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 owners 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 banks 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 banks 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 banks 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 banks 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 cant 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.
Thats about as simple as it comes: companies that make more money for
the owners are worth more than companies that dont 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 dont 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 Margin

AAA |
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 Gulf
region in the Middle East. Currently there are a total of 15 interestbased
commercial banks. At the same time, there are 6 interest-free
Islamic commercial banks operating along with the century old interestbased
commercial banks. Of them, two locally incorporated banks,
Bahrain Islamic Bank and Faysal Islamic Bank are prominent. Since
their incorporation in Bahrain (in 1999)

The following is a discussion of these four principles that make the

Islamic banking unique.
i. RibOE
The QurOEn explicitly prohibits ribOE but does permit trade (al-QurOEn,
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 in
the past. However, there now seems to be a general consensus that
the term ribOE includes any amount charged over and above the principal.
The payment of interest or receiving of interest, which is the fundamental
principle of conventional banking and financing, is explicitly prohibited
in Islamic banking and finance. Thus, the prohibition of interest, in
payment or receipt, is the nucleus of Islamic banking and its financial
instruments, while the charging of interest in all modes of transaction
whether it is in loan, advances or leasing is the core in the conventional
banking. The Islamic banking is not simply interest-free banking. It
takes into account issues of gharar, arOEm, zakOEt and qar al-asan.
ii. Gharar
Gharar is speculation or gambling and is forbidden in Islam. Islam
allows risk-taking in business transactions, but it prohibits speculative
4 IIUM Journal of Economics & Management 12, no.2 (2004)
activity and gambling. Any transaction involving the element of
speculation like buying shares at a low price and selling them at a
higher price in the future is considered illegal. Conventional banks, on
the other hand, have no constraint in financing investment involving
speculation.
iii. ZakOEt
ZakOEt is a compulsory religious payment or tax on the wealth of the
rich payable to the poor. It is a built-in mechanism in Islam for ensuring
the redistribution of wealth and the protection of a fair standard of
living for the poor. ZakOEt is one of the five pillars of Islam. Each Islamic
bank must establish a zakOEt fund and pay zakOEt on the profits earned.
The payment of zakOEt is in addition to any conventional tax imposed (if
the government is non-Islamic). Thus, the Islamic bank pays dual
taxes zakOEt and corporate business tax. The interest-based
conventional banks, on the other hand, are subjected to only corporate
business tax, and thus have special advantage over the Islamic bank.
iv. Islamic ethics of investment
In Islam, investment in production and consumption is guided by strict
ethical 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 be
profitable. Providing financing for such activities is illegal in Islam.
Hence, it is forbidden for an Islamic bank to finance activities or items
that are not permitted by the Sharcah. The limitation of investment

and financing is extended to cover any activity or business which may

be harmful to the individual or the society. Thus, financing investment
for the production or consumption of tobacco, alcohol or pornography
is also prohibited. This restriction provides limitation on the profitability
of the Islamic banks. On the other hand, conventional banks do not
face any such constraint in their financing investments.
Thus, Islamic banks face constraints and operate in a non-friendly
environment in most of the Muslim countries. One should keep the
underlying differences in mind in order to make a fair comparison
between the Islamic and the conventional banks.