees on Loans and Leases
Usually, this is the major component of interest income for commercial banksand savings & loans. It represents interest payments on loans and leases that a bank makes.

Interest Income
This is the first component of a bank's or financial services company's revenues. It is comprised of interest, dividends, and fees received on earning assets such as loans, bonds, preferred stock, and other interest-bearing assets. Depending on the company, interest income will be broken down by business line (such as lending, trading, and securities).

Interest Expense
The cost of funds the company borrows on a short- and long-term basis, buys in the money markets, or takes in from depositors.

Interest Income
This is the first component of a bank's or financial services company's revenues. It is comprised of interest, dividends, and fees received on earning assets such as loans, bonds, preferred stock, and other interest-bearing assets. Depending on the company, interest income will be broken down by business line (such as lending, trading, and securities).

(Interest Income on) Federal Funds Sold
These are essentially short-term and overnight loans made in the money markets. A bank sells excess reserves when it has more cash than it needs to satisfy its reserve requirements and when another bank does not have enough cash to meet its reserve requirements. A reserve requirement is a percentage of deposits, varying from 3% of certain deposits to 12% of transaction, or checkable deposits. Below a certain level of deposits, reserve requirements can vary.

These requirements are set by the Federal Reserve (http://www.bog.frb.fed.us/), and cash used to meet the requirements does not earn interest as it is kept in the bank's own vault, at a Federal Reservebank, or on deposit in a special checking account at another qualifying bank. Reserve requirements are a tool of monetary policy used by the Fed, and they are not changed very often. The term "reserve system" comes from the requirement that a fraction of deposits be kept on hand in cash to satisfy normal customer transaction needs and to quell potential panic-induced runs on the bank.

(Interest Income on or Interest Expense on) Repurchase Agreements
A repurchase agreement is another money market instrument that a bank has at its disposal. A repurchase agreement is an agreement from the borrower to buy back a note at its face value. The note is sold to the lender at a discount. The difference between the discounted purchase price and the price at which the note is sold back to the issuer represents the interest earned on the agreement. Banks and financial services companies operate extensively in the money markets because there is so much cash passing through these businesses on a regular basis.

Loan loss provisions, or Provisions for Loan Losses, or Provisions for Credit Losses
When a company makes 10,000 loans during the quarter, it knows from experience and from other data (such as macroeconomic data) that, say, one percent of those loans will go bad. It doesn't know which ones will go bad, it just knows from statistical experience that 100 of those loans will not be repaid or will become slow-paying loans. If it knew who was going to welsh on their loans and who was going to be a slow-payer, then it wouldn't make those loans and wouldn't need to take provisions for credit losses. While the excellent financial services companies have the capability to go beyond standard credit bureau reports and construct proprietary risk profiles, thus lowering their credit loss experience, it's still a fact of life that sometimes people will run into financial trouble and not perform on the loan agreement.

So, rather than waiting for the credit loss to occur, a financial services company uses its best judgment to account for those losses when the loans are made. On the Statement of Cash Flows, the provision for credit losses is shown as a non-cash charge to earnings. It is temporarily a non-cash item because the provision is taken in advance of the loss experience or event. That provision for credit losses is transferred to the company's credit loss reserve or loan loss reserve, which is a balance sheet item called an asset contra account.

An asset contra account is a valuation adjustment to assets, stated against, or contra, the value of those assets. It is a valuation adjustment that reflects what the company believes to be the realizable net present value of asset that the asset contra account underlies. It has the same effect as a liability in that it reduces the net asset value carried on the balance sheet, but it's not a liability for which the company will incur a cash expense. The cash has already left the balance sheet of the company making the loan.

Another example of this accounting regime is accounting for accounts receivable and the asset contra account of allowance for doubtful accounts for companies that sell goods or services on credit.

When a company is said to charge off a loan, this is not an income statement event. It is a balance sheet event. When a loan is charged-off, it means the company has basically abandoned hope (in an accounting sense) of recovering the loan. Though the value of the loan was reflected in the loan loss reserve, a charge-off is a firmer admission that the value probably won't be recovered. The charge-off, then, is deducted from the loan loss provision.

If a loan starts to perform to the satisfaction of the bank, it is then deducted from the provision for loan losses and added back to loans. When a previously charged off loan is recovered or partially recovered, that amount is added back to the loan loss reserve. On the way out of a recession, a bank can frequently lessen its loan loss provision on the income statement because recoveries of charged off loans build up the loan loss reserve. Also, the income statement of a bank can be considerably less burdened by provisions for loan losses on the way out of a recession because the reserves during bad times was built up to such a high degree that actual loss experience down the road is not as bad as expected.

