Last week in my financial literacy series for credit unions, I got us warmed up with some commonly used and easily confused acronyms (looking at you, ALM/AML/ALLL).
This week we will be taking a look at the basics of financial statements. What their function is, what they can tell you about your organization, and how to read them.
At their most basic understanding, financial statements are the reports that provide important financial accounting information about your credit union or CUSO. Remember GAAP, or Generally Accepted Accounting Principles? These standards are what govern how credit unions prepare their financial statements so that interested parties can easily read and understand them.
The balance sheet
Your balance sheet is essentially a slice in time of your organization’s finances. It tells you about the assets you own and the liabilities owed. There’s a very common formula for accountants as they look at a balance sheet: assets have to equal liabilities plus equity.
When evaluating line items on a balance sheet, it’s a very good practice to compare the current balance to prior periods. That enables you to detect any trends, positive or negative, to be followed up with research.
What constitutes an asset?
An asset in its simplest form is something you own. It is a tangible or intangible economic resource.
The credit union has different types of assets, some earning and some non-earning. One of the most important categories to consider is the ones you earn from, your earning assets. Those would be loans and investments. Generally speaking, loans are the highest earning assets the credit union holds on its balance sheet.
Some examples of non-earning assets would include fixed assets (e.g. your branch), prepaid expenses (e.g. the insurance on that branch), and accrued income (e.g. interest accrued on loans not yet paid).
You might be thinking “wait, how can insurance, an expense, be considered an asset!?” The keyword here is “prepaid.” If, for example, you pay for a 12-month insurance policy all up front, you’ve paid for a future benefit. As those benefits are realized (i.e. each month of coverage), a corresponding entry is made between the insurance expense and the prepaid insurance.
A credit union’s liabilities
When you think liabilities, it’s a simple term to understand: you owe somebody something. How do you pay off your liabilities and how do you settle? You use cash and other transfers of assets. Liabilities are simple. They’re bills. Pay them!
As a liability is defined as something you owe, shares and deposits would be considered liabilities. They are not equity in a credit union. So said the American Institute of Certified Public Accountants back in 1987, prior to which shares were considered equity. And it makes sense when it comes down to it, members deposit shares, but at any time they can ask for those funds back.
NCUA hemmed and hawed about the change, as they had chosen to follow regulatory accounting principles (RAP) instead of GAAP, but eventually did go along with the guidance. Nowadays shares are considered a liability the vast majority of the time, but for certain ratio calculations, shares can be included in equity. As such, shares and deposits exist in this gray area between liabilities and equity.
Equity, or net worth, represents the total accumulated earnings that have not been distributed to members as dividends. It is commonly broken down into retained earnings and capital.
Going by the NCUA’s definition:
“A credit union’s capital is defined as the total of its regular reserves, allowance for loan and lease losses, special reserves, undivided earnings, accumulated unrealized gains or losses on available-for-sale (AFS) securities, and that portion of year-to-date net income that has not yet been closed to the appropriate capital account. Capital accounts provide (1) a cushion for anticipated and unidentified losses, (2) a base for future growth, and (3) a means by which the credit union can meet competitive pressures as they arise. Capital provides the credit union a cost-free source of funds.”
Credit unions with a strong net worth have a little more liberty to assume risk than those with weak net worth. As the primary measure of a credit union’s financial strength, it’s important that credit unions manage their net worth (to assets) ratio. A net worth ratio of 7% or higher is considered “well capitalized” and 6% is considered “adequately capitalized.” But if you’re thinking more is better, credit unions can go overboard and be considered “over-capitalized” which can also harmful to members’ interests.
Unfortunately, this simple ratio isn’t the only one credit unions need to care about anymore. With NCUA’s decision to move forward with the new Risk-Based Capital Rule, credit unions will also need to perform a second, more complex calculation. A credit union that is considered “well capitalized” will need to have a 10% RBC ratio on top of their 7% net worth ratio.
The income statement: revenue and expenses
While the balance sheet provides a lot of useful information about the current state of your credit unions financials, when comparing two months it won’t do a good job of explaining how you got there. Cue the income statement.
The income statement shows the organization’s profitability for a given period, comparing revenue with expenses. For a credit union, income will typically include interest from loans, investment income, members fees and charges (e.g. NSF, minimum balance, delinquency, etc.), and other operating income. Expenses typically include operating expenses, the provision for loan loss, and dividends on shares).
When it comes to a credit union, net income is the income earned minus operating expenses. The net interest income is the difference between the interest earned on your loan and investment portfolios and the interest made to members on the shares and deposits. That income is then used to pay the operating expenses of the credit union.
If you recall from last week, the Allowance for Loan and Lease Loss is a reserve against loans that may not be repaid. This is considered a contra-asset found on the balance sheet. To fund that reserve, we debit or expense to the Provision for Loan Loss account on the income statement.
Wrapping up and sneaking a peak at next week
Hopefully these basic descriptions of the balance sheet and income statement will help in translating all those numbers on the page to meaningful insights about the performance of the credit union and where any shortfalls may lie.
Next week, I’ll be taking a look at some key ratios and statistics that credit union executives can benefit from understanding, such as growth of loans/assets/members/etc., net interest margin, delinquency ratio, and more. Useful information that isn’t just for board members and C-suite staff!