This evaluation report conducts a comprehensive analysis of Lloyds Banking Group plc (Lloyds), keeping in view that the Arden Fund wants to invest in its stocks. The analysis presented in this report is carried out from internal and external perspectives to help fund managers identify key strengths and weaknesses of Lloyds and decide whether an investment in its stocks is financially feasible or not.
Financial Ratio Analysis 2399
This section of the report conducts a financial ratio analysis of Lloyds, which is one of the leading financial institutions in the UK with its strategic focus on retail banking. The current section of the report presents the calculated values of important financial ratios grouped in different categories, including profitability, liquidity, and financial structure. Since Lloyds is a financial institution and it does not have working capital, therefore it is not possible to perform a working capital management analysis. Instead, capital management analysis is performed in this report. There are other ratios used to perform the CAMEL rating analysis of Lloyds, including capital adequacy, asset quality, management, earnings, and liquidity as the bank’s performance parameters (Ferrouhi, 2018).
Lloyds was formed after Lloyds-TSB acquired HBOS in September 2008 based on a deal worth more than £12 billion. HBOS was hard hit by the great financial crisis, and Lloyds was on the brink to file bankruptcy in October 2008 when the UK government stepped in and saved the financial institution by investing £20.3 billion for a 43% stake (Dyer, 2017).
Lloyds faced significant challenges as its management adopted a conservative approach to improve its balance sheet position and recover from heavy financial losses that it incurred during the financial crisis (Dyer, 2017). The government gradually sold its stake in the bank to private investors, and it has become a private ownership. The bank reported a net interest income of £10.180 billion and a statutory profit of £3.006 billion in 2019 (Lloyds Banking Group, 2019). Its total assets were £833.893 billion, and its total liabilities were £786.087 billion in the last financial period (Lloyds Banking Group, 2019).
Profitability
The bank’s profitability is measured by the net interest margin, which is a ratio of the interest earned on its advances to individual and institutional borrowers to the average interest-earning banking assets (Fabozzi et al., 2017). It implies that the higher the net interest margin is, the stronger the bank’s profitability. The net interest margin of Lloyds for the last two financial years is calculated in the following:
Table 1. Net Interest Margin (NIM).
It is noted that the net interest margin of Lloyds declined from 2.93% in 2018 to 2.88% in 2019. The reason for this negative change in the ratio value was that the interest income of the bank reduced as its total assets (advances) also declined in 2019. Further analysis of the ratio’s components showed that Lloyds’ retail segment’s net interest margin slightly reduced from 2.68% in 2018 to 2.63% in 2019 (Lloyds Banking Group, 2019). However, there was a significant change in its commercial banking segment’s net interest margin from 3.27% in 2018 to 3.14% in 2019 (Lloyds Banking Group, 2019).
The decline in the bank’s profitability was mainly due to Brexit’s uncertainties in 2019 and its impact on the UK’s economy. It is reported that commercial activities in the UK slowed down before the Brexit because businesses were not fully aware of the expected changes in the UK’s relationship with the European Union, and they did not want to take high-risk decisions of borrowing from banks.
Furthermore, the UK financial services industry was expected to be severely hit by these changes as UK banks as it anticipated a slowdown in economic growth in the years before Brexit (Agathocleous and Evagorou, 2016). Lloyds, which has investments in Europe, is also likely to be affected by the EU exit decision. It is reported that the management expected to have a moderate level of impact of the UK government’s decision to go ahead with Brexit with or without any deal with the EU.
Another profitability measure used in this report is the Return on Equity (ROE), which measures the bank’s profitability and is calculated as a ratio of net income to total equity (Bhattacharyya, 2019). The ROE of Lloyds for the last two financial years is calculated in the following:
Table 2. Return on Equity (ROE).
Table 2 indicates that the ROE of Lloyds declined from 8.98% in 2018 to 6.29% despite a reduction in its equity due to the bank’s shares buyback scheme and redemption of equity instruments. The bank’s low profitability was mainly due to its wrong estimation of Payment Protection Insurance (PPI) charge of £2.45 billion in 2019 (Lloyds Banking Group 2019) against its underlying profit of £7.531 billion. The significantly high PPI charge was due to the increase in PPI information requests on claims and costs of complaints submitted from the Official Receiver (Lloyds Banking Group, 2019).
Lloyds’ management recognized this as its weakness, which resulted in low earnings distributable to shareholders. The UK banking industry average was 6.9% in 2019 (Cherowbrier, 2020), which means that Lloyds’ earnings were less than its competitors in the market. However, it is indicated that the bank’s low ROE was due to the mistake that it made, which also raises concerns about the management’s capability to anticipate possible financial claims against the bank. However, it should recuperate its earnings position in the next year.
Capital Management
Capital management of a bank is crucial to ensure that it remains solvent and continues operating as a going concern (Brigham & Ehrhardt, 2017). This is analyzed by calculating the Loan to Deposit (L/D) ratio of Lloyds, which is a ratio of its loans and advances to customer deposits. The idea value of the loan to deposit ratio is around 80% (DiSalvo & Johnston, 2017), which is used as a benchmark for assessing capital management by Lloyds based on its L/D ratio values for the last two years provided in the following:
Table 3. Loan to Deposit (L/D) ratio.
Table 3 indicates that the L/D ratio value was more than 100% in the last two years. If repos and reverse repos are excluded from customer deposits and loans and advances to customers, respectively, the ratio value was 107% in 2018 and 2019. This points to the serious issues related to the bank’s over-lending, which also means that it did not have sufficient statutory reserves that were essential for avoiding insolvency. If the bank is unable to reduce its L/D ratio value, then it could face financial problems as it is indicated that it already made a significant loss due to PPI charge in 2019 (Lessambo, 2018).
Additional factors such as the slowing UK economy and a decline in customer deposits could severely affect its ability to fulfil regulatory requirements. It would also affect shareholders as the bank’s market value could be severely affected by such a change in its solvency position. Furthermore, the L/D ratio value of more than 100% also means that the bank loans its customers by borrowing from other banks. It is also noted that the bank had deposits of £28.179 billion from other banks as well on December 31, 2019 (Lloyds Banking Group, 2019).
Another ratio used for assessing Lloyds’ capital management is Financial Assets to Financial Liabilities (FA/FL), which determines the capital structure of a bank and also measures its ability to manage its assets (Welch, 2011). The FA/FL values of Lloyds for the last two years are calculated in the following:
Table 4. Financial Assets to Financial Liabilities (FA/FL).
Table 4 indicates that the FA/FL value increased from 79% in 2018 to 94% in 2019. The mismatch between the bank’s financial assets and financial liabilities in the last two years shows that it did utilize its capital with a prudent approach.
CAMEL Rating Analysis
The CAMEL rating analysis is also conducted in this section of the report by determining the values of the model’s different elements.
Capital Adequacy
All UK banks are required to meets the statutory reserve requirement set by the Bank of England and other regulatory authorities (Athma et al., 2018). Furthermore, Basel III defines Common Equity Tier 1 Capital as the capital that banks must maintain to ensure that they can immediately manage losses that may arise from its operations (Bank for International Settlements, 2019). This component of capital is necessary for banks to remain a going-concern. On the other hand, Tier 2 capital includes debt instruments that could be converted to cover losses that the bank may incur. This is gone-concern capital, which is used when the bank faces bankruptcy (Bank for International Settlements, 2019). Different components of Lloyds’ capital are provided in the following table:
Table 5. Capital Adequacy.
Table 5 indicates that Lloyds’ CET 1 capital ratio was 14.62% in 2018 and 13.64% in 2019. It shows that the bank met the criteria of CET 1 > 4.5% set in Basel III. However, the CET 1 capital ratio’s industry average was 15.6% in Q4 2019, which means that Lloyds’ had a lower ratio value than other banks in the UK (Bank of England, 2020).
Asset Quality
Banks’ asset quality is also a crucial measure of their performance, which is used for determining the proportion of advances and loans that are uncollected by the year-end and is recognized as a loss in the income statement (Ferrouhi, 2018). The asset quality ratio of Lloyds is calculated for the last two years in the following:
Table 6. Asset Quality.
