capital adequacy ratio formula for an nbfc

Capital adequacy ratio is Tier 1 capital plus Tier 2 capital, divided by risk-weighted assets. Tier 1 is the permanent loss-absorbing core — equity and reserves — while Tier 2 counts subordinated instruments up to a cap and does not do the same job. Risk-weighted assets scale the book by prescribed weights, so a loan against a house and an unsecured personal loan of the same size do not consume the same capital.

the amount a finance company can lend is ultimately limited by

Its own capital, working through the capital adequacy ratio — a lender may carry only so many rupees of risk-weighted assets against each rupee of capital funds, and that multiple is set by the regulator rather than by demand. A company can have every borrower and every rupee of funding it wants and still be unable to grow, which is why the constraint bites hardest in the good years.

why does a fast growing nbfc keep issuing new shares

Because capital grows only at the rate the company earns and retains, and a loan book growing faster than that meets the capital adequacy floor on a date that is pure arithmetic. A lender earning 16% on equity and paying out 15% of it adds a little under 14% to capital a year; a book compounding at 28% outruns that within a couple of years, so the equity raise that follows is a schedule rather than a decision.

what happens to book value per share when a lender issues new shares

It rises if the shares are issued above the existing book value per share and falls if they are issued below it — the same rupees of fresh capital are accretive or dilutive purely according to the price at which they come in. Return on equity dips for a year or so either way, because the new money enters the denominator at once and takes time to be lent out, so a lower ratio after a raise is not by itself evidence that anything about the lending has deteriorated.

Capital adequacy ratio and Tier 1 capital

A finance company has grown its loan book at 28% a year for two years and management has guided to the same again. It earns 16% on equity and pays out a modest dividend. Nothing about that combination is unusual and nothing about it is sustainable, and the reason has nothing to do with demand, competition or credit quality. A lender can only carry so many rupees of loans against each rupee of its own capital, that limit is written down by the regulator, and capital grows at the rate the company earns and retains — which here is a little under fourteen per cent. A book growing at twenty-eight per cent and a capital base growing at fourteen meet a wall on a date that is arithmetic. The announcement, when it comes, will be presented as a decision. It was a schedule.

Think of it like this

The lorry with a load limit

A lorry is rated for a maximum load. The driver can find more freight, the freight can pay well, and none of that raises the plate on the door. Beyond the limit he needs a second lorry, and a second lorry costs money he has to find from somewhere. The load he can carry is set by the vehicle, not by the market for freight.

In the market

Capital adequacy is the plate on the door. A lender may have all the borrowers it wants and all the funding it wants, and it still cannot lend beyond a multiple of its own capital. Growing faster than capital grows means buying another lorry, and there are exactly two places the money comes from: profits it did not distribute, or shareholders.

What the ratio actually measures

Capital adequacy ratio = (Tier 1 capital + Tier 2 capital) ÷ Risk-weighted assets

Tier 1 capital: Broadly the shareholders’ own money — paid-up equity and reserves, less prescribed deductions. It absorbs losses first and is the tier with the separate floor beneath it
Tier 2 capital: Subordinated debt and certain reserves, counted only up to a prescribed limit. It is borrowed money that ranks behind everything else, so it supports growth without diluting anybody
Risk-weighted assets: Assets scaled by prescribed risk weights, so a loan against a house and an unsecured personal loan of the same size do not consume the same capital

Example: The floor for a systemically important finance company has stood at fifteen per cent of risk-weighted assets, with a separate minimum for Tier 1 beneath it — materially higher than the figure a bank must hold. The categories and the numbers have been rewritten more than once, and the layered framework now in force sets different requirements by size and activity, so take the applicable figure from the company’s own capital disclosure rather than from memory.

