PERFORMANCE INDICATORS IN MICROFINANCE P.V. Viswanath Learning Goals What are the different measures of an MFIs performance? How can these financial ratios be used to evaluate a microfinance institution? Caveat: Some of the ratios discussed here are more appropriate to MFIs that are mainly involved in microcredit. Much of this material is taken from the Technical Guide published by MicroRate and the Inter-American Development Bank, as well as from Armendariz and Morduch, Economics of Microfinance Four categories of indicators Portfolio Quality Efficiency and Productivity These ratios measure the efficiency with which the MFI conducts its operations. MFI rates of efficiency are much lower than that of commercial banks because their operations are highly labor-intensive. Financial Management These ratios measure the quality of the MFIs loan portfolio. MFI portfolios are generally of better quality than those of commercial lenders. These ratios ensure that there is enough liquidity to meet an MFI’s obligations to disburse loans to its borrowers and to repay loans to its creditors. Profitability These ratios summarize the overall performance of the MFI. Portfolio Quality Portfolio at Risk Provision Expense Ratio Risk Coverage Ratio Write-Off Ratio Portfolio at Risk PAR = Outstanding Balance in Arrears over 30 Days plus Restructured Loans/ Total Outstanding Gross Portfolio It shows the portion of the portfolio that is “contaminated” by arrears and therefore at risk of not being repaid. This ratio is relatively manipulation-free, compared to ratios such as the repayment rate which may not take into account loans that are past due. In cases of agricultural loans, where there might be balloon payments, PAR 30 ratios may be irrelevant because there is no warning of non-repayment until the event actually occurs. Loan Loss Provisions A loan provision records the possibility that an asset in the balance sheet is not 100% recoverable. Provisions expense this anticipated loss of value in the portfolio gradually over the appropriate periods in which that asset generates income, instead of waiting until the actual loss of the asset is realized. Provisions are only accounting estimates and entries, and they do not involve a movement of cash, like saving for a rainy day. Loan loss provisions charged to a period are expensed in the income and expense statement. The corresponding credit accumulates over time in the balance sheet as reserves shown as a negative asset. The accounting transaction is: Debit Loan loss provision; Credit Loan loss reserve Provision Expense Ratio Ratio = Loan Loss Provisioning Expenses/ Period Average Gross Portfolio The Loan Loss Provisioning Expense is an incomestatement number, not a balance-sheet number. It represents the charge to income that is taken to take into account future loan losses. For non-regulated MFIs, this may be at the discretions of the MFI and thus may be underestimated. Even where regulatory guidelines are satisfied, an MFI could show profits by scaling back on provision expenses. Risk Coverage Ratio Ratio = Loan Loss Reserves/ Outstanding Balance on Arrears over 30 days plus Refinanced Loans This shows what percent of the portfolio at risk is covered by actual loan loss reserves. Refinanced loans are added to the denominator because a non-performing loan can be converted into a performing loan by the simple device of allowing the borrower to extend the payment period or by refinancing it. Write-off Ratio Ratio = Value of Loans Written Off/ Period Average Gross Portfolio This ratio represents the loans that the institution has removed from its books because of a substantial doubt that they will be recovered. Loan losses or write-offs occur when it is determined that loans are unrecoverable. Because loan loss reserves already provided for possible losses, loan losses are written off against loan loss reserves and are also removed from the outstanding portfolio. The accounting transaction is: Debit Loan loss reserve; Credit Outstanding loans Write-offs do not affect the net portfolio outstanding unless an increase in the loan reserve is made. When write-offs are recovered, they are booked in the income and expense statement as miscellaneous income. Efficiency and Productivity Operating Expense Ratio Cost Per Borrower Personnel Productivity Loan Officer Productivity Operating Expense Ratio Ratio = Operating Expenses/Period Average Gross Portfolio Operating Expenses include Personnel Expenses, Administrative Expenses, Depreciation and any other expenses necessary for the operation of the MFI. Interest and provision expenses, as well as extraordinary expenses are not included. This ratio measures the institutional cost of delivering loan and other services. Operating Expense Ratios are related to loan size and portfolio size. Similarly, rural MFIs have higher operating expenses, since their clients are more dispersed. Hence one should be careful in comparing this ratio across MFIs. Cost per Borrower Ratio = Operating Expenses/Period Average Number of Borrowers This measures the cost of maintaining an active borrower. A borrower is an individually identifiable person who has at least one current outstanding loan. All borrowers in a group loan are counted separately. Since the size of the portfolio is not included in the denominator as in the Operating Expense Ratio calculation, MFIs with larger loans do not automatically appear more efficient. Pawn loans and consumer loans are excluded from the denominator, since they require far less screening and analysis efforts. (Why?) Personnel Productivity Ratio = Number of Borrowers (excluding Consumer and Pawn Loans)/ Total Staff Since MFIs are very labor intensive, this is a very important measure of efficiency. Low staff productivity often is due to excessive paperwork. A variant of this ratio is the loan officer productivity ratio, where the denominator includes all personnel whose main activity is the direct management of a portion of the loan portfolio; it does not include administrative staff or analysts who process loans without direct client contact. Financial Management Funding Expense Ratio Cost of Funds Ratio Debt/Equity Ratio Funding Expense Ratio Ratio = Interest and Fee Expenses/ Period Average Gross Portfolio This ratio measures the total interest expense incurred by the institution to fund its loan portfolio. The difference between the portfolio yield and the funding expense ratio is a measure of the net interest margin. The funding expense ratio plus the provision expense ratio plus the operating expense ratio determines the minimum lending rate an MFI must charge to cover tis costs. If the MFI uses non-debt sources of finance, obviously this ratio underestimates the total cost of funds. Cost of Funds Ratio Ratio = Interest and Fee Expenses/ Period Average Funding Liabilities The denominator contains all funding liabilities of the MFI, including deposits, commercial funds, subsidized funds and quasi-capital. It does not include accounts payable, since these are short-term obligations not directly related to the lending operations of the MFI; neither are mortgage loans obtained to finance the MFIs buildings, for the same reason. This ratio measures the average cost of the company’s borrowed funds and shows whether it has access to low cost funding sources, such as savings. Debt-Equity Ratio Ratio = Total Liabilities/Total Equity Total liabilities include everything the MFI owes to others. This ratio measures the overall leverage of the institution. Traditionally, NGO MFIs have low debtequity ratios, since their ability to obtain commercial debt is limited. Most MFIs have lower leverage than commercial banks. Profitability /Sustainability Profitability Ratios Return on Equity Return on Assets Portfolio Yield Sustainability Ratios Operating Self-Sufficiency Financial Self-Sufficiency Return on Equity Ratio = Net Adjusted Income Before Donations (after taxes)/ Period Average Equity This ratio measures the profitability of the institution. This is more important for for-profit institutions. For non-profit institutions, it can be used as a measure of commercial viability. When comparing across MFIs, differences in accounting policies have to be taken into account. Return on Assets Net Adjusted Income Before Donations/Period Average Assets This is an overall measure of profitability that reflects both the profit margin and the efficiency of the institution, as can be seen from the following identity. ROA = Net Adjusted Income/Revenue x Revenue/Assets. Portfolio Yield Ratio = Interest and Fee Income/ Period Average Gross Portfolio This measures how much money the MFI actually collected from its clients. A comparison between the portfolio yield and the average effective lending rate gives an indication of the MFI’s efficiency in collecting from its clients. Since portfolio yield is a cash measure, it is not affected by accrual accounting practices that might mask bad loans. Operational Self-Sufficiency OSS = Operating Revenue/(Financial Expense + loan-loss provision expense + operating expense) Revenues come from interest and fees paid by borrowers, as well as income from investments and from other services (e.g. sales of insurance products) The denominator measures the cost of raising capital. It includes the interest and fees that the institution pays to commercial banks, shareholders and the other investors. It includes interest paid to depositors. The loan-loss provision is the amount set aside to cover the cost of loans that are not expected to be recovered. Operating Expenses include rent, staff wages and transport costs among others. Operational Self-Sufficiency A value of 100% or more for OSS indicates full operational self-sufficiency; such an institution does not need outside support. A value under 100 indicates that the MFI relies on continued outside funding to maintain its current level of operation. However, some of the operations of the MFI may be subsidized. In order to adjust for this, we have the financial self-sufficiency ratio. Financial Self-Sufficiency FSS = Adjusted Operating Revenue/(Financial Expense + loan-loss provision expense + operating expense + expense adjustments). Operating Expenses are adjusted for subsidized cost-of-funds and for in-kind donations. Cost-of-funds are computed at market rates and the difference is added back to the financial expense. The market rate used should be the prime rate, adjusted for the riskiness of microloans. In-kind donations add in the cost, or fair market value, of goods and services that the MFI does not pay for but that are important to the operation of its business. This could include technical advice, training, rent, use of transport and so on. If FSS is below 100, the institution is considered subsidy-dependent.