Net Charge-Off (NCO)

Key takeaways
* Net charge-off (NCO) equals gross charge-offs minus recoveries on previously charged-off debt.
* NCOs represent the portion of outstanding loans a lender does not expect to collect.
* Regulators and investors monitor NCOs and NCO-to-loans ratios to assess lender credit quality and economic stress.

What is a net charge-off?

A net charge-off is the dollar amount a lender writes off as uncollectible after accounting for any subsequent recoveries. When a borrower’s debt is deemed unlikely to be repaid, the lender records a gross charge-off. If some money is later recovered on that debt, the recovered amount is subtracted from the gross charge-offs to arrive at the net charge-off.

How it’s calculated
* Net charge-off (NCO) = Gross charge-offs − Recoveries
* NCO ratio = Net charge-offs ÷ Average total loans (for the reporting period)

Accounting and financial impact
* Lenders estimate expected loan losses through a loan loss provision. Actual charge-offs reduce that provision.
* The loan loss provision is reported as an expense on the income statement and reduces operating profits.
* After recording net charge-offs, lenders typically replenish the allowance for loan losses to reflect current risk expectations.

Why NCOs matter
* Credit quality indicator: Rising NCOs can signal deterioration in underwriting standards or borrower creditworthiness.
* Economic signal: Trends in aggregate NCOs often reflect broader economic conditions — higher NCOs typically accompany economic downturns.
* Regulatory monitoring: Central banks and regulators track NCOs and NCO-to-loans ratios across loan categories (residential, commercial, consumer, agricultural, etc.) to assess financial system health.

Example
* A major bank reported total net charge-offs equal to approximately 2.53% of average loans outstanding in 2019 (about one basis point higher than 2018). The bank applied the net charge-off amount against its loan loss provision, illustrating how charge-offs affect allowance and earnings.

Practical use for analysts and investors
* Compare a bank’s NCO ratio over time and against peers to evaluate credit performance.
* Break down NCOs by loan type to identify problem segments (e.g., consumer vs. commercial loans).
* Watch changes in loan loss provisions alongside NCOs to judge whether a lender is adequately reserving for future losses.

Summary

Net charge-offs quantify the portion of loans lenders do not expect to recover after accounting for recoveries. They are an important measure of credit losses, influence financial statements through the loan loss provision, and provide insight into lender health and economic trends.