Computing the year the raise happens

Worked example

A book growing at 28% against capital growing at 13.6%

A finance company, figures in crore, risk weights assumed unchanged

Capital funds todayAgainst risk-weighted assets of ₹12,860 — a ratio of 21.0%₹2,700

How fast capital grows on its ownReturn on equity of 16%, of which 15% is paid out: 16% × 0.8513.6% a year

How fast the book is guided to growRisk-weighted assets assumed to grow with it28% a year

End of year oneStill comfortable. But 2.4 points of ratio have gone in a single year, which is 40% of the six-point cushion between 21.0% and a fifteen per cent floorCapital ₹3,067 against ₹16,461 — 18.6%

End of year twoStill above the floor, and the board is now discussing itCapital ₹3,484 against ₹21,070 — 16.5%

End of year threeBelow a fifteen per cent floor. This does not happen; the raise happens firstCapital ₹3,958 against ₹26,970 — 14.7%

So the announcement landsNobody runs to the line. Boards approve enabling resolutions a year ahead of the needDuring year two, or early in year three

What could postpone itThe first two are unpopular, the third has limits and a cost, and the fourth is capped and does not count as Tier 1Cutting the dividend, growing slower, selling loan pools, or issuing Tier 2 debt

The useful part of this exercise is not the forecast. It is that a growth guidance and a return on equity together contain a prediction about equity issuance, and the prediction can be extracted in five minutes from two published numbers. An investor who has done it is not surprised by the announcement and, more usefully, has already worked out the question that actually matters — which is not whether the company will issue shares but at what price it will issue them.

Why the price of the issue is the whole of the news

For a lender, book value is the anchor of the valuation, because the assets are financial and the return is earned on the capital base. So when new shares are issued, the question for an existing holder is simple and arithmetical: did the new shareholders pay more per share than the book value they are buying into, or less? Above book, the money they put in raises the book value of every existing share. Below book, it lowers it. The company received the same ₹1,000 crore either way and put it to work in the same loans.

Worked example

The same ₹1,000 crore raised at two different prices

Net worth ₹4,000 crore, 40 crore shares, book value ₹100 a share

Raised at ₹250 a share — 2.5 times book4 crore new shares issued

Net worth afterwardsAcross 44 crore shares₹5,000 crore

Book value per shareUp 13.6% for existing holders, who did nothing and paid nothing**₹113.64**

Raised at ₹80 a share — 0.8 times book12.5 crore new shares issued

Net worth afterwardsAcross 52.5 crore shares₹5,000 crore

Book value per shareDown 4.8%, again without existing holders doing anything**₹95.24**

Difference to an existing shareholderOn the same raise, funding the same growth, at the same company₹18.40 a share

Share of the company an existing holder retains40 shares out of 44, against 40 out of 52.590.9% against 76.2%

This is why the identical press release — the board has approved a raise of ₹1,000 crore — is genuinely different news depending on where the shares are trading. A lender trading well above book can fund its growth by issuing shares and make its existing owners better off per share while doing it, which is a self-reinforcing advantage the cheap lender does not have. A lender trading below book must either issue and dilute, or stop growing. It is the same mechanism that has run through the recapitalisation of weaker Indian lenders for decades, and it is the arithmetic behind an uncomfortable observation: the companies that can raise capital most cheaply are the ones that need it least. Note the limit of the point. High book value accretion on an issue is not a reason to own the shares; it is a reason the announcement means something different at one price than at another.

◆ Checkpoint

Module checkpoint: the lender that is not a bank

5 questions. Answers are revealed once you submit all of them.

1.A finance company’s average cost of funds is 8.25%, while money raised during the year cost about 9.1%. Its loan book is fixed-rate with several years to run. What follows for next year, assuming no change in lending rates?

2.Lender A: net interest margin 10.1%, credit cost 2.5% of assets, equity multiplier 6.3. Lender B: margin 3.2%, credit cost 0.25%, equity multiplier 12.0. Both report a return on equity of about 21%. What does that tell you?

