The significance of gross and net NPAs in investment evaluation

Non Performing Assets (NPAs) play a crucial role in determining a bank’s financial health. If you invest in banking stocks or use a trading platform to track market movements, understanding gross NPA vs net NPA is essential. These indicators help assess the risk associated with a bank’s loan portfolio and can influence investment decisions.

Allow us to explain what is gross NPA and what is net NPA, highlight their differences, and discuss their impact on the financial sector.

What is gross NPA?

Gross NPA is the total value of loans that have stopped generating interest income for a bank. When a borrower fails to make payments for 90 days or even more, the loan is then classified as an NPA.

Components of gross NPA:

• Principal and interest overdue beyond 90 days
• All non-performing loans before any provisions are made
• Includes all types of credit, such as corporate, retail, and agricultural loans

Example: Suppose a bank lends ₹100 crores, and loans worth ₹8 crores remain unpaid for over 90 days. The gross NPA is ₹8 crores.

Causes of rising gross NPAs

Several factors contribute to an increase in gross NPAs:

1. Economic slowdown

During recessions, businesses struggle, leading to loan defaults. This impact is amplified when banks fail to anticipate or mitigate the effects of downturns. Reduced consumer spending and business investments shrink revenue streams, making loan repayments difficult. Furthermore, prolonged economic stagnation can create a ripple effect, impacting even previously stable sectors.

2. Poor credit evaluation

Lending to high-risk borrowers without proper due diligence is a major contributor to NPAs. Inadequate risk assessment models, coupled with pressure to meet lending targets, can lead to the approval of loans to entities with questionable financial stability. A lack of thorough background checks and insufficient collateral evaluation further exacerbates this issue.

3. Fraudulent activities

Misuse of funds by borrowers can turn loans into NPAs. This includes instances of fabricated financial statements, diversion of funds for non-business purposes, and deliberate defaults. Such fraudulent activities are often difficult to detect early, leading to significant losses for banks.

4. High exposure to specific industries

Banks lending heavily to volatile sectors like infrastructure and real estate face higher NPA risks. These industries are susceptible to market fluctuations, regulatory changes, and project delays, all of which can severely impact borrowers' ability to repay loans. Diversification of loan portfolios is crucial to mitigate this risk.

5. External shocks

Events like pandemics or geopolitical tensions disrupt businesses, causing loan defaults. Unforeseen global events can trigger widespread economic instability. That can lead to market volatility, supply chain disruptions, and reduced consumer confidence. These shocks can severely impact businesses across various sectors, resulting in a surge of NPAs.

What is net NPA?

Net NPA is the amount remaining after deducting provisions and interest that banks expect to recover. It gives a clearer picture of actual bad loans since banks set aside a portion of their income as provisions.

How net NPA is calculated:

Net NPA = Gross NPA - Provisions

Banks create provisions according to RBI guidelines to mitigate potential losses. A lower net NPA indicates better financial stability.

Importance of net NPA in banking

1. Reflects actual risk exposure: Net NPA shows how much bad debt a bank still holds after accounting for provisions.
2. Impacts profitability: Higher net NPA means lower net interest income and reduced profits.
3. Affects investor confidence: Investors prefer banks with lower net NPAs as it suggests better financial discipline.
4. Regulatory implications: Banks with high net NPAs may face restrictions from the RBI, affecting their lending capacity.

Difference between gross NPA and net NPA

Why do NPAs matter to investors?

If you trade in banking stocks using a trading platform, NPAs can impact stock prices. Banks with high NPAs may struggle with profitability, affecting dividends and stock returns.

Key points for investors:

• A higher gross NPA means a bank has more bad loans.
• A lower net NPA suggests better financial management.
• Banks with high NPAs may see reduced investor confidence.
• Banks with lower NPAs have more capital for lending, leading to higher growth prospects.

How do NPAs impact the economy?

1. Banking sector stability

High NPAs reduce a bank’s ability to lend, affecting credit availability in the economy. If many banks struggle with NPAs, overall economic growth slows down.

2. Investor confidence

Investors closely monitor NPAs when investing in banking stocks. High NPAs indicate financial stress, leading to lower stock valuations and reduced capital inflows.

3. Government intervention

To control NPAs, the government and RBI introduce reforms like asset quality reviews, recapitalisation plans, and bad bank initiatives.

4. Impact on borrowers

When banks suffer from high NPAs, they adopt stricter lending policies. This makes it harder for businesses and individuals to get loans at favourable terms.

How do banks manage NPAs?

Banks take several measures to control NPAs, such as:

• Loan restructuring: Extending repayment timelines.
• Asset sales: Selling bad loans to asset reconstruction companies.
• Legal action: Filing cases under the Insolvency and Bankruptcy Code (IBC).
• Tighter credit policies: Stricter loan disbursal procedures to reduce default risks.

What can be done to reduce NPAs?

Reducing NPAs requires a combination of government policies, regulatory measures, and better banking practices:

• Stronger risk assessment models to avoid lending to risky borrowers.
• Faster resolution processes under the Insolvency and Bankruptcy Code.
• Encouraging responsible lending by monitoring credit expansion in high-risk sectors.
• Promoting financial literacy to ensure borrowers understand repayment obligations.

Understanding gross NPA versus net NPA is vital for investors who deal with banking stocks. A high gross NPA indicates potential financial stress, while a lower net NPA reflects strong risk management. By staying informed, investors can make well-calculated decisions while tracking bank performance effectively.