Non-Performing Assets (NPAs) denote loans or advances provided by banks or financial institutions that cease to generate revenue for the lender due to the borrower's failure to fulfill payments on the principal and interest of the loan for a minimum of 90 days.
Financial lending institutions play a critical role in the Indian economy. Through loans and other credit facilities, they supply the capital required for businesses to grow and develop. However, despite their crucial contribution to the economy, these institutions are constantly challenged by the threat of NPAs.
Continue reading to learn about the full form of NPA, its various types, and its impact on lending institutions.
What is a non-performing asset?
Non-Performing Assets (NPAs) refer to loans or advances from banks or financial institutions that have stopped generating income for the lender due to the borrower’s failure to pay the principal or interest for at least 90 days. When a debt remains unpaid and overdue beyond a specific time frame, it is classified as a non-performing asset (NPA).
How do non-performing assets work?
Now that you are aware of the meaning of non-performing assets, let us take a closer look at how they work.
Borrowers across the country — whether retail or institutional — avail of loans and credit facilities from financial institutions. When a borrower does not repay the principal and the interest components of such loans for more than 90 days from when they are due, it is automatically classified as a non-performing asset by the lender.
NPAs often have a multi-fold impact on banks and financial institutions. Firstly, a large number of non-performing assets will negatively impact the asset quality, revenue, and profitability of the lender. Moreover, since the funds are locked up in non-performing assets, the entity’s lending capacity decreases significantly. Finally, there is also the possibility of complete write-offs, where NPAs are recorded as a loss in the lender’s books.
Also read: Key Differences Between Asset Vs Equity
Types of non-performing assets (NPA)
Non-performing assets can be broadly classified into three major categories depending on how long they have been marked as such by the lender.
- Substandard assets
Assets that remain as NPA for up to 12 months are classified as substandard assets. Although they have significantly higher credit risk, they do have some recovery prospects. - Doubtful assets
Assets remaining as NPA for over 12 months are classified as doubtful assets. The credit risk of such assets is much higher than that of substandard assets. Their recovery prospects are also very slim. - Loss assets
Assets with very little recovery value or no recovery prospects are deemed to be loss assets. Banks and financial institutions often write off the entire value of these assets or sell them to asset reconstruction companies (ARCs).
NPA provisioning
Provisioning is a financial risk management technique that is widely used to account for non-performing assets and other extraordinary expenses. Here, financial institutions set aside a portion of their profits to cover the losses that may arise due to non-performing assets.
By setting aside some of their profits to account for NPAs, lending institutions can keep their financial statements clean and write off loans if they become uncollectible. The Reserve Bank of India determines the provisioning norms for banks, which vary depending on the type of NPA, their size, and the location of the lender.
Also read: What Are Assets and Liabilities
GNPA and NNPA
GNPA is an acronym for Gross Non-Performing Assets. It represents the total amount of NPAs before any provisioning is made.
NNPA, meanwhile, is an acronym for Net Non-Performing Assets. It represents the amount of NPAs in the lender's books after they have made provisions for such losses.
NPA ratios
The Gross NPA Ratio (GNPAR) and Net NPA Ratio (NNPAR) are two of the most commonly used metrics in this category. These ratios provide insights into the asset quality and financial health of financial institutions.
The GNPAR is determined by dividing the gross NPAs by the gross advances (before provisions) made by the bank during a specific period. The resulting figure is multiplied by 100 to arrive at the percentage value.
The NNPAR is determined by dividing the net NPAs by the net advances (after provisions) made by the bank during a specific period. The resulting figure is multiplied by 100 to arrive at the percentage value.
Also read: What is an Asset Management Company (AMC)
Example of an NPA
Assume a person borrows Rs. 1,00,000 from a bank. According to the terms of the agreement, they need to repay the loan in one year, along with 10% interest on the principal.
