REPORT

By

M. Saqib Shahzad

361-570-88

Answer 3 (a)

I have analyzed the performance of an Islamic bank working in Bahrain (BISB) and a commercial

bank working in Bahrain (FUTUREBANK). After the critical analyses of the annual reports (which

includes bank statement, income statements, cash flow statements, and statement of owner’s

equity). By the critical analysis of the last annual reports of the both banks, the performance of

the banks is evaluated on the various factors. Although net income gives me, an idea of how

well a bank is doing, it suffers from one major drawback. It does not adjust for the bank’s size,

thus making it hard to compare how well one bank is doing relative to another. A basic measure

of bank profitability that corrects for the size of the bank is the return on assets (ROA).

Secondly, because the owners of a bank must know whether their bank is being managed well,

ROA serves as a good method to identify it.

ROA = Net profit after taxes / assets

The return on assets provide information on how efficiently a bank is being run because it

indicates how much profits are generated by each dollar of assets.

However, what the bank’s owners (equity holders) care about most is how much the bank is

earning on their equity investment. This information is provided by the other basic measure of

bank profitability, the return on equity (ROE).

ROE = Net profit after taxes / equity capital

There is a direct relationship between return on assets (which measures how efficiently the

bank is run) and the return on equity (which measures how well the owners are doing on their

investment). This relationship is determined by the equity multiplier (EM), the amount of assets

per dollar of equity capital.

EM = Assets / Equity capital

ROE can also be expressed as a multiplication of ROA and EM

ROE = ROA * EM

This formula tells us what happens to the return on equity when a bank holds a smaller amount

of capital (equity) for a given amount of assets. For example, X bank has $100 million of assets

and $10 million of equity, which gives it an equity multiplier of 10 ( = $100 million / $10 million).

The Y bank, in contrast, has only $4 million of equity and $100 million of assets, which gives it

and equity multiplier of 25 ( = $100 million / $4million).

Suppose that these banks have been equally well run so that they have the same return on

assets, 1%. The return on equity for the X bank equals to 1% * 10 = 10% , while the return on

equity for the Y bank equals 1% * 25 = 25%. The equity holders in the Y bank are clearly a lot

happier than the equity holders in the X bank because they are earning more than twice as high

a return. We now can see why the owners of bank may not want it to hold a lot of capital.

Given the return on assets, the lower the bank capital, the higher the return for the owners of

the bank.

Another commonly used measure of bank performance is called the net interest margin (NIM).

NIM is the difference between interest income and interest expenses as a percentage of total

assets.

NIM = (Interest income – Interest expenses) / Assets

One of the bank’s primary intermediation functions is to issue liabilities and use the proceeds to

purchase income earnings assets. If a bank manager has done a good job of asset and liability

management such that the bank earns substantial income on its assets and have low costs on

its liability, profits will be high. How well a bank manages its asset and liabilities is affected by

the spread between the interest earned on the bank’s assets and the interest cost on its

liabilities. This spread is exactly what net interest margin measures.

If the bank is able to raise funds with liabilities that have low interest costs and is able to

acquire assets with high interest income, the net interest margin will be high and the bank is

likely to be highly profitable. If the interest cost of its liabilities rises relatively to the interest

earned on its assets, the net interest margin will fall, and bank profitability will suffer.

Answer 3 (b)

I am taking three criterias for assessing and evaluating factors used, first of all ROA: When you are considering stocks to buy, there are certain metrics and numbers that are more important than others.

They can’t be used as the sole qualifier to determine great stocks, but you can use them to eliminate poor performers.

You must always look at the big picture when considering a stock and that means considering a number of metrics.

Return on Assets

Return on Assets is one of the handful of really important metrics every investor should know.

Return on Assets (ROA) tells you how efficiently (or inefficiently) a company turns assets into net income. It is a way to tell at a glance how profitable a company is.

Consider that companies take capital from investors and turn it into profits, which are in turn returned to the investor in one form or another.

ROA measures how efficiently the company does this. Obviously, the more efficient a company is in converting assets (capital) into profits, the more attractive it will be to investors.

That’s about as simple as it comes: companies that make more money for the owners are worth more than companies that don’t make as much money.

ROA is made up of two components: net margin and asset turnover. When used together, these two metrics tell an important story.

Net Margin:

Net margin is found by dividing net income by sales. Net margin reveals what percentage of each Rupee in sales and company retains.

Asset Turnover:

The other component is asset turnover, which gives you an idea of how well a company does in producing sales from its assets. You find asset turnover by dividing sales by assets.

Once you have net margin and asset turnover, multiply them together to determine ROA. You now have an idea how well a company can convert assets into profits. Companies with high ROA compared to their peers, are more efficient at using assets to generate profits.

You can calculate ROA for yourself or you can use one of the Web sites that has done all the math for you.

Even if you don’t do the calculations yourself, it is important to know how the numbers are generated.

Improving Efficiency

ROA shows how companies have two choices in improving efficiency.

Companies can raise prices and create high margins or rapidly move assets through the company. Either way (or both) improves ROA.

It is important to compare companies in the same industries. Some industries traditionally have higher margins or asset turnover than other industries do.

ROA is an important measure to use and understand, but its flaw is that the metric does not consider the effect of borrowed capital.

DEFINITION of 'Return On Equity - ROE'

The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.

Also known as "return on net worth" (RONW).

INVESTOPEDIA EXPLAINS 'Return On Equity - ROE'

The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following: return on common equity (ROCE) = net income - preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income by average shareholders' equity. Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

Things to Remember If new shares are issued then use the weighted average of the number

of shares throughout the year.

For high growth companies you should expect a higher ROE. Averaging ROE over the past 5 to 10 years can give you a better idea of

the historical growth.

Net Interest MarginAAA |

DEFINITION OF 'NET INTEREST MARGIN'A performance metric that examines how successful a firm's investment decisions are compared to its debt situations. A negative value denotes that the firm did not make an optimal decision, because interest expenses were greater than the amount of returns generated by investments.

Calculated as:

I EXPLAINS 'NET INTEREST MARGIN'

For example, ABC Corp has a return on investment of $1,000,000, an interest expense of $2,000,000 and average earning assets of $10,000,000. ABC Corp's net interest margin would be -10%. This would mean that ABC Corp has lost more money due to interest expenses than was earned from investments. In this case, ABC Corp would have been better off if it had used the investment funds to pay off debts instead to making an investment.

Answer 3 (C

After the criticlal analysis, I come to know that Islamic bank is better than commercial bank, Bahrain is a small state, but an important financial centre in the Gulfregion in the Middle East. Currently there are a total of 15 interestbasedcommercial banks. At the same time, there are 6 interest-freeIslamic commercial banks operating along with the century old interestbasedcommercial banks. Of them, two locally incorporated banks,

Bahrain Islamic Bank and Faysal Islamic Bank are prominent. Sincetheir incorporation in Bahrain (in 1999)

The following is a discussion of these four principles that make theIslamic banking unique.i. RibOEThe Qur’OEn explicitly prohibits ribOE but does permit trade (al-Qur’OEn,2: 185). It does not clearly mention whether ribOE is interest or usury.The lack of clarity led to a controversy among the Muslim scholars inthe past. However, there now seems to be a general consensus thatthe term ribOE includes any amount charged over and above the principal.The payment of interest or receiving of interest, which is the fundamentalprinciple of conventional banking and financing, is explicitly prohibitedin Islamic banking and finance. Thus, the prohibition of interest, inpayment or receipt, is the nucleus of Islamic banking and its financialinstruments, while the charging of interest in all modes of transactionwhether it is in loan, advances or leasing is the core in the conventionalbanking. The Islamic banking is not simply interest-free banking. Ittakes into account issues of gharar, úarOEm, zakOEt and qarè al-úasan.ii. GhararGharar is speculation or gambling and is forbidden in Islam. Islamallows risk-taking in business transactions, but it prohibits speculative4 IIUM Journal of Economics & Management 12, no.2 (2004)activity and gambling. Any transaction involving the element ofspeculation like buying shares at a low price and selling them at ahigher price in the future is considered illegal. Conventional banks, onthe other hand, have no constraint in financing investment involvingspeculation.iii. ZakOEtZakOEt is a compulsory religious payment or tax on the wealth of therich payable to the poor. It is a built-in mechanism in Islam for ensuringthe redistribution of wealth and the protection of a fair standard ofliving for the poor. ZakOEt is one of the five pillars of Islam. Each Islamicbank must establish a zakOEt fund and pay zakOEt on the profits earned.The payment of zakOEt is in addition to any conventional tax imposed (ifthe government is non-Islamic). Thus, the Islamic bank pays ‘dual’taxes – zakOEt and corporate business tax. The interest-basedconventional banks, on the other hand, are subjected to only corporatebusiness tax, and thus have special advantage over the Islamic bank.iv. Islamic ethics of investmentIn Islam, investment in production and consumption is guided by strictethical codes. Muslims are not permitted to invest in production,distribution and consumption enterprises involved in alcohol, pork,

gambling, illegal drugs, etc., even though these enterprises may beprofitable. Providing financing for such activities is illegal in Islam.Hence, it is forbidden for an Islamic bank to finance activities or itemsthat are not permitted by the Shar¥cah. The limitation of investmentand financing is extended to cover any activity or business which maybe harmful to the individual or the society. Thus, financing investmentfor the production or consumption of tobacco, alcohol or pornographyis also prohibited. This restriction provides limitation on the profitabilityof the Islamic banks. On the other hand, conventional banks do notface any such constraint in their financing investments.Thus, Islamic banks face constraints and operate in a non-friendlyenvironment in most of the Muslim countries. One should keep theunderlying differences in mind in order to make a fair comparisonbetween the Islamic and the conventional banks.