Table of Contents
Let’s discuss about cost of liabilities. Ever wondered how do the banks provide loans to so many individuals and businesses and what might it cost them for the amount they lend to you? Well, banks also borrow money other than the deposit it collects. Let’s find out how to determine the cost of funding for banks.
Banks have a unique business model. They earn income from the money that they lend to the public. On the other hand, the interest payments on the deposits form a major part of its operating expenses. Thus, a bank considers deposits as the liabilities as there is a cost that is the interest that they have to pay on these deposits.
Importance
The banks also need funds in order to function properly. For that, it needs to borrow other than the deposits that it receives.
These borrowings are usually from the Central Bank or the (RBI), other institutions, other banks or Bonds, etc.
Any type of borrowings carries an interest component which needs to be paid at regular intervals without fail. This interest component which a bank needs to pay is said to be a part of the Cost of Liabilities.
As a bank is involved in a lot of borrowing and lending, it is important to have an idea of how much does it cost to borrow. A bank has the option to borrow from various sources, so it also needs to consider that how much cost will it incur if it borrows from a certain source. This determines the final interest costs and hence the cost of liabilities.
See also: Return on Capital Employed (ROCE)
Impact
Cost of Liabilities helps an investor to get an idea as to how much is the borrowings costing to the banks. It reflects the effective rate a company pays on its debt. A bank may use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid by the Banks or NBFC’s.
For a business to be profitable, it is important to keep the costs under control and as low as possible. For a bank, the majority portion of the liabilities is interest expenses which needs to be paid on its borrowings.
Lower the cost on the liabilities, the better it is for the banks as it will increase the margins and hence increase the profitability. A high cost of liability is generally considered bad for a company as it will reduce the margins and also increase the interest paying obligation of the company.
Cost of Liabilities (%) Formula
Now let’s have a look at the formula for calculating the cost of liability.
Cost of liabilities (%) = Total interest on all borrowings and deposits X 100
Total borrowings and deposits
For Example
Let’s take the example of ABC bank which has Rs. 10,00,000 loan with 8% interest rate and deposits of Rs. 1,00,00,000 with 4% interest rate. Then,
Cost of liabilities (%) = [ 8% of 10,00,000 ]+ [ 4% of 1,00,00,000] / 1,10,00,000 X 100 = 4.36%
Thus, the Cost of Liability for ABC bank is 4.36%.
We can see from the HDFC bank that the Cost of Liability for it has come down from 5.63% in FY14 to 4.49% in FY18. This is a good sign as the company has been able to reduce its interest-paying obligations as a percentage of its total liabilities, which ultimately reduces the cost for the bank. This ultimately reflects in the company’s profit margins.
StockEdge App
Nowadays we don’t have to calculate the cost of liabilities (%) on our own. StockEdge gives us the cost of liabilities (%) of the last five years of any company listed in the stock exchange. We can look and compare the cost of liabilities (%) of any company and filter out stocks accordingly.
Suppose we want to look at cost of liabilities (%) of HDFC Bank Ltd. for last 5 years then in the Fundamental tab of HDFC Bank Ltd., click on the fundamentals tab, we will get Ratios tab. Then in the Ratios tab click on the Efficiency Ratios, we will get cost of liabilities (%) of HDFC Bank Ltd.
See also: Cost to Income Ratio (%)
Bottomline
Cost of liabilities (%) is an important measure which needs to be kept a track of because borrowing cost forms a major component of the overall cost of a bank. It can be compared with the peer companies as to whether the cost is high or low compared to the other industry players. With a click of a button, you can see the comparison of a company’s cost of liabilities(%) for five years.
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