Business and Financial Planning for
Transformation
Agenda
• The business question
• Capital structure
• Key considerations
The business question
• MFIs need productive assets to generate revenues
– How are these assets created?
• Assets represent use (investment) of funds
• How does one get these funds?
– In order to lend “X” amount to “N” number of borrowers, an MFI needs “NX”
amount of funds
The business question
• What are the options?
–
–
–
–
Use own money
Ask friends to jointly own the assets created by investing in equity
Ask friends to provide loan funds in assurance of attractive interest
Look for institutional support
• What are the considerations?
Capital structure
•
•
•
•
•
Cost of funds
Scale
Rights and recourses available to funders
Tenor and maturity
Other considerations
– Regulations
– Currency
Investing in an MFI
• Lets look at its projected financials (illustration 1)
• Does the MFI cover its operating expenses in Year 1?
– How does it fund its portfolio?
– How does it fund its short-fall?
– What returns would funders expect?
• What alternative investment opportunities do they have?
Illustration 1
Nos. of active borrowers
Average loan O/S per
borrower
Total Loan Portfolio O/S
Portfolio yield (% age)
Income from portfolio
Operating Expense
Field Staff Salary
Fixed Office Expense
Loan losses (2% of average
portfolio)
Total Operating Expense
and loan loss
Income net of Operating
Expense
In percentage of Average
Portfolio
Year 1
2,000
Year 2
5,000
Year 3
15,000
Year 4
30,000
5,000
5,000
5,000
5,000
10,000,000 25,000,000 75,000,000 150,000,000
28%
28%
28%
28%
1,400,000 4,900,000 14,000,000 31,500,000
Year 1
1,440,000
1,000,000
Year 2
2,400,000
1,000,000
Year 3
5,400,000
1,000,000
Year 4
8,640,000
1,500,000
100,000
350,000
1,000,000
2,250,000
2,540,000
3,750,000
7,400,000
12,390,000
(1,140,000)
1,150,000
6,600,000
19,110,000
-23%
7%
13%
17%
Year 1
6,000
100
20
1,000,000
51%
Year 2
6,000
150
33
1,000,000
21%
Year 3
6,000
200
75
1,000,000
15%
Year 4
6,000
250
120
1,500,000
11%
Checks
Salary/Field Staff/Month
Borrower/Field Staff
Nos. of field staff
Fixed office expense
Operating Expense Ratio
Investing in an MFI
• Lets look at the cost of funding the loan portfolio of the MFI
– Assuming the cost of funds at 12%
• In the first three years, the surplus of Income over operating expenses
(EBIT) is less than this cost
• How do we service the cost on this fund?
• How do we fund the operating deficit in Year 1?
Investing in an MFI
• Lets assume the portfolio as well as the operating
deficits are funded at 12% cost
• How would the financials look then?
• What are the insights we can derive from the
projected financials?
– Additional funds are required to meet the operating
deficits & cost of funds in the early years
– If these funds are made available, there could be profits
later
Investing in an MFI
• Is this scenario an attractive proposition for a lender?
• Lets look at the kind of cashflows a loan entails, assuming a
loan of 1 million with interest @ 12% to be serviced in
perpetuity
Outstanding
Annual Interest Cost
1,000,000 1,000,000 1,000,000 in perpetuity….
120,000 120,000 120,000 in perpetuity….
• The present value of a perpetuity of 120,000 @ 12% is 1
million, equal to the loan amount
• Lenders are most interested in assured cashflows as loans
carry fixed obligations
• If these obligations are not met, it is seen as a default on
obligations
Investing in an MFI
• Lenders are also concerned with
– If the loan is only one element of financing necessary to
fund the business fully or are there other sources of
finance in place and secure?
– Will sufficient cash be generated in the business to meet
interest payments on the loan and to repay the principal?
– Are there physical assets, or other forms of collateral,
within the business against which a loan can be secured
so that, were the business to fail, the lender will be get all
or some of its money back?
