As a small-cap finance stock with a market capitalisation of US$805m, the risk and profitability of Central Pacific Financial Corp (NYSE:CPF) are largely tied to the underlying economic growth of the region it operates in US. A bank’s cash flow is directly impacted by economic growth as it is the main driver of deposit levels and demand for loans which it profits from. After the GFC, a set of reforms called Basel III was imposed in order to strengthen regulation, supervision and risk management in the banking sector. These reforms target bank level regulation and aims to improve the banking sector’s ability to absorb shocks arising from economic stress which could expose financial institutions to vulnerabilities. Since its financial standing can unexpectedly decline in the case of an adverse macro event such as political instability, it is important to understand how prudent the bank is at managing its risk levels. High liquidity and low leverage could position Central Pacific Financial favourably at the face of macro headwinds. A way to measure this risk is to look at three leverage and liquidity metrics which I will take you through today.
Why Does CPF’s Leverage Matter?
Banks with low leverage are better positioned to weather adverse headwinds as they have less debt to pay off. A bank’s leverage may be thought of as the level of assets it owns compared to its own shareholders’ equity. Financial institutions are required to have a certain level of buffer to meet capital adequacy levels. Central Pacific Financial’s leverage level of 11.98x is significantly below the appropriate ceiling of 20x. With assets 11.98 times equity, the banks has maintained a prudent level of its own fund relative to borrowed fund which places it in a strong position to pay back its debt in times of adverse events. Should the bank need to increase its debt levels to meet capital requirements, it will have abundant headroom to do so.
What Is CPF’s Level of Liquidity?
As I eluded to above, loans are relatively illiquid. It’s helpful to understand how much of this illiquid asset makes up the bank’s total asset. Generally, they should make up less than 70% of total assets, which is consistent with Central Pacific Financial’s state given its ratio of 69%. This means slightly over half of the bank’s total assets are tied up in the form of illiquid loans, leading to a sensible balance between interest income and liquidity.
What is CPF’s Liquidity Discrepancy?
Banks operate by lending out its customers’ deposits as loans and charge a higher interest rate. Loans are generally fixed term which means they cannot be readily realized, however, customer deposits are liabilities which must be repaid on-demand and in short notice. The disparity between the immediacy of deposits compared to the illiquid nature of loans puts pressure on the bank’s financial position if an adverse event requires the bank to repay its depositors. Since Central Pacific Financial’s loan to deposit ratio of 79% is within the sensible margin, below than the appropriate maximum of 90%, this level places the bank in a relatively safe liquidity position given it has not excessively lent out its deposits and has maintained a suitable level for compliance.
Central Pacific Financial ticks all the boxes for operational prudency in terms of liquidity and leverage. These factors often sideline next to other fundamentals but are equally important to consider as part of the investment thesis. High liquidity and low leverage places the bank in an ideal position to repay financial liabilities in case of adverse headwinds. Keep in mind that a stock investment requires research on more than just its operational side. I’ve put together three key factors you should look at:
Future Outlook: What are well-informed industry analysts predicting for CPF’s future growth? Take a look at our free research report of analyst consensus for CPF’s outlook.
Valuation: What is CPF worth today? Has the future growth potential already been factored into the price? The intrinsic value infographic in our free research report helps visualize whether CPF is currently mispriced by the market.
Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
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