If you're in any business that offers loans, from a small pawn shop to a big bank, you need to calculate your nonperforming assets. Using the nonperforming asset ratio you can assess the strength of your loan portfolio. This will tell you what percentage of your loans are actually generating profits for you.
Defining Nonperforming Assets
A nonperforming asset is a loan that the borrower ceases to make payments on for an extended period. It's said to be "nonperforming" because the lender ceases to receive any income from it. The exact length of time that can pass without a payment before an asset is categorized as nonperforming depends on the individual lender's criteria. If the borrower secured a loan with property or other assets the lender can use these to try to recoup the value of the loan. This is what happens in the case of property repossessions.
Nonperforming Asset Ratio
As a lender, you can assess the overall quality of your loans with the nonperforming asset ratio. The nonperforming asset ratio is a measure of your nonperforming assets relative to the total value of the loans that you have made -- often referred to as your loan book. To calculate this ratio, simply divide your nonperforming assets by your total loans. This will give you the ratio as a decimal. Multiply it by 100 to represent it as a percentage.
Example
Assume, for example, that you have made $10,000 in total loans. Of those loans, assume that you have classified $3,300 as nonperforming assets. To calculate the nonperforming asset ratio you would divide $3,300 by $10,000. This would give you 0.33 as a result. You would simply multiply this result by 100 to convert it to 33 percent. In this case, it would mean that approximately one third of the loans you've made are nonperforming.
Interpretation
The lower your nonperforming asset ratio, the better. A higher nonperforming asset ratio indicates that a greater number of the loans you've made are not making profits. While you want to keep your nonperforming asset ratio low, there is no standard level to aim for. If you are risk tolerant you may be willing to tolerate a higher ratio than if you are risk averse.