Banks' financial statements differ in a few significant ways from commercial entities that sell tangible products. We've looked at examples for manufacturing entities in the article, Understanding Income Statements and Balance Sheets for Non-Accountants. There's been a lot of news about federal bailout money going to the financial services industry, so I thought we might want to understand some of the types of information the banking industry, Congress and the Administration are looking at. This article is going to focus on the Income Statement and Balance Sheet.

There are usually four items of most interest on a bank's income statement. They are:

•1. net interest income which is similar to a commercial entity's sales or revenues.

•2. net interest expense which is similar to a commercial entity's cost of goods sold/cost of sales.

•3. provision for credit losses

•4. net income

A bank's main revenue generating activity is making loans, and earning interest on the money they've loaned homeowners for their primary residence and vacation home and to commercial developers for building houses or skyscrapers and shopping malls. Interest and principal payments are received every month, so there is no accounts receivable like you would see in a commercial manufacturing entity's balance sheet. Loan interest is the largest category within net interest income.

Another large category within net interest income is the interest earned on cash that a bank has not loaned. Banks usually invest in interest earning securities of the U.S. Treasury. Banks also have access to interbank funding and will invest in very short term instruments such as federal funds sold and securities purchased under agreements to resell also known as repurchase agreements.

A bank's largest expense is usually the interest it pays on the cash it has received from depositors. Another large category within net interest expense is the interest paid on short term financing specific to the banking industry including commercial paper, federal funds purchased, and securities sold under agreements to repurchase also known as repurchase agreements.

The difference between net interest income and net interest expense is the net interest margin. This is similar to the gross margin for a commercial manufacturing company.

The net interest margin may also be expressed as a percentage, and typically follows the trends in the general interest rate environment.

There may be significant non interest income associated with fees earned on other services the bank provides such as credit card income, investment banking income, and mortgage banking income.

The next significant item on a bank's income statement is its provision for credit losses. This is the income statement side of the allowance for loan and lease losses on the balance sheet. This is the line item where you'll see the millions of dollars in loan losses (and billions for the larger multinationals). A bank is required to evaluate its loan portfolio by assigning default risk to specific loans or to pools of loans based on their risk profile. The definitions vary from bank to bank, but characteristics such as payment history, current economic conditions, industry trends, and geographic concentrations are some of the items analyzed by banks to evaluate its loan portfolio. Depending on how risky a loan is deemed, an estimate of loss is made, and the allowance is accrued to recognize potential losses. Actual write offs are applied against the allowance.

There are footnotes that are part of the financial statements that go into more detail into the loan portfolio's composition as well as more information regarding the loan allowance.

Congratulations, you've just grasped the concept of how an item on a bank's income statement affects a bank's balance sheet item, and what kind of information is contained in a bank's footnotes to the financial statements.

Now let's take a closer look at the balance sheet. Banks have other financial differences that should be understood. Average balances are much more important to banks for analysis than they are to commercial entities. Let's look at an example.

Let's say our bank has two loans at the end of last month recorded on the balance sheet at $50 million. One loan was for $20 million, and the other for $30 million. Interest income on loans increased $2.5 million from period to period. At the end of this period, loans on the balance sheet equaled $30 million.

If interest income increased, why didn't the loan balance? What happened was our $30 million loan was fully paid off before the end of the reporting period. In our example, the average loan balance was $49 million ($50 million for 29 days, and $20 million for 1 day). So on an average balance of $49 million, we earned interest for the period of 5% ($2.5 million interest/$49 million). Therefore, we needed to know the average loan balance to make sense of the increase in interest income and the decrease in the loan balance.

Deposits can be similarly analyzed.

Now take a look at your own bank's balance sheet and income statement or the balance sheet and income statement of a bank that's received bailout money. Congratulations! You've got the basic concepts of how to read a bank's balance sheet, income statement, and how the income statement interacts with the balance sheet.