Net Charge-Offs are the final score in a lender's game against bad debt. Imagine a bank as a goalie. Every loan that goes bad and is deemed uncollectible is a “shot on goal”—this is a charge-off. The bank has to write this loan off its books, accepting it as a loss that impacts its earnings. However, sometimes the bank's collection department makes a great save and manages to recover some or all of the money from a previously written-off loan. These are called recoveries. Net Charge-Offs are simply the total amount of bad loans written off (Gross Charge-Offs) minus the total amount recovered from old bad loans during a period. This figure represents the real, bottom-line cost of lending mistakes and is a critical health metric for any company in the business of lending money, especially banks.
The concept is a straightforward piece of accounting arithmetic that reveals a lender's true losses from soured loans. When a borrower stops making payments for a significant period (typically 90 to 180 days), the lender gives up hope of collecting the full amount and removes the loan from its active assets by “charging it off.” This doesn't mean they stop trying to collect, but for accounting purposes, it's considered a loss. The formula is simple:
Let's look at a quick example. Imagine “Value Bank” has a tough quarter:
For a value investing practitioner analyzing a bank or credit card company, net charge-offs are not just another number; they are a direct look into the quality and prudence of the company's management.
A consistently high or rapidly rising level of net charge-offs is a massive red flag. It suggests the bank has poor underwriting standards, meaning it's lending money to people or businesses who are less likely to pay it back. This might create impressive loan growth in the short term but inevitably leads to painful losses down the road. Value investors seek durable businesses, and a bank that can't manage its core risk of lending is anything but durable.
Net charge-offs are one of the best tools for comparing the quality of different banks. When an economic downturn hits, all banks will see their charge-offs rise. The key question is, whose rise less? A bank that maintains lower net charge-offs than its peers during tough times is demonstrating superior risk management. This is a hallmark of the well-managed, conservative institutions that legendary investors like Warren Buffett favor.
Banks don't just absorb these losses out of thin air. They maintain a reserve account called the allowance for loan and lease losses (or a similar account under modern accounting). Charge-offs are written off against this allowance. If charge-offs are higher than expected, the bank must take a larger provision for credit losses from its current revenue to rebuild the allowance. This provision is a direct expense that reduces the bank's reported profit. In short: more charge-offs equal lower profits.
You can find a bank's net charge-off data in its quarterly (10-Q) and annual (10-K) reports filed with the SEC. The best places to look are the Management's Discussion and Analysis (MD&A) section and the footnotes to the financial statements, which often provide detailed tables on loan quality.
An investor should never look at the absolute dollar amount of net charge-offs in isolation. A giant bank like JPMorgan Chase will naturally have far more charge-offs than a small community bank. To make a fair comparison, you must use the Net Charge-Off Rate (NCO Rate).
This ratio tells you what percentage of the bank's total loan book went bad in a period. It's the single most important metric for comparing the underwriting quality between banks of different sizes.
When analyzing the NCO rate, always do the following: