If you are using the ROA profitability method to evaluate the relative profitability of a relationship, you would like it to approximate how ROA is calculated at the institution level. So how do we calculate the ROA of a single relationship? We certainly know how to do this at the institution level; we take annual net income and divide by institution total assets. Can we just do the same thing with a relationship? That is, take net income for the relationship (we’re already calculating it) and divide by the total assets in the relationship?

There are a number of reasons why that approach is not accurate. First, and most importantly, relationships contain more than financial assets. In addition to the loan or loans that make up a relationship, there are likely to be deposit balances belonging to that relationship. And in many cases, the deposit balances are an inseparable part of the relationship. If the mortgage loan leaves the institution, it isn’t unusual for some or all of the deposit balances to leave as well.

In LoanEDGE we calculate the income of both loans and deposits when calculating the net income portion of the ROA (the numerator). If you paused for a moment when I said we calculate the income of a deposit, hold that thought. We will get to the deposit “income” topic in a moment. Just assume for now that we have total relationship income as our numerator. What should we divide by to get ROA?

If we use the total of loans and deposits as the denominator, we are understating the return of that relationship. We would also understate the return if we just use relationship loans as the income source. To see why, imagine that your institution has one customer and that customer has two products – a loan representing your entire loan portfolio and a deposit representing total deposits. Each product produces income after costs.

In this case let’s just say the deposit product produces some decent fee income and by coincidence, the loan and the deposit each produce exactly the same amount of net income after costs. If in this case we take the relationship income and divide by the total of loans and assets, we will end up calculating the relationship ROA as half of the institution ROA. Institution ROA would simply be the relationship income divided by total assets, which is the same as total loans in our simplified relationship.

The next step is to realize that some relationships have more loans than deposits, while some have more deposits than loans. We are trying to consistently calculate the ROA of every relationship, and the only way to make it consistent with institution ROA is to average out that imbalance by using (relationship loans + relationship deposits) divided by 2 as the denominator. Please note – if a relationship has equal loan to deposit ratio, then (relationship loans + relationship deposits) / 2 is the same as loans balance.