What Is a Net Charge-Off (NCO)?
Let me explain what a net charge-off, or NCO, really is. It's the dollar amount that shows the difference between gross charge-offs and any recoveries that come in later on delinquent debt. Essentially, net charge-offs are the debts owed to a company that you can bet won't be recovered by that company.
This bad debt gets written off and labeled as gross charge-offs. But if some money trickles back in later, you subtract that from the gross charge-offs to get the net charge-off value.
Key Takeaways
- A net charge-off (NCO) is the amount representing the difference between gross charge-offs and recoveries of delinquent debt.
- Net charge-offs are the debt owed to a company unlikely to be recovered by that company.
- The Federal Reserve Bank tracks aggregate net charge-off ratios for banks in the U.S.—the ratio is defined as net charge-offs divided by average total loans during a period.
Understanding Net Charge-Offs (NCOs)
You should know it's rare for a lender to collect 100% on all outstanding loans. As standard practice, a creditor sets up a loan loss provision, which is an estimate based on historical data of what won't be repaid, and then they charge off the amounts they determine aren't coming back.
Usually, these loss provisions are close to the actual gross charge-offs, but recoveries can happen eventually, and when you net those against gross charge-offs, you get the net charge-off figure. During an accounting period, a lender reduces the loan loss provision by the net charge-off amount and then replenishes it. This provision shows up as an expense on the income statement, which cuts into operating profits.
The Federal Reserve Bank keeps tabs on aggregate net charge-off ratios for U.S. banks. They define the ratio as net charge-offs divided by average total loans over a period. There's also a breakdown by categories like real estate (residential, commercial, farmland), consumer, leases, commercial and industrial (C&I), and agricultural loans. For the first quarter of 2022, the seasonally adjusted net charge-offs to total loans for banks ratio was 0.21%.
Company Example of a Net Charge-Off
Take Capital One Financial Corp. as an example. They reported total net charge-offs in 2019 as a percent of average loans outstanding at 2.53%, up from 2.52% in 2018, which is an increase of 1 basis point. Following accounting rules, the bank applied this net charge-off amount to the loan loss provision. These NCO amounts give investors key info on lenders' credit standards and can signal broader economic conditions.
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