The cost-to-income ratio is a key financial measure, one which is mostly used when valuing banks. It shows a company's costs as a proportion of its income. Calculating the ratio is straightforward. You simply take the bank’s operating costs (this includes administrative and fixed costs, such as salaries and property expenses, but not bad debts that have been written off, for example). You then divide this number by the company’s operating income (which is simply turnover minus operating costs).
Here’s the equation:
Operating costs / operating income = Cost-to-income ratio
The resulting ratio gives investors a clear view of how efficiently the bank is being run (at least in theory). In effect, it shows how much input (cost) the bank requires to generate one pound (or dollar or euro, say) of output (profit).
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
The lower the ratio, the more profitable, productive and competitive the bank will be. For example, a ratio of one would mean the bank is spending every penny of operating income it makes – it has to spend a pound to make a pound. Clearly, that is not a sustainable state of affairs.
As with most valuation measures, the cost-to-income ratio really needs to be used in conjunction with relevant comparators. For example, you can look at how the ratio for a given bank has changed over the years. Changes in the ratio can highlight potential problems: if the ratio rises from one period to the next, it means that costs are rising at a higher rate than income, which could suggest that the bank has taken its eye off the ball in the drive to attract more business.
That said, slashing costs may drive the ratio lower in the short term, but in the longer run may have an impact on customer service or compliance with regulators, for example, and therefore have an eventual negative impact on income.
It’s also important to compare ratios across the sector. If a given bank stands out (as either having an unusually high or unusually low ratio) it is worth digging deeper to find out why. In the case of banks, different regulatory environments in different countries can make a significant difference to average cost-to-income ratios between nations.
-
Four most influential people in 2024We look at the four most influential people in 2024 who moved markets – from Elon Musk reshaping US politics to Rachel Reeves struggling as Britain's chancellor
-
François Bayrou appointed as France's new prime ministerFrançois Bayrou becomes France's new PM after a no-confidence vote ousts Michel Barnier.
-
Real exchange rateGlossary The real exchange rate between two currencies combines the nominal exchange rate with the ratio of the price of goods or services in two different countries.
-
Balance of payments
Glossary The balance of payments refers to the accounts that sum up a country's financial position relative to other countries.
-
Index fund
Glossary Index funds (also known as passive funds or "trackers") aim to track the performance of a particular index, such as the FTSE 100 or S&P 500.
-
What is a rights issue?
Glossary A rights issue gives investors who already hold shares in a company the right to buy additional shares in a fixed proportion to their existing holding.
-
Short squeeze
Glossary When a large number of short sellers target the same stock, the price can rise in a self-perpetuating circle known as a 'short squeeze'.