Table 6 indicates that Lloyds’ asset quality ratio increased from 0.21% in 2018 to 0.29% in 2019. This implies that the bank impaired a higher value of advances and loans in the last year. The bank’s loans impaired in 2018 were £937 million, and their value increased to £1.291 billion in 2019. This raises concerns about the bank’s ability to recover its loans. It is noted that the banks’ assets increased significantly in the last year, but it did not manage its capital adequacy ratio well. This means that the bank could experience additional financial losses due to its weak capital management strategies (Trotman and Carson, 2018).
Management
Management of Lloyds is analysed by the cost to income ratio, which is calculated by dividing the operating costs of the bank by its net income. The justification for using this ratio for evaluating management’s effectiveness is that operating expenses are non-income, generating expenses incurred by the bank, which should be controlled to generate a high return for shareholders (Narayanaswamy, 2017).
Table 7. Cost to Income Ratio.
Table 7 indicates that the bank managed to control its operating costs, which means that its management efficiency improved in 2019 compared to 2018. However, it is noted that operating costs were significantly high as a proportion of its net income in the last two years. Therefore, it is recommended that the management should take measures to reduce non-income generating expenses further.
Earnings
The next element of CAMEL is earnings measured by the bank’s Return on Assets (ROA), which is the ratio of the bank’s total net income divided by its total assets (Wahlen et al., 2018). It is a vital indicator of the bank’s profitability as it could determine whether it is operating efficiently to use customer deposits to generate high-interest margins and other income or not (Atrill and McLaney, 2017). The ROA of Lloyds for the last two financial years is calculated in the following:
Table 8. ROA.
Table 8 indicates that the ROA of Lloyds declined from 0.56% in 2018 to 0.36% in 2019. It means that the bank only generated 36p from every £1 that it gave to its customers or other financial institutions as advances and loans. The low ROA is justified on the basis of the trend observed in the UK banking industry as it operated at low margins in the last few years due to low-interest rates and low economic growth. Furthermore, the UK banks incurred high compliance costs and experienced tough competition from companies offering digitalized financial services (Carletti et al., 2020). It is noted that Lloyds’ profit for the year declined significantly from £4.506 billion in 2018 to £3.006 billion due to the reasons already discussed above, including a high PPI charge.
This is a key concern about the bank’s management and methods that it used for determining the loss provision. Furthermore, the bank incurred financial loss on different hedging activities that it performed to mitigate transaction risks. However, it is noted that its total assets grew by 4.55% in 2019, which means low mark-up on loans resulted in lower ROA value (Lloyds Banking Group, 2019).
Liquidity Coverage Ratio
The sustainability of banks’ operations depends on their ability to maintain strong liquidity to meet its short-term deposit obligations. Customers place most of the retail banking sector deposits for short periods; particularly, current account deposits can be withdrawn immediately. Therefore, banks need to have sufficient reserves to ensure that all such deposit withdrawals can be fulfilled (Pilbeam, 2018). Lloyds’ liquidity is assessed by calculating the Liquidity Coverage Ratio (LCR), which is a ratio of short-term assets, including advances and loans to customers due within one year to its short-term average liabilities.
Table 9. Liquidity Coverage Ratio (LCR).
Table 9 indicates that the LCR of Lloyds bank was more than 100%, which implies that its short-term average assets were more than its short-term average liabilities. This means that the bank had sufficient liquidity, and there were no immediate threats to its ability to fulfil its financing requirements. Furthermore, the analysis shows that the LCR value improved in the last year as the bank gave more loans to its customers and held fewer short-term deposits. It is pertinent to have substantial liquidity for the firm’s going-concern, as pointed out by Young et al. (2019). It is inferred from the analysis that the bank had no liquidity issues in the last two years.
Governance, Financial Reporting, and Dividend Policy
The UK financial services sector is highly regulated, and banks must follow existing and new regulations developed by the Bank of England and other regulatory authorities. Furthermore, the governance framework in the UK is regulated by the Bank of England through three bodies, including the Financial Policy Committee (FPC), the Prudential Regulatory Authority (PRA), and the Financial Conduct Authority (FCA). UK banks are required to follow the Cadbury principles of corporate governance, which include guidelines for the board of directors’ composition and functions, eligible institutional ownership and its role, risk management, and remuneration of executives (Tahtamouni and Alnahleh, 2015).
