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).
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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.
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