However, they default on the payment of monthly EMIs from the very first instalment. About 90 days after the due date, the bank will mark the Rs. 1,00,000 loan as an NPA. The bank can either attempt to recover its dues from the borrower or write it off completely.
How to calculate gross non-performing assets ratio and net non-performing assets?
Comparing Gross NPA and Net NPA ratios serves as pivotal indicators in evaluating a bank's financial well-being. Let's delve into their calculation methodologies.
What is the gross NPA ratio?
The Gross NPA ratio, also known as the GNPA ratio, is computed by dividing the total amount of gross Non-Performing Assets (NPAs) by the aggregate value of assets held by the bank. Gross NPAs encompass loans categorized as non-performing for over 90 days. The total assets encompass all holdings of the bank, comprising loans, cash reserves, and investments. The formula for calculating the Gross NPA ratio is:
Gross Non-Performing Asset Ratio = Total Gross NPAs / Total Assets |
Consequently, a heightened Gross NPA ratio suggests a significant proportion of loans remain unpaid, signaling potential financial turbulence for the bank.
Also read: What are non-current assets
What is net NPA?
Net NPA is determined by deducting the provisioned value from the total gross NPAs. Provisions represent funds allocated by banks to mitigate losses arising from NPAs. The formula for computing the Net NPA ratio is:
Net Non-Performing Asset = Total Gross NPAs – Provision |
Net NPA provides insight into the actual losses incurred by the bank due to NPAs. Elevated levels of Net NPA imply substantial losses stemming from NPAs, indicating potential financial distress for the bank.
Significance of NPAs
Understanding the distinction between performing and non-performing assets is crucial for both borrowers and lenders in India. For borrowers, if an asset becomes non-performing due to missed interest payments, it can hurt their credit rating and limit future borrowing opportunities, ultimately affecting their financial growth.
For banks and financial institutions, interest income from loans is a primary revenue source. When assets turn non-performing, it reduces the lender’s income potential and impacts profitability. Monitoring NPAs is vital, as a high volume of non-performing assets can strain a bank’s liquidity and growth capacity.
While a manageable level of NPAs is often sustainable in the short term, an increasing volume of overdue NPAs can threaten the financial stability and long-term viability of the institution. Maintaining control over NPAs is therefore essential for safeguarding the lender’s financial health and growth prospects.
Impact of non-performing assets on operations
Listed below are some important points to remember regarding the impact of non-performing assets on operations of a firm:
- Financial stability: Elevated NPAs can undermine the financial standing of the lender by diminishing interest income and necessitating larger provisions for potential losses. Consequently, this can impair both stability and liquidity.
- Constrained lending capacity: Financial entities might adopt a more cautious approach towards disbursing fresh loans due to the inherent risk associated with existing NPAs. This caution can curtail their capacity to foster economic expansion through lending activities.
- Regulatory adherence: Financial institutions are bound by regulatory frameworks governing NPA management. Failure to uphold prescribed NPA thresholds can result in penalties, constraints, or regulatory intervention.
- Investor trust: Prolonged elevation of NPA levels can corrode investor trust, leading to depreciation in the financial institution's stock value and market capitalisation. This, in turn, impacts shareholder returns and influences broader market sentiment.
Key takeaways
- Definition and classification: NPAs are loans or advances not repaid for over 90 days, affecting a bank’s income.
- Types of NPAs: Substandard (up to 12 months), Doubtful (over 12 months), and Loss assets (little to no recovery prospects).
- Impact on banks: High NPA levels reduce asset quality, revenue, and lending capacity, potentially leading to write-offs.
- Financial ratios: Gross and Net NPA ratios provide insights into a bank’s asset quality and financial health.
- Provisioning: Banks set aside profits to cover NPA losses, adhering to RBI norms to maintain clean financial statements.
Conclusion
With this, you must now be aware of what NPA is and the significant challenges it presents. Financial institutions must manage NPAs effectively to reduce their impact on their balance sheets, maintain financial stability, and sustain growth.