Lloyds’ management report included on pages 65-93 of its annual report provided details of its corporate governance. The board size is 13, and eight directors are independent. The average tenure of directors on the board is between two and three years, and most of them are between 56-65 years of age (Lloyds Banking Group, 2019). The board is highly diversified as non-executive directors are from different industries and have a wide range of expertise and skills that benefited the bank. However, it is noted that executive management members are also part of the board, which somewhat undermines its effectiveness. Board oversight is also a crucial element of the bank’s corporate governance that ensures that directors and executives promote a culture of due diligence and operations sustainability.
There are different committees, including the nomination and governance committee, audit committee, board risk committee, and remuneration committee, which meet regularly with senior management to discuss material nature issues and matters (Lloyds Banking Group, 2019). Each committee has a purpose according to the Cadbury Code, and they comprise of executive and non-directors who evaluate business situation and address issues that could affect the bank. Furthermore, the bank has a comprehensive risk management policy, which entails different risks that it faced and strategies that the management has adopted according to the bank’s approved risk appetite and guidelines of PRA (Lloyds Banking Group, 2019). The bank’s management provided details of these risks and their impact on the business along with the strategies that they followed to mitigate their effects.
The audit committee raised concerns about the payment protection insurance provision that was underestimated and resulted in a financial charge of £2.45 billion in 2019 (Lloyds Banking Group, 2019). Furthermore, the remuneration report provides details of compensation during employment, post-employment benefits, and redemption of shares assigned to executives. It includes the basis for executives’ compensation. It highlights the role of oversight committees to determine whether the management team members are compensated according to the industry standards and the bank’s financial performance.
Lloyds has taken various initiatives to give its customers fair treatment, protect their information, and address their concerns with professionalism and transparency in its deals (Lloyds Banking Group, 2019). Furthermore, management of Lloyds is already working on determining the implications of upcoming regulatory initiatives, including “operational resilience, climate change, General Insurance, revised Payment Services Directive (PSD2) requirements, MIFIDII and fraud” (Lloyds Banking Group, 2019, p. 11).
Lloyds’ financial statements are prepared according to International Financial Reporting Standards (IFRS) provided by the International Accounting Standards Board (IASB). The bank followed IAS 1 to prepare various financial statements on a consolidated basis, including a “statement of financial position, a statement of profit and loss, a statement of changes in equity, a statement of cash flows along with notes to financial statements” (Dolgikh, 2017).
The bank also presents its financial statements on a comparative basis by providing last two and three years’ information. It is also indicated that the bank prepares and publishes financial statements periodically, that is, every quarter and fiscal year, which ends on the 31st of December (Lloyds Banking Group, 2019). Furthermore, the bank follows IFRS to present a true and fair view of its financial position. It is an important consideration as financial statements are prepared for external users who decide to form their relationships with the entity based on companies’ financial information (ACCA, 2018). Therefore, Lloyds can be held accountable for not following IFRS properly.
An independent audit firm audits financial statements, corporate governance, and internal controls. The audit firm is responsible for giving its opinion about the truth and fairness of the bank’s financial statements and information provided by management (Etim et al., 2020). The audit report highlighted key issues about the use of estimates and judgements by the bank’s management and its potential impact on the financial position. This is important for users of financial statements to understand that Lloyds’ management works as shareholders’ agents. Their responsibilities include avoiding risky activities and reporting accurate information about the bank’s financial position (Renn et al., 2011).
Lloyds had an active dividend policy before the financial crisis and its subsequent bailout in 2008-09. Still, it stopped paying dividends to its shareholders because of its weak financial position and efforts by its management to recover from the massive losses it made because it acquired HBOS in 2008. However, the bank finally recommenced its dividend payments in 2015 when it reported a significant profit of £1.8 billion (Dyer, 2017). Shareholders expect companies to make regular dividend payments rather than accumulating their earnings. The company made an interim dividend payment of 1.12p on the 13th of September, 2019. However, Lloyds’ management decided not to undertake interim or quarterly dividend payments or engage in any activity in the capital market until the end of 2020 (Lloyds, 2020a).