Here are the allowance for credit loss, charge-off, and loan loss reserve activity for a particular regional bank for one quarter.

                                                 Third Quarter
                                              1997          1996
Allowance for credit losses:
(1) Balance at June 30        $123,458    $116,478
(2) Provision for loan losses    12,753          8,853
(3) Charge-offs                     (14,521)      (10,742)
(3) Loan recoveries                  2,185          3,128

Balance at September 30     $123,875     $117,717

(1) Is a balance sheet item. (2) Is an income statement item. (3) Affects both (1) and (2).

The company's reserves for loan losses is equal to 25 months of charge-offs (take charge-offs for the quarter and divide by three to get monthly charge-offs, then divide into credit loss reserves). A well-reserved bank has 9-12 months of charge-offs in its loan loss reserves or credit loss reserves. Note, also, that recoveries were $2.18 million. Reserves for credit losses were equal to 30 months of net charge-offs.

So, what comes through the income statement depends on what is shown on the balance sheet in the loan loss reserve and on the company's estimates of what loan loss activity will be. It also depends partly upon the effectiveness of the company's credit collection activities. The better the credit collection, the better the income statement will look. Of course, this all depends on how well the company is able to select desirable borrowers. You want someone who needs money but not someone who can't pay it back.

Like any other company, the interplay between balance sheet and income statement, which flows through the statement of cash flows, is very important. These statements can't tell you everything you need to know about the conservativeness or riskiness of a management team, but they can give an investor a very good starting point for assessing the financial condition of the company and the faith that can be put in the company's preparation of the income statement.

Mortgage Servicing
Once a person has taken out a mortgage and the bank has booked the revenues for originating the loan, a bank has to service the loan. This includes making sure payments are up-to-date and insurance is in-force on the property, property taxes are paid, liens are in order, and that interest and principal are passed through to holders of securities representing master trusts, which buy the mortgages that banks and financial services companies sell.
Net interest income
This is interest income minus interest expense. Net interest margin, which is the net yield on earning assets, is calculated as interest income minus interest expense divided by average earning assets:

Interest income minus interest expense
----------------------------------------------
             Average earning assets


Mathematically, it can also be calculated by:


      Interest income Interest expense
--------------------- minus -------------------
Avg. Earning Assets Avg. Earning Assets


The three components can tell you a lot about what sort of business the company is in, even if you have no idea what type of bank you are looking at. This takes some experience, but the general rule of thumb in lending and in the securities markets is the higher the rate of interest (reward), the higher

By breaking down a company's interest income and interest expense as a percentage of average earning assets, you can see the difference between the yield of earning assets and the cost of earning assets. The combination of the two is the net yield on earning assets. Unlike the income statement of a manufacturing or service company, what can be seen as an explicit expense is shown on the revenues line. The income statement of a bank is somewhat more integrated than other income statements, as a major cost of revenues -- interest expense -- is right next to interest income (a major part of revenues) on the income statement.

Net Margin
Net income available for common equity divided into revenues. This measures how much of the company's revenues make it to the bottom line. How revenues make it to the bottom line is another story, though. The company's overhead efficiency ratio, reserves for credit losses, asset turnover, leverage, and net interest margin all play a part of determining net margin and therefore need to be assessed before pronouncing a high net margin as a final arbiter of a company's quality.

Net Revenue
Net revenue is comprised of revenues minus its provision for loan losses or provision for credit losses.

Personnel Expense
If broken out, employee efficiency can be assessed by dividing this expense into revenues (net interest income before loan loss provision plus noninterest income). The lower the resulting ratio, the better.

Revenue
Revenue is comprised of net interest income plus noninterest income, before loan loss provisions. This measure of revenue is used to calculate a company's efficiency ratio.

Securitization
A bank or financial services company is said to securitize a mortgage or other loan when it sells the loan. Most large companies set up a master trust to acquire the loans. The master trust then issues its own securities called asset-backed securities, which represent claims on interest, principal, or both paid to the trust by the borrower. This allows banks to unload their assets and use the cash for other activities like making new loans or repurchasing shares or whatever.

Companies that sell their loans are now forced to recognize gains on sale of these assets by the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 125 (FAS 125). The residual asset created when these loans are sold represents the net present value of cash flows the company will receive for servicing the assets held by the trust. The creation of these excess servicing rights, which are intangible assets, is represented on the income statement as a gain on sale of assets. That income is non-cash because it represents the present value of cash to be received in the future. Those cash flows are represented in future periods on the cash flow statement and on the balance sheet as a reduction in excess servicing rights.