A Balance Sheet and an Income Statement provide the basic financial information about microfinance institution and its activities. Together, they report on the financial position of the institution and its income and expenditures. Progressive balance sheets and income statements, together with the portfolio report, serve as the foundation for further analysis of the institution’s financial health, performance and viability.
However, the top, or left-hand side of the Balance Sheet reports the microfinance institution’s assets, or ‘what it owns’. Whether financed through debt or its own equity, these assets are the income generating base for the institution.
Assets include items such as buildings, desks in branch offices, safes for secure deposits, cash on hand or in bank accounts, and the loan portfolio. Each of these is essential to microfinance institution’s operations, and hence the continued capacity to generate income.
In microfinance institution, the largest income-generating asset is its loan portfolio. Increases in fixed assets do not have a direct impact on revenues generated by the institution, while the size and quality of the loan portfolio do. Portfolio quality, then, has a direct impact on microfinance institution’s capacity to generate income and to sustain its operations.
Investors, managers and board members of any institution rely on financial statements to assess the financial health of the institution. Disclosure guidelines within an industry, such as microfinance, helps to ensure that the necessary information for sound management is available to stakeholders, and that the information is comparable industry-wide.
Disclosure pertains not only to the financial information itself, but also to the accounting methods used to record it. Though the guidelines do not prescribe a given accounting method for calculating depreciation, they do require that the method used be disclosed with the financial statements.
Given their social mission and the fact that they are a financial service provider, microfinance institution must be more rigorous about disclosure than is required under International Accounting Standards.
Effective disclosure should report on subsidies, whether cash, in-kind, or through soft loans, as well as loan portfolio quality, the extent and methods used to report aging of loans and write-offs for bad debt.
As the microfinance industry evolves, the cumulative experience of the various microfinance institution will be used to develop standards in financial disclosure and in the very types of financial statements presented. Current efforts at defining standards require that microfinance institution produce a Balance Sheet and Income Statement, the two statements discussed herein.
International Accounting Standards require two other statements: a cash flow statement and a statement of changes in equity. Current microfinance standards projects do not require these statements.
Moreover, soft or concessional loans are one type of subsidy to microfinance institution. As a liability, loans are claims on future resources of the institution. In this case, it is in the form of repayments of principal. Soft loans do not require that microfinance institution pay commercial interest rates for the use of the money.
Rather, such loans decrease the cost of funds below commercial rates, providing an effective subsidy to the microfinance institution. This subsidy is calculated by subtracting the amount of interest and fees paid on soft loans from the amount the institution would have paid if the loans had been priced at commercial rates. Such loans should be reported separately from commercial rate liabilities, as their interest payments do not represent the true market cost of carrying this debt.
Microfinance institution mobilizes funds from the right side of its Balance Sheet (also known as Liabilities and Equity) to finance the left side (the Assets). The microfinance institution’s largest asset, its loan portfolio, can be funded by liabilities, such as loans or deposits mobilized from customers, or by its own capital, its equity. The ratio of debt to equity is known as leverage.
A highly leveraged institution is one with a high percentage of debt to equity. Attracting more debt, for a financial institution, allows it to make more loans, but if debt increases significantly as a percentage of total funding, then the institution risks having too small a cushion of its own capital (equity) to absorb losses.
In international banking norms, the 1988 accord by the Basle Committee on Banking Standards set the capital adequacy requirement at equity of at least 8% of risk-weighted assets, limiting an institution’s leverage of around 12 times its equity base. MicroFinance institution have not yet leveraged this much.
In the November 2001 issue of the MicroBanking Bulletin, only around 20 institutions, African Community Banks and large Latin American microfinance institution, reported leverage as high as 6.9 and 5.7 times, respectively, their equity base. No other categories or microfinance institution peer groups reported average leverage this high.
In addition, equity provides an important source of funds for microfinance institutions. Institutions use it to meet capital requirements stipulated under regulatory frameworks or as reserves in case of losses.
As discussed above, equity also provides a base for leveraging an institution and for gaining access to debt financing or deposit mobilization. Two common types of equity include retained earnings and share capital.
As an institution becomes financially self-sufficient and covers its costs, earnings in excess of costs are reinvested in the institution, increasing equity through retained earnings. For institutions allowed to issue shares, share capital from direct investment in microfinance institution can provide another source of equity building.
Most microfinance institutions have not yet reached this stage or institutional form. Donors have provided more traditional forms of equity and quasi-equity for microfinance institution through grants for loan capital, capital expenditures or operating shortfalls. Donated equity should be reported transparently and cumulatively on microfinance institution’s Balance Sheet.
Conclusively, the Balance Sheet presents the balance, inherent in accounting, between assets (often called the left side of the Balance Sheet) and the sum of liabilities and equity (likewise, referred to as the right side of the Balance Sheet), as follows:
Assets = Liabilities + Equity
The left side represents what an institution owns and the right side what financed these assets. In other words, you can think of the Balance Sheet as stating the sources (right) and uses (left) of funds. You can also restate the accounting equation:
Assets – Liabilities = Equity
From this perspective, the equation describes the net worth (or equity) of an institution as the total of assets minus all claims on these assets: what the institution really owns once all claims have been paid off.
For financial institutions, this balance between different sources of funding, whether equity (from the institution) or debt (from outside) plays an important role in capital adequacy standards determined by regulatory bodies.
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