Banks and other lending institutions lend money to individuals and businesses. A borrower pays back a loan along with interest in periodic payments over the term of the loan. However, some borrowers may fall behind on their payments, making the loan delinquent. If a loan stays delinquent for too long, the bank charges it off as an uncollectible loan. The net charge-off ratio indicates the performance of a bank's loan portfolio.
The net charge-off ratio is the ratio of the net charge-offs to the average outstanding loans. The net charge-offs of an accounting period are equal to the loans charged off during the period minus recoveries, which are partial or full payments from customers on loans that the bank had charged off in previous accounting periods. One way to calculate the average outstanding loan balance is to add the beginning and ending loan balances and divide the result by two.
The accounting for a loan-loss provision involves recording it in loan loss expenses, which is an income-statement expense item, and in allowance for loan losses, which is a contra asset on the balance sheet. A contra asset has a negative balance that reduces the value of loan assets. Loans to customers are assets on a bank's books because they represent future cash inflows, similar to accounts receivable for a retail store. When the bank charges off outstanding loan balances that it deems uncollectible, the accounting process is to remove the amounts from the loan and the loss allowance accounts.
The net charge-off ratio is one of the financial ratios that indicate the quality of a bank's loan assets. A high charge-off ratio relative to previous periods or to other banks in the industry could be a cause for concern. In addition, the charge-off ratio does not include the cost of recovery, such as the costs of following up with delinquent customers and pursuing legal remedies. During recessions, charge-off ratios tend to rise as people lose their jobs and are unable to make their loan payments.
Financial ratios, such as the net charge-off ratio, allow investors and credit analysts to evaluate the financial performance of a bank relative to its peers. However, in a research note on its website, Canadian credit rating agency Dominion Bond Rating Service notes that finding true peers is difficult because banks typically have different business lines and use different accounting procedures. Ratios do not provide qualitative information, such as why the charge-off ratio may have increased from the previous period.