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As a small-cap finance stock with a market capitalisation of US$321m, the risk and profitability of Enterprise Bancorp, Inc. (NASDAQ:EBTC) are largely tied to the underlying economic growth of the region it operates in US. Since a bank profits from reinvesting its clients’ deposits in the form of loans, negative economic growth may lower deposit levels and demand for loan, adversely impacting its cash flow. Following the Financial Crisis in 2008, a set of reforms termed Basel III was enforced to bolster risk management, regulation, and supervision in the financial services industry. The Basel III reforms are aimed at banking regulations to improve financial institutions’ ability to absorb shocks caused by economic stress which could expose banks like Enterprise Bancorp to vulnerabilities. Unpredictable macro events such as political instability could weaken its financial position which is why it is important to understand how well the bank manages its risk levels. Strong management of leverage and liquidity could place the bank in a protected position at the face of macro headwinds. We can gauge Enterprise Bancorp’s risk-taking behaviour by analysing three metrics for leverage and liquidity which I will take you through now.
Is EBTC's Leverage Level Appropriate?
Banks with low leverage are exposed to lower risks around their ability to repay debt. A bank’s leverage can be thought of as the amount of assets it holds compared to its own shareholders’ funds. Financial institutions are required to have a certain level of buffer to meet capital adequacy levels. Enterprise Bancorp’s leverage level of less than the suitable maximum level of 20x, at 11.61x, is considered to be very cautious and prudent. This means the bank has a sensibly high level of equity compared to the level of debt it has taken on to maintain operations which places it in a strong position to pay back its debt in unforeseen circumstances. If the bank needs to firm up its capital cushion, it has ample headroom to increase its debt level without deteriorating its financial position.
What Is EBTC'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 Enterprise Bancorp’s total asset. Normally, they should not exceed 70% of total assets, but its current level of 79% means the bank has lent out 9.4% above the sensible upper limit. This means its revenue is reliant on these specific assets which means the bank is also more likely to be exposed to default compared to its competitors with less loans.
What is EBTC'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, conversely, on the liability side, customer deposits must be paid in very short notice and on-demand. 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 Enterprise Bancorp’s loan to deposit ratio of 92% is higher than the appropriate level of 90%, this level puts the bank in a risky position as it borders negative liquidity disparity between loan and deposit levels. Essentially, for $1 of deposits with the bank, it lends out more than $0.9 which is risky.
We've only touched on operational risks for EBTC in this article. But as a stock investment, there are other fundamentals you need to understand. There are three essential factors you should further research:
- Future Outlook: What are well-informed industry analysts predicting for EBTC’s future growth? Take a look at our free research report of analyst consensus for EBTC’s outlook.
- Valuation: What is EBTC 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 EBTC 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.