February 9, 2012

Credit Union Management magazine’s Web-only “CFO Focus” column runs the second Thursday of the month.

During my MBA studies I had to read many case studies. Some were about successful companies; some were about companies that succeeded and then failed. Yet others were about companies that succeeded, nearly failed and then turned into a success again.

All the analysis of different business trials and tribulations led me to conclude (among other things) that, for a business to succeed, it needs a clear business model and the ability to monitor how well the business model is performing financially.

A simple, but powerful business model helps make it clear what market you want to reach, what you must do to reach people in that market, what you must offer them and what price you can charge them. Measuring what happens under that model is key to tweaking your operations and overall direction.

An article in the January 2012 McKinsey Quarterly noted that investors were looking to large U.S. banks to radically change their business models because their return on equity was projected to drop from 11 percent to 7 percent by 2015 against a projected cost of equity of 9 percent.

By comparison, the credit union average ROE was 4.48 percent in third quarter 2010, according to a CUNA Mutual Group analysis. The average ROE for credit unions between $1 billion and $10 billion was 6.17 percent—hardly a number that would attract investors in the traditional sense, but credit unions do not focus on growth in the same way that for-profit businesses do.

However, the ratio itself—which equals (profit margin x asset turnover (which is net revenue/average assets  x leverage (which is average assets to average equity))—is a great way to gauge the health of both public companies and not-for-profit cooperatives, and how sustainable the measured company’s business model is. This is especially true if you include an analysis of the financial levers that influence the ratio.
 
(View a simple ROE calculator that allows a look at the levers that influence the ratio)

The levers that affect ROE are individual measures that your strategies and tactics can directly impact … such as interest income, loan loss, operating expense, etc. While credit unions do watch most of these numbers already, seeing how changes in these levers impact your sustainable growth rate is not only eye-opening, but also key to prioritizing strategic initiatives, product and service development and more.
 
(View a detail of the calculator focuses on the main components of the calculation)

Try ROE

I am encouraging every credit union executive I talk with to consider using an analysis to determine strategies (consistent with their business model) that will improve ROE. Analyzing the components of each of the “levers” that contribute to ROE can help a credit union determine if its business model is sustainable and what strategies to implement to improve results.

The levers:

• leverage;
• asset turnover;
• net interest income;
• fee and other operating income;
• loan loss provision;
• operating expense; and
• non-operating income.

Here is a quick example of how a credit union can use ROE to decide which strategy to implement. Let’s say the credit union below is looking at either implementing a couple of non-interest income strategies that are expected to increase revenues by $250,000 in addition to the 5 percent growth it has averaged over the last few years without increasing expenses beyond the normal 5 percent increase it budgets each year. Unless the credit union experiences changes in other income or expenses beyond the norm, its ROE would increase from 6.63 percent to 7.18 percent.

The second option the credit union is considering is to spend $1 million in capital to improve operational efficiencies (process redesign, a new phone system, improved web services, etc.). The investment is expected to stop the increase in operating expenses and actually decrease it by 2 percent over the previous year ($267,790 to be exact) while maintaining a 5 percent growth rate in the rest of the categories. The result is an increase in ROE to 8.91 percent.

Looking at the levers, you can see why the operational efficiency strategy had a much bigger effect on ROE. First, the impact on net income was much larger in the efficiency scenario—nearly $700,000—resulting in a much stronger profit margin (ratio #1 in the ROE calculation). Second, while only the revenue strategy had an impact on asset turnover, the efficiency strategy had an even larger impact on leverage (remember the credit union spent $1 million to create the efficiencies).

The effect of leverage on ROE is helpful to remember. Being well capitalized is important, but using capital to keep the organization healthy and growing can be just as important. Manufacturing companies often have to invest in new plants and close old ones to improve their efficiency. Chrysler spent a small fortune on marketing to create and air an extra long spot in the 2011 Super Bowl, and the attention garnered revived the company’s fortunes.

Run “what if” scenarios on your own financials to determine the long-term financial impact of different strategies. What would be the impact on ROE if you run market-leading loan rates all year? What other levers would have to change to support that strategy? What does ROE look like in a few years if we invest in new branches? Which would have a bigger impact on our ROE: a drive to increase non-interest income, decrease operating expense, or a combination of both?

Simply put, no planning strategy should be considered complete without evaluating the financial impact of each strategy to help prioritize the allocation of scarce resources.

Jim Craig is VP/marketing of 1st Advantage Credit Union, Yorktown, Va.