The dividend policy of the bank can be explained based on different dividend policy theory. The agency theory is relevant as the bank changed its dividend policy in different situations because of its low earnings. The management’s primary role is to generate a growing profit for distribution to shareholders (Jabbouri, 2016). The bank stopped its dividends pay-out in the post-financial crisis period because of weak earnings and pressure from shareholders to take strict measures to revive the bank’s position. This bank’s approach can also be explained by using the signalling theory, which states that management announces dividends to signal to the market about the firm’s financial position throughout their life-cycle (Zhao, 2016). It is noted that Lloyds made dividend payments when its earnings improved and then halted them due to the changing business and market conditions.
Finance Function in Lloyds Banking
The finance function coves all those activities that are undertaken for the financial management of resources (Parrino et al., 2017). The finance function role in a banking organization, Lloyds, is pivotal as it is engaged in receiving deposits from its customers and utilizing them to give out loans to its individual and institutional customers. Banks play a significant role in supporting economic activity by providing financial resources to individuals and businesses (Watson and Head, 2016). Its primary activities include collecting funds from lenders and then delegating them to borrowers through its retail and commercial banking segments. However, the role of banks such as Lloyds has changed significantly from the traditional intermediation approach to offering diverse, innovative financial services to their customers (Ayadi, 2019).
The bank uses customer deposits for creating its assets in the form of advances and loans. Furthermore, it manages its investments by mitigating the risks involved in asset and wealth creation for its depositors (Hopkin, 2018). This requires careful planning and control of the bank’s resources to ensure that it fulfils the statutory requirements and maintain strong liquidity and solvency (Renn et al., 2011).
This is vital for banks to manage their finance function as they are responsible for depositors’ money and utilizing them for generating income for them. If depositors want to withdraw their funds, then the bank must fulfil their requirements (Bank for International Settlements, 2019). For this purpose, the bank may borrow from entities in the financial services sector as Lloyds had more than £28 billion, which it got local and international banks (Lloyds Banking Group, 2019).
Lloyds also offers general insurance and long-term savings to its customers (Lloyds Banking Group, 2019). This implies that the bank assists its customers in their financial decisions. The bank provides them different financial products and solutions to meet their personal and business requirements. This is a key finance role of banks as they should play an advisory role for customers to generate high returns and get the best outcome of their investment decisions.
It is argued that banking activities are highly sensitive to changes in local and international markets’ fiscal and monetary policies (Arnold and Lewis, 2019; Banerjee, 2017). This also requires Lloyds to adopt strict internal controls and data security protocols to ensure that it meets the Bank of England’s regulatory requirements. The bank complies with the industry regulations to ensure that its practices do not generate risks for its customers.
Lloyds also follows Basel III reforms that require financial institutions to ensure sufficient liquidity and solvency to fulfil deposits withdrawal requirements and continuity of lending services to their customers (Ramirez, 2017). The Financial Conduct Authority (FCA) regulates bank-customer relationships to ensure that financial services institutions take measures to gain customers’ trust in the UK retail banking industry (Ahmed et al., 2020).
Mergers and Acquisition Process
Mergers and acquisitions are essential for business growth and expansion in the financial services industry, which undergoes regular restructuring with fewer banks consolidating their operations, having a large number of branches, and a high-value of capital (Micu and Micu, 2016). The decision to merge with or acquire other businesses depends on the expected synergies, whether they are in business growth or financial gains. Therefore, the value that a firm is willing to pay for another company depends on various factors (Shaffer, 2019). However, one of the critical determinants of this value is the financial performance of the targeted company. One way of estimating the business value is its net book value, which is the value of its equity.
