Net Interest Margin

Meaning and definition of Net Interest Margin

The net Interest margin can be expressed as a performance metric that examines the success of a firm’s investment decisions as contrasted to its debt situations. A negative Net Interest Margin indicates that the firm was unable to make an optimal decision, as interest expenses were higher than the amount of returns produced by investments. Thus, in calculating the Net Interest Margin, financial stability is a constant concern.

Calculating the Net Interest Margin

The Net Interest Margin is calculated as:

Net Interest Margin = (Investment Returns – Interest Expenses) / Average Earning Assets

Illustrating the Net Interest Margin

The Net Interest margin has been illustrated in the following example:

Let us presume that XYZ Corp has an investment return of $1,000,000 with an interest expense of $2,000,000 and average earning assets of $10,000,000. The net interest margin for XYZ Corp would be -10%. This indicates that the XYZ Corp has lost more money because of interest expenses than what was earned from investments. In this case, XYZ Corp would have been better off if it had used the investment funds for paying off the obligations rather than making an investment.

Applications of Net Interest Margin

The use of net interest margin is helpful in tracking the profitability of a bank’s investing and lending activities over a specific course of time. Besides, a period end balance sheet, average balance sheet published by the banks indicating the breakdown of bank’s loans, deposits, investments, and borrowed funds, and their related interest rates provides more insight to investors seeking for more info on the fluctuation of Net Interest Margin.

Limitations of Net Interest Margin

One of the drawbacks of Net Interest Margin is that it does not measure the total profitability of the bank as most of them earn fees and other non-interest income through services like brokerage and deposit account services, without taking account operating expenses, such as personnel and facilities costs, or credit costs. Besides, net interest margin of two banks can’t be contrasted as both the banks are poles apart in their own way, like in the nature of their activities, composition of customer base, and similar more.