3.Two lenders with ₹10,000 crore books report stage 3 assets of 4.5% and 3.0%. The second wrote off ₹390 crore during the year against the first’s ₹120 crore. What is the correct adjustment?

4.A company reports assets under management up 26%, on-book loans up 11%, and a gain on derecognition of ₹185 crore within pre-tax profit of ₹760 crore. What is the most accurate description?

5.A lender trading at 2.5 times book announces a ₹1,000 crore share issue. Net worth is ₹4,000 crore across 40 crore shares. What happens to book value per share?

0 of 5 answered

Simple bhasha mein

Truck pe likha hua load limit

Maal chahe jitna mil jaaye, gaadi ke darwaze pe likhi limit nahi badalti. Lender ka bhi wahi: capital ₹2,700 crore, book ₹12,860 crore — ratio 21%. Kamai se capital 13.6% badhta hai (16% RoE me se 15% dividend nikal ke), par book 28% guidance pe. Do saal baad 16.5%, teen saal baad 14.7% — 15% ke floor se neeche, jo hone nahi diya jaata. Yaani share issue ki tareekh pehle se likhi hai, aur asli sawaal bhaav ka hai: ₹4,000 crore net worth, 40 crore shares, book ₹100. ₹1,000 crore ₹250 pe utha to 4 crore naye share, book ₹113.64. Wahi ₹1,000 crore ₹80 pe utha to 12.5 crore share, book ₹95.24. Ek hi press release, ₹18.40 ka farak.

What to remember

Capital adequacy is capital funds over risk-weighted assets, and it sets a ceiling on how much a lender can carry regardless of demand.
Capital grows at return on equity times the retention rate; a book growing faster than that has a dated appointment with a share issue.
Risk weights mean what a lender lends against decides how much it can lend, so a change in a weight can end a growth plan.
Issuing shares above book value raises book value per share for existing holders; issuing below it lowers them — same money, opposite effect.
Return on equity falls mechanically in the year of a raise, because the capital lands before the lending does.

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Common questions

Short, direct answers to what people ask about this topic.

capital adequacy ratio formula for an nbfc: Capital adequacy ratio is Tier 1 capital plus Tier 2 capital, divided by risk-weighted assets. Tier 1 is the permanent loss-absorbing core — equity and reserves — while Tier 2 counts subordinated instruments up to a cap and does not do the same job. Risk-weighted assets scale the book by prescribed weights, so a loan against a house and an unsecured personal loan of the same size do not consume the same capital.
the amount a finance company can lend is ultimately limited by: Its own capital, working through the capital adequacy ratio — a lender may carry only so many rupees of risk-weighted assets against each rupee of capital funds, and that multiple is set by the regulator rather than by demand. A company can have every borrower and every rupee of funding it wants and still be unable to grow, which is why the constraint bites hardest in the good years.
what is the minimum capital adequacy ratio for an nbfc in india: Fifteen per cent of risk-weighted assets has long been the floor for a systemically important non-deposit-taking finance company, with a separate lower minimum for Tier 1 sitting inside it — materially higher than the figure a bank must hold. The categories and the numbers have been rewritten more than once, and the layered framework now in force sets requirements by size and activity, so take the applicable figure from the company’s own capital disclosure rather than from memory.
why does a fast growing nbfc keep issuing new shares: Because capital grows only at the rate the company earns and retains, and a loan book growing faster than that meets the capital adequacy floor on a date that is pure arithmetic. A lender earning 16% on equity and paying out 15% of it adds a little under 14% to capital a year; a book compounding at 28% outruns that within a couple of years, so the equity raise that follows is a schedule rather than a decision.
what happens to book value per share when a lender issues new shares: It rises if the shares are issued above the existing book value per share and falls if they are issued below it — the same rupees of fresh capital are accretive or dilutive purely according to the price at which they come in. Return on equity dips for a year or so either way, because the new money enters the denominator at once and takes time to be lent out, so a lower ratio after a raise is not by itself evidence that anything about the lending has deteriorated.