Another way of determining business value is to assess the market value of the firm’s equity. In both cases, other financial and non-financial factors are also considered for estimating the value that the firm’s M&A decision would generate for Lloyds. The historical financial performance of firms is analysed by using different techniques such as financial ratio analysis. This identifies the target firm’s strengths and weaknesses and any issues that may arise after the deal is made. A complete and comprehensive audit by independent M&A analysts, managers, and lawyers is also required to assess the potential outcomes of the deal between companies (Yaakov, 2011).
It is noted that Lloyds maintained a strong M&A approach since the early 1900s. The M&A strategy of Lloyds has been motivated by its management’s decision to grow its network of services locally and internationally. The company acquired various financial services institutions in different markets that helped it achieve its objectives. However, diversification of business was also a key element of its M&A decisions as it acquired not only mainstream banking institutions but also other financial services businesses (Berger et al., 2019).
The corporate history of Lloyds shows that the company was involved in significant M&A transactions. The earliest acquisitions made by the bank were of a French private bank, Armstrong & Co, and Capital & Counties Bank in the UK, and the latest significant acquisition made by the bank was of HBOS in 2008, which turned out to be a wrong decision at the wrong time (Lloyds, 2020b). In every M&A decision that Lloyds took non-financial factors such as institutional interests contributed to the success or failure (Wigger, 2012).
The biggest failure of Lloyds’ M&A decision was the acquisition of HBOS in a deal worth £12 billion despite opposition by the Office of Fair Trading (OFT) (Stephan, 2011). The financial valuation of HBOS was wrongly assessed when the possibilities of a severe economic crisis were high. It resulted in almost the failure of Lloyds (Dyer, 2017). Since then, Lloyds has maintained a loss reserve to recapitalize the losses it made. It is indicated that the bank had a reserve of £7.420 billion in 2019, which was distributable to shareholders Lloyds (Lloyds Banking Group, 2019).
Valuation of Lloyds
A key aspect of the analysis is the valuation of the firm’s stocks. Ethical investors aim to invest in companies that have a strong financial position and promising prospects regarding their earnings and assets growth. Their primary objective is to achieve a high or moderate level of return on investment by accepting a low or medium risk level (Pike et al., 2018). This implies that their decision to invest in specific stocks depends on the determination of their intrinsic values. The intrinsic value of a stock, bond, or option is the assessment of its true or inherent value based on the company’s past performance and its growth plans (Fabozzi et al., 2017).
Therefore, it is stated that the historical financial information and financial analysis of Lloyds, similar to the one performed in this report, is useful for determining its intrinsic value, which is compared with the current stock price to determine whether its stocks are overpriced or under-priced. The valuation of the company’s stock based on its intrinsic value is somewhat subjective. Still, analysts use financial information and management reports, which are publicly available to them to assess banks and identify any significant strategic and operational issues that could affect the business’s future value.
The intrinsic value of a company’s stock can be determined by using different valuation techniques, including the Dividend Discount Model (DDM), Discounted Cash Flow Model (DCF), Relative Value model (RVM), and others (Husam-Aldin et al., 2010). These models use the historical financial information of companies and assumptions about their future. However, their approach is different, as some of them use external information made public by companies. In contrast, others perform a comparative analysis by using other firms’ market performance indicators to determine the intrinsic value of the target company. Some of these models, such as DDM and DCF, are also criticized for their subjective nature based on assumptions about future dividends and cash flows. Therefore, it is recommended that an average of different intrinsic values by using various techniques is determined and then compared with the stock price.
Moreover, it is stated that ethical investors would select stocks whose intrinsic value is close to their current stock price. It means that their stock preference would be to invest in equities with a low probability of value deterioration. However, it is not always possible to invest in stocks and achieve a capital gain whose intrinsic values are equal to their current price (Fabozzi et al., 2017). Therefore, it is indicated that investors may also prefer to invest in stocks that are under-priced for capital gains or pay regular dividends to their shareholders. Lloyds’ shares’ forecasted value is 75.37p, which is higher than the current stock price of 28.38p (Yahoo! Finance, 2020).
It implies that investors could gain from buying its shares and holding them over the medium-term. Moreover, investors would use rational decision making by comparing different stocks before making their investment decisions. Therefore, they must use various valuation techniques to determine the intrinsic value of Lloyds (Fabozzi et al., 2017).
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