Measuring Financial Viability Of Microfinance Institution
Tunde Raji - February 26, 2017

According to CGAP, measuring financial viability of MicroFinance Institution involves considering the real, not subsidized profit (or loss) of that institution. Generally, financial statements do not account for many hidden costs, like the effect of inflation on the institution’s equity, the cost of subsidized funds or the value of in-kind donations.


In order to measure financial viability, Microfinance Institution’s financial statements are adjusted to account for these costs. Adjusted statements can provide meaningful information on whether the institution can function without donor funding. Standard adjustments enable a comparison among Microfinance Institutions.


It states that diverse fields such as medicine, and manufacturing produce bench-marking standards against which organizations and companies in that field can compare their performance among their peers. Producing benchmarks, however, requires a set of comparable data and agreed upon performance measures.
In the field of Microfinance, an agreed upon set of ratios to measure performance has been developed. Accurate data, adjusted along common lines, are a prerequisite for benchmark.


For instance, a Microfinance Institution that does not set aside a Reserve for loan losses cannot compare its Return On Assets to a Microfinance Bank that does. When comparing its own performance against industry benchmarks, a Microfinance Institution can identify performance variance and highlight the key factors that influences performance.
It stresses that the Return On Assets (ROA) measures how well a Microfinance Institution has used its asset base to generate Income. The Adjusted Return On Asset (AROA) of different institutions can be calculated and compared. The Adjusted Return On Asset (AROA) is calculated as follows:


Adjusted Operating Profits     Vs    Average Total Assets


However, as a ratio that measures financial return over a given period on a set of assets whose value varies from the beginning to the end of the period, average total assets for the period are used in the denominator.


CGAP expresses that such measures of profitability must still be carefully interpreted. Exceptional income or expenses can have a marked impact on the adjusted operating profits of a Microfinance Institution in one year, causing a spike or a dip in its Adjusted Return On Asset as compared with previous years. Such events as sale of an asset, purchase of a building, investment in a new Management Information System or recovery of principal on loans written-off could cause such fluctuations.


Further, CGAP asserts that Adjusted Return on Equity (AROE) is a financial analysis tool similar to Adjusted Return On Asset. It measures Return Earned On Equity used to finance the institution’s assets, rather than the Return On Assets. Assets can also be financed by liabilities. Hence, the Adjusted Return On Equity is calculated as follows:


Adjusted Operating Profits    Vs     Average Total Equity


It is emphasized that Inflation has a real impact on the Equity of a Microfinance Institution. If the Adjusted Return On Equity is less than zero, then the institution’s equity erodes year after year. Like Adjusted Return On Assets, Adjusted Return On Equity measures return over a given period. Hence, equity must be averaged to reach an average total equity for the year.


A distinction should be made here to account for institutional forms. In private for-profit Microfinance Institutions, whether they are banks or non-bank financial institutions, owners would use the Adjusted Return On Equity measure to determine the return on their invested capital. In not-for-profit Microfinance Institutions, this measure yields a proxy of the institution’s commercial viability, were it to open up to investors to raise capital.


Another measure to determine financial viability is through Portfolio Yield. It measures how much a Microfinance Institution earned through its lending operations. Income used to calculate yield includes all Cash Interest and Fee payments, but does not include Interest Accruals. The following formula calculates the yield:


Income from Lending    Vs    Average Outstanding Portfolio


Portfolio Yield as a measure of financial viability is particularly useful in demystifying the actual Cash flow of the various Interests and Fees structure on microfinance loans. It measures the amount of actual income from lending for the period and compares it to the period average outstanding portfolio that produced it. As such, Portfolio Yield is an initial indicator that a Microfinance Institution is saddled with responsibility of generating the required income in order to become sustainable. As an average, Portfolio Yield represents a measure of yield over a given period, and not a particular moment or on a particular loan product.


Operational Self Sufficiency (OSS) is another measure for financial viability in Microfinance Institution. Donors and Microfinance Institution’s management use this benchmark to assess how far a Microfinance Institution come in covering its operating expenses with its operating income.


Two variants of Operational Self Sufficiency exist. The first includes the actual cash cost of funds in its calculations, as follows:


Operating Income    Vs    Total Operating Expenses


Expenses in this calculation include all cash and non-cash expenses from the income statement, such as depreciation and loan loss provision expenses, as well as any cash costs of funds, such as interest and fees actually paid on debt or to savers with voluntary deposits.


Some analysts prefer to use a different version of Operational Self Sufficiency, which excludes the cash cost of funds from total operating expenses:


Operating Income    Vs    Total Operating Expenses, less Cash Cost of Funds


From a comparative perspective, this formula has one distinct advantage: it does not penalize Microfinance Institutions that have accessed commercial financial markets, through debt or voluntary deposit taking, to fund their portfolios. As Microfinance Institutions have different debt/ equity structures, or funding structures, two institutions with similar performance as measured in Adjusted Return On Asset, could have huge varying Operational Self Sufficiency if one funded its portfolio mostly from equity and the other from liabilities.



Both these versions of Operational Self Sufficiency use data over a given period. Unlike other indicators, such as Adjusted Return On Asset (AROA), which compares Income Statement accounts to Balance Sheet accounts.The calculation of Operational Self Sufficiency does not require period averages in the denominator. Rather, since both the amounts in the numerator and the denominator come from the Income Statement, the total amount at the end of the period is used.


CGAP declares that Financial self-sufficiency (FSS) also measures the extent to which Operating Profits cover a Microfinance Institution’s costs. Financial Self Sufficiency measures how much coverage exists on an adjusted basis. These adjustments are similar to those made for Adjusted Return On Asset(AROA) and Adjusted Return On Equity (AROE), and it shows how the financial picture of the Microfinance Institution would look on an unsubsidized basis, where funds would be raised on the commercial market, rather than through donor grants or subsidized capital. As such, Financial Self Sufficiency is measured as follows:


Adjusted Operating Income    Vs    Adjusted Operating Expenses


CGAP concludes that Financial Self Sufficiency calculations require adjustments to the operating expenses of a Microfinance Institution. Customer deposits (savings) and debt must be adjusted to reflect market rates on loans and deposits. Likewise, as inflation erodes the value of equity, financial equity balances must be adjusted for inflation. If a Microfinance Institution receives subsidies or in-kind donations, it must be accounted for in the adjustments. Cash donations must be excluded from Operating Income.


It is important to note that Financial Self Sufficiency (FSS), like Operational Self Sufficiency (OSS), is an indication of performance over a period and not at a given point in time.



Recommended Reading

CGAP, “Format for Appraisal of Microfinance Institutions,” CGAP Technical Tools Series No. 4, July 1999


Source: CGAP

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