As a small-cap finance stock with a market capitalisation of US$819m, the risk and profitability of Carolina Financial Corporation (NASDAQ:CARO) are largely tied to the underlying economic growth of the region it operates in US. Since banks make money by reinvesting its customers’ deposits in the form of loans, strong economic growth will drive the level of savings deposits and demand for loans, directly impacting the cash flows of those banks. 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 banking regulations and intends to enhance financial institutions’ ability to absorb shocks resulting from economic stress which could expose banks like Carolina Financial 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. Sufficient liquidity and low levels of leverage could place the bank in a safe place in case of unexpected macro headwinds. Today we will be measuring Carolina Financial’s financial risk position by looking at three leverage and liquidity metrics.
Is CARO’s Leverage Level Appropriate?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. Carolina Financial’s leverage level of 6.59x is very safe and substantially below the maximum limit of 20x. 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 increase its debt levels to firm up its capital cushion, there is plenty of headroom to do so without deteriorating its financial position.
What Is CARO’s Level of Liquidity?Since loans are relatively illiquid, we should know how much of the bank’s total assets are comprised of these loans. Usually, they should not be higher than 70% of total assets, which is the case for Carolina Financial’s ratio at 66%. This is a reasonable ratio and suggests that slightly over half of the bank’s total assets are tied up in the form of illiquid loans, striking an appropriate balance between liquidity and interest income.
What is CARO’s Liquidity Discrepancy?A way banks make money is by lending out its deposits as loans. These loans tend to be fixed term which means they cannot be readily realized, yet customer deposits on the liability side must be paid on-demand and in short notice. The discrepancy between loan assets and deposit liabilities threatens the bank’s financial position. If an adverse event occurs, it may not be well-placed to repay its depositors immediately. Compared to the appropriate industry loan to deposit level of 90%, Carolina Financial’s ratio of over 92% is higher which positions the bank in a risky spot given the potential to cross into negative liquidity disparity between loan and deposit levels. Basically, for $1 of deposits with the bank, it lends out over $0.9 which is imprudent.
The bank’s liquidity and leverage ratios suggest it has sensible operational risk management. Its high liquidity and low leverage levels suggest it is well-positioned to meet its financial obligations in the case of any adverse and unpredictable macro events. We’ve only touched on operational risks for CARO in this article. But as a stock investment, there are other fundamentals you need to understand. There are three key aspects you should look at:
- Future Outlook: What are well-informed industry analysts predicting for CARO’s future growth? Take a look at our free research report of analyst consensus for CARO’s outlook.
- Valuation: What is CARO 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 CARO 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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