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Provision Coverage Ratio – Meaning, Importance & Calculation

The Provision Coverage Ratio (PCR) is an important metric employed by banks and other financial institutions to assess their preparedness for defaults on their interest payments

In this article, we’re going to learn about a critical accounting ratio – the Provision Coverage Ratio (PCR) – explore what it means, why it is important, and how it is calculated. We will also understand its significance with respect to other similar ratios, side-by-side.

Understanding the meaning of PCR

The PCR is a financial ratio that measures the adequacy of provisions a bank sets aside to cover potential losses arising from bad loans, also known as Non-Performing Assets (NPAs).

The ratio estimates the bank’s ability to absorb financial losses and shocks in case these NPAs fail to perform to expected levels.

Banks usually set aside provisions to deal with bad loans like these from their own funds, mostly from their net profits. Understanding this ratio is important also because banks are required to disclose their ratios regularly to investors and regulators in their annual financial statements under their Notes to the Balance Sheet section.

One can look at the PCR and estimate how vulnerable the bank is to bad loans. The higher the ratio is, the more funds have been kept aside by the bank to deal with these contingencies. The lower the ratio, hence, the more vulnerable the entity is to defaults.

The RBI had initially set 70% as the ideal benchmark for PCR. This means that the provisions set aside to deal with NPAs should equal to at least 0.7 times the total value of all NPAs.

Calculating the Provision Coverage Ratio

The provision coverage ratio formula is fairly simple. It combines the two variables that it measures into a simple fraction:

Provision Coverage Ratio (PCR) = Total Provisions / Gross NPAs

where…

Total provisions refer to the total amount of funds a bank sets aside to cover potential losses from bad loans

Gross Non-Performing Assets (GNPAs) represent the total value of loan accounts where borrowers haven’t made their scheduled payments for a specific period (typically 90 days or more).

CTA: NPA Meaning

Importance of the Provision Coverage Ratio

Here are some important pointers relating to the PCR, summarised according to the stakeholders they affect.

• Banks: A healthy PCR ratio reassures banks about their financial resilience. It indicates their ability to deal with potential losses and maintain profitability even if their assets don’t perform as expected. This, in turn, allows banks to lend more confidently to loan seekers and expand their balance sheet.
• Investors in banks and other financial institutions: For investors, a strong PCR translates to financial stability in the institution they’re investing in. By reducing risk of failure, investors can categorise their financial services investments into several categories, aiding risk management.

It is important to note, however, that one coverage ratio is hardly proof of financial stability for any company, much less for a bank where balance sheets are much more complicated. It is important to look at the PCR in conjunction with other industry-specific ratios to understand the big picture behind a company’s financial performance.

CTA: Ratio analysis
• Regulators: Regulatory bodies like the Reserve Bank of India (RBI) utilise PCR to monitor the health of the banking system. A low PCR across the industry might spur regulatory interventions to ensure financial stability of the banking system as a whole. Regulators can also look at company figures and their patterns over time to revise benchmarks.
• Borrowers: Indirectly, a healthy PCR benefits borrowers as well. Banks with adequate provisions are more likely to continue lending sustainably, ensuring credit availability for businesses and individuals who depend on banks for liquidity, or to finance their everyday operations.

How does the Capital Adequacy Ratio (CAR) relate to PCR?

The CAR measures a bank’s capital buffer compared to its risk-weighted assets. A strong CAR signifies the bank’s ability to absorb financial losses. A healthy PCR complements a strong CAR by indicating that the bank has set aside specific provisions to cover potential losses from bad loans.

Should I focus on PCR or liquidity ratios like the Current Ratio or Liquidity Coverage Ratio (LCR)?

All these ratios paint different aspects of a bank’s health. The PCR focuses on provisioning for bad loans, while liquidity ratios assess the bank’s ability to meet its short-term financial obligations.

Is it better to have a high PCR and high NPA ratio, or a low PCR and low NPA ratio?

Generally, a low NPA ratio is preferable. It signifies a bank with a healthy loan portfolio and fewer defaults. However, a very low PCR with a low NPA ratio might suggest the bank isn’t adequately provisioning for potential future losses.

How can I use PCR along with other ratios to compare different banks?

It is generally a bad idea to compare ratios in isolation. In fact, ratio analysis is meant to be comparative – both to the company or bank’s peers or to a well-established and regarded benchmark. We encourage you to look for a balanced profile across various metrics.

What is the Return on Assets (ROA) ratio, and how does it relate to banks?

ROA measures a bank’s overall profitability by calculating its net profit as a percentage of its total assets. A healthy ROA indicates the bank is efficiently generating profits using its assets, which include loans, investments, and cash.