Investing in an MFI
• Quite clearly not all the required funds can come as
loans
– Service of debt requires new loans in Years 1 to 3, which
may not be acceptable to lenders
• We need a funder who is willing to take the risks
involved?
– What would be the expectations of such a funder of risk
capital?
– We need an investor who owns up the initial losses as
well as potential future profits: Equity
Contrasting Equity and Debt: Seniority
• Debt (Loan)
– Carries a fixed
obligation to pay interest
and principal as per
terms and conditions
irrespective of profits or
losses
– Paying off loan may
even require liquidation
of assets
• Equity (Ownership)
– Profits increase net
equity, losses diminish it
– Only residual claim on
assets of the
organization, after the
claims of the lenders
have been satisfied
– Is junior to debt
Returns on equity is uncertain and it depends on multiple factors
Equity Scenario -1
• Lets see what happens for the same operational
projection when
– Loan portfolio is created from on-lending debt which
carries an interest of 12%
– All losses are met by equity investments
• Equity infusion is required in the initial years to
– Ride over operating losses
– Service interest on debt
– Maintain safe cash balances
Equity Scenario -1
• How does the net equity value (net worth) change
over this period?
– Losses in Years 1 and 2 lead to an erosion of net equity
value
• Is this form of financing a viable proposition?
– Lets consider the financials the financial statements
Equity Scenario -1
• In the Year 1, the net equity turns negative, this
means:
– All the assets are funded by debt (loan)
– The losses also are funded by debt (loan)
– The interest burden is high, reflecting risk
• In Years 3 to 5, in spite of profits ~ 95% of assets
are funded by debt
• This is not a desirable scenario for lenders, why?
Illustration 1
Nos. of active borrowers
Average loan O/S per
borrower
Total Loan Portfolio O/S
Portfolio yield (% age)
Income from portfolio
Operating Expense
Field Staff Salary
Fixed Office Expense
Loan losses (2% of average
portfolio)
Total Operating Expense
and loan loss
Income net of Operating
Expense
In percentage of Average
Portfolio
Year 1
2,000
Year 2
5,000
Year 3
15,000
Year 4
30,000
5,000
5,000
5,000
5,000
10,000,000 25,000,000 75,000,000 150,000,000
28%
28%
28%
28%
1,400,000 4,900,000 14,000,000 31,500,000
Year 1
1,440,000
1,000,000
Year 2
2,400,000
1,000,000
Year 3
5,400,000
1,000,000
Year 4
8,640,000
1,500,000
100,000
350,000
1,000,000
2,250,000
2,540,000
3,750,000
7,400,000
12,390,000
(1,140,000)
1,150,000
6,600,000
19,110,000
-23%
7%
13%
17%
Year 1
6,000
100
20
1,000,000
51%
Year 2
6,000
150
33
1,000,000
21%
Year 3
6,000
200
75
1,000,000
15%
Year 4
6,000
250
120
1,500,000
11%
Checks
Salary/Field Staff/Month
Borrower/Field Staff
Nos. of field staff
Fixed office expense
Operating Expense Ratio
Contrasting Equity and Debt: Control
• Debt (Loan)
– Lenders have limited
control over the
management of the
assets of an
organization
– While, lenders may
insist on a board seat,
and restrictive
covenants, they do not
have voting rights
• Equity (Ownership)
– Equity providers have
control over the
management of the
assets of an
organization
– They have voting rights
and make important
decisions regarding the
organization’s future
Owners may take risky decisions if most of the assets
are funded by debt
Equity Scenario -1
• Lets also look at this scenario with an Asset
Liability Management (ALM) lens:
– at least some portion of short term assets should be
financed through long term capital
– this represents the permanent part of working capital and
helps in ensuring smooth liquidity
Contrasting Equity and Debt: Maturity
• Debt (Loan)
– Short term debts
(current liabilities) have
a maturity of one year or
less
– Long term debts have
an average maturity of
more than one year
• Equity (Ownership)
– Equity represents long
term capital
Asset liability mismatch occur when the
financial terms of assets and liabilities do not match
Equity Scenario -2
• Lets see what happens for the same operational
projection:
– 10% - 15% of the loan portfolio is created from equity
– Remaining is created from on-lending debt which carries
an interest of 12%
– All losses are met by equity investments
• Higher amount of equity infusion is required over
the five years to:
– Ride over operating losses, and fund part of the portfolio
– Service interest on debt initially
– Maintain safe cash balances
Equity Scenario -2
• How does the net equity value (net worth) change
over this period?
– Losses in Years 1 and 2 still lead to an erosion of net
equity value, however additional equity ensures
comfortable levels of net equity
– Profits in Year 3 increase the value
– Profits in Years 4 and 5, result in net equity increasing by
26% and 27% respectively
• Is this form of financing a viable proposition?
Equity Scenario -2
• Even in the Year 1, the net equity remains positive, and
funds 15% of assets apart from the operating losses
• In all the Years, net equity funds > 15% of assets (capital
adequate)
• The interest burden is lower indicating lower financial risks
• This situation reflects a desirable ratio of debt to equity or
Financial LEVERAGE
Financial Leverage
• Leverage (or gearing) is using given resources in such a
way that the potential positive or negative outcome is
magnified and/or enhanced
– generally refers to using loan, so as to attempt to
increase the returns to equity
• If the firm's EBIT/Assets is higher than the rate of interest on
the loan, then its return on equity (ROE) will be higher than
if it did not borrow
• If the firm's EBIT/Assets is lower than the interest rate, then
its ROE will be lower than if it did not borrow
Financial Leverage
• Measures of financial leverage
• Debt-to-equity ratio = Debt/Equity
• Debt-to-assets ratio = Debt/Assets
= Debt/(Debt + Equity)
• Leverage allows greater potential returns to the
equity than otherwise would have been available,
through higher scale of operations
• Potential for loss is also greater, if there are losses,
the loan principal and all accrued interest on the
loan still need to be repaid
Financial Leverage
• Leverage in firms providing financial services is
closely related to regulatory capital requirements
• Best financial risk management practices
require (may also be required by regulations):
– adequate level of capitalization is maintained
– capital adequacy refers to the proportion of own capital to
risk weighted assets of the firm
• for simplicity, think of it as Equity/ Total assets
• Capital adequacy is related to leverage
– Equity/Total Assets = Equity/ (Debt + Equity)\
= 1/(1+Debt/Equity)
Contrasting Equity and Debt: Leverage
• Debt (Loan)
– Increase in borrowings
lead to increase in
leverage
– Higher the leverage,
higher the debt burden,
higher the perception of
financial risk
• Equity (Ownership)
– Increase in equity leads
to reduction of leverage
(de-leveraging)
– Increase in equity
improves capital
adequacy
Optimal leverage helps an organization in scaling up operations
Debt, Equity and Value
• Value of a firm is equal to value of debt and equity
in the firm
– Book value of the firm is equal to the sum of the book
values of debt and equity
– Book value of equity is also called Net Worth or Net
Equity
– Book value is backward looking - created by past actions
Debt, Equity and Value
• Value of a firm is equal to value of debt and equity
in the firm
– Market value of the firm is equal to the sum of the market
values of debt and equity
– Market value of firm is independent of the capital
structure
• Why?
– Market value is forward looking – based on the
expectations of the returns generated by the ASSETS of
the firm
Contrasting Equity and Debt: Value
• Debt (Loan)
– Present value of all
cashflows to lenders
– Constitutes principal
and interest payments,
which are precontracted
• Equity (Ownership)
– Present value of all cash
that comes to equity
investors through the
period of their
investment
– May be through
dividends or sale of
equity
– Returns on equity
cannot be precontracted
Value generated by the assets of the firm is shared between
providers of debt and equity
Recapitulate
• Capital structure refers to the way a firm finances
its assets through some combination of debt,
equity and hybrid securities
• There are many considerations in financial planning
for MFIs
– Scale, Cost, Control, Leverage, Maturity
• Value generated by the assets of the firm is shared
between providers of debt and equity
• While lenders look for assured returns, equity
investors get returns only when the firm makes
profits