How Lloyds makes money

LBG makes money from four main areas of activity:

1. Providing services such as loans, current accounts, savings products and mortgages to retail customers via high street banks and internet banking.
2. Commercial banking services to businesses.
3. Consumer finance - things such as the provision of credit cards and finance for motor cars.
4. Insurance - house and life insurance policies, investment and income protection products.

Let's see how the income and the costs from these activities show up in LBG's income statement.

Interest income

LBG makes most of its money from lending money to customers. The money it lends out in loans attracts interest paid by the borrower. This is known as interest income. As you can see, the amount of interest income has been steadily falling since 2010. This can be explained by a decrease in the amount of loans outstanding and a decline in the interest rate that it charges on those loans.

Interest expense

Simple banking involves taking money from savers (or depositors) and lending it out to borrowers. In order to get people to deposit money with them a bank has to offer them an attractive interest rate. Banks also borrow money from the money markets (known as wholesale finance). The interest paid to depositors and wholesale lenders is a cost of doing business and is shown as an expense on the income statement.

LBG's interest expense has fallen significantly in recent years. This is mainly due to the fact that interest rates in general have fallen to record lows. Banks can borrow money for virtually nothing as anyone with a savings account will tell you.

Net interest income

This is the difference between a bank's interest income and interest expense. It is a key measure of a bank's profitability and is very similar to a non-financial company's gross profit. Ideally you want to see this number growing every year. After falling sharply in 2012, LBG's net interest income has seen a healthy increase during the last couple of years.

Insurance premium income

This is income earned from selling insurance policies during the year. This source of income has been declining in recent years.

Other income

This will include income from fees and commissions from banking services as well as trading income from trading financial assets and securities.

Banking costs

Like all companies banks have to incur costs to generate their income. The biggest costs are wages and other staff costs as well as items such as rents, IT costs, advertising and regulatory costs. A large chunk of a these costs are fixed and do not vary with a bank's income. These costs are included in the "other expenses" row in SharePad. In there you will also find one-off costs such as provisions for fines. For example, those to do with the mis-selling of payment protection insurance (PPI) which totalled £4bn in 2015.

Impairments occur when a bank realises that a total amount of a loan or outstanding investment cannot be recovered in full and has to be written down to its recoverable amount. This writing down of value is shown as an expense in the income statement. Following the financial crisis, LBG incurred some big impairment expenses but the value of these has fallen significantly in recent years as bad loans have disappeared from the company's balance sheet.

Insurance companies have to pay out against claims each year. In some years, the value of claims can be bigger than the insurance premium income earned and a loss can be made from insurance activities. LBG has suffered some years of big losses and made a small insurance loss in 2015.

Profits

When all these sources of income and costs are considered together you arrive at a bank's pre-tax profit. For LBG this was just over £1.6bn - a slight decline from the year before. According to LBG's 2015 annual report its underlying pre-tax profit (which excludes one-off costs such as provisions and restructuring costs) was £8.1bn - a big difference.

Which profit figure should you use?

Well it depends if you believe that a lot of LBG's costs are genuine one-offs or not. PPI will not be an issue very soon but restructuring costs and provisions can happen more frequently. We will look at this issue later when looking at LBG's financial returns and valuation.

How safe and how good are banks as investments?

Many investors got their fingers badly burned by owning banking shares during the financial crisis. They found out the hard way that, when times got tough, a lot of banks weren't very safe at all. There are a number of ratios you can look at to check out if the finances of a bank are shaky or not.

Before we start looking at these it is useful to have a look at a bank's balance sheet.

There are four things to take away from LBG's balance sheet:

1. A large proportion of its assets are made up loans to customers and other banks.
2. Deposits from customers and banks make up a large proportion of liabilities.
3. Equity is quite small relative to the bank's total assets.
4. There are still some significant derivative assets and liabilities. Trying to fully understand the potential risks here is very difficult for the private investor.

Tier 1 Equity ratio

SharePad doesn't calculate this ratio but many investors look at it in order to work out how safe a bank is. The ratio compares what is known as tier 1 capital as a percentage of a bank's risk weighted assets (RWA).

RWA's are the assets that are used to work out the minimum amount of capital a bank must hold in order to protect its creditors and reduce the risk of it going bust. Each bank asset - such as a loan - is assessed according to its risk and given a weight. For example a personal, unsecured loan is more risky than a mortgage which is secured against the value of a property.

A bank also has to match its capital against certain types of assets so that it doesn't get into trouble if one particular class of asset suffers from a big fall in value.

Below is a screenshot from Lloyds' 2015 annual report which shows you how the components of the tier 1 ratio are calculated.

Tier 1 equity capital of £28.5bn is based on the value of shareholders' equity less adjustments. Risk-weighted assets are £222.9bn - just over a quarter of total assets - giving a tier 1 equity ratio of 12.8%. This is well above the minimum level demanded by banking regulators of 6% which suggests that LBG is quite safe at the moment and has enough capital to protect itself from unexpected shocks.

Less leverage means lower returns for shareholders

The simple truth of the matter is that banks are not very good businesses compared to the many options available for investors out there. I say this because banks don't make very high returns on their assets (Profits after tax / Total Assets). LBG's return on assets (ROA) was just 0.1% in 2015 or 0.98% if all the one-off expenses are ignored. There are many good businesses out there with ROAs of more than 10%.

Because the return on assets is so low, banks are forced to take on lots of debt to create new assets (loans) in order to make acceptable returns for shareholders - measured by return on equity (ROE). This increase in gearing (leverage) increases the assets to equity ratio. If you multiply a company's ROA by its assets to equity ratio then you get a company's return on equity as a bit of simple school maths below proves.

The table above is very revealing about LBG's ROE history. The higher assets to equity ratio and higher ROE before 2009 shows that it was only able to make decent returns for shareholders by taking on lots of debt and lots of risk. When profits collapsed with the financial crisis, ROE collapsed as well. Since then the Return on assets has not recovered whilst the amount of leverage has come down a lot which has meant that LBG has not been able to deliver consistently good returns on equity.

However, if all the one-off costs are ignored, LBG says that its underlying ROE was 15% in 2015. The bank reckons it is capable of making ROEs of 13.5% to 15% over the long haul. We'll come back to this number shortly when looking at how to value bank shares.

The value of future dividends

LBG has recently started paying dividends again. If its business stays in good health then City analysts expect it to pay some big dividends over the next few years. If I use the dividend valuation model in SharePad (also found in the Investor tools section) then I can get another estimate of how much LBG's shares might be worth.

Look at the screenshot below. SharePad pre-populates the dividend per share forecasts for the next three years. I have then entered dividends for years four and five. I have based these on lower growth rates of 7% and 5% respectively - for a more cautious estimate. After that, I assume that dividends grow at 3% forever. Assuming a required return (called discount rate in SharePad) of 10% gives me an estimated value per share of 82p.

Of course, these projections might be worthless if the UK economy goes into recession and the housing market falls - causing loans to go bad. If you want to use this tool to value a share then you need to make sure that your forecasts are realistic and sensible.

LBG's future prospects

As well as crunching numbers, it is important to try and understand LBG a little better in order to weigh up its future prospects. As with all companies, you want to try and find out if profits can grow in the future.

City analysts don't seem to think so. Whilst they expect the one-off costs to disappear, underlying pre-tax profits are expected to stay at around £8.1bn for the next three years. Earnings per share is expected to grow slightly whilst most of the company's profits are expected to be paid out in dividends.

LBG and other banks face a number of challenges. Firstly, there is a lot of competition for loans and savings accounts in the UK. This could limit LBG's ability to grow its loans but also restrict the interest rates they can charge.

Low interest rates are another potential threat. In some countries, the interest rates on government bonds have turned negative. If that was to happen in the UK - not likely at the moment - or interest rates were to fall further it would make it more difficult for LBG to write profitable loans.

The bank also has a significant exposure to the UK housing market as one of the country's biggest mortgage lenders. A fall in house prices would slow down the growth in mortgages but it seems that LBG has a relatively safe portfolio of mortgages as shown below.

Most of LBG's mortgages have a loan to value (LTV) ratio of less than 80%. Over half of them have a LTV of less than 50 and the average is just 46.1%. House prices will have to fall a long way before the value of these loans are in danger of being written down and profits take a hit.

That said, there is still some risk. Out of total mortgages of over £300bn, 4.6% of them have a LTV of 90% or more. Problems in the housing market could still hit profits in the years ahead.

However, it would seem that LBG is taking a very cautious approach to lending. Mortgage lending has not grown at all in 2015 as the market has become very competitive. LBG has seen some growth from buy-to-let mortgages but has grown its mortgages slower than the overall market.

The other possible risk is interest-only mortgages account for over a third of its residential mortgages. The average LTV is 46.6% but problems could be caused with higher LTV mortgages if house prices fall and borrowers default on their mortgage payments.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.