P P A A R R T T I I C C I I P P A A N N T T C C O O U U R R S S E E M M A A T T E E R R I I A A L L S S Financial Analysis C O N S U L T A T I V E G R O U P T O A S S I S T T H E P O O R E S T NOTE The participant course materials contain the main technical messages and concepts delivered in this course. It is not intended to serve as a substitute for the full information and skills delivered through the individual courses Skills for Microfinance Managers training series. During the actual courses, key concepts are presented with case studies, exchange of participant experiences and other activities to help transfer skills.
Users interested in attending a training course should directly contact CGAP hubs and partners for course dates and venues or visit the CGAP Web site at www.cgap.org/html/mfis_skills_microfinance_manag.html. CGAP would like to thank those who were instrumental to the development and design of the original course that led to ... more. less.
this participant summary: Michael Goldberg, Ruth Goodwin- Groen, Lorna Grace, Brigit Helms, Jennifer Isern, Joanna Ledgerwood, Patricia Mwangi, Bridge Octavio, Janis Sabetta and all CGAP training hubs and partners. Copyright 2001, The Consultative Group to Assist the Poorest (CGAP).<br><br> Contents Overview and Goals ............................................................................................. 3 Overview ........................................................................................................... 3 Goals of the Course .............................................................................................<br><br> 4 Chart of Accounts.................................................................................................. 5 Financial Statem ents............................................................................................. 7 Balance Sheet.....................................................................................................<br><br> 7 Income Statement............................................................................................... 8 Cash Flow Statement ........................................................................................... 9 Portfolio Report.................................................................................................<br><br> 10 Form atting Financial Statem ents ........................................................................ 12 Adjustm ents........................................................................................................ 19 Inflation...........................................................................................................<br><br> 19 Subsidized Cost of Funds.................................................................................... 20 In-Kind Donations ............................................................................................. 21 I ndicators for Financial Analysis ........................................................................<br><br> 23 Loan Portfolio Quality Analysis............................................................................. 25 Efficiency ......................................................................................................... 29 Profitability Analysis...........................................................................................<br><br> 31 CGAP Participant Course Materials: Financial Analysis " 3 Overview and Goals ! !! !<br><br> Overview International best practice in microfinance around the world suggests good financial analysis is the basis for successful and sustainable microfinance operations. Some would even say that without financial analysis your MFI will never achieve sustainability. What is Financial Analysis?<br><br> The computation of analytical ratios from financial statements and interpretation of these ratios to determine their trends as a basis for management decisions Sustainability means relying on commercially priced and internally generated funds rather than on donors for growth. CGAP Participant Course Materials: Financial Analysis " 4 Sustainability Coverage of administrative costs + Loan loss + Costs of funds + Inflation + Capitalization for growth from operating income Goals of the Course " To master the tools needed for understanding the financial position and sustainability of your institution. " To use financial analysis to improve your institution 9s sustainability, by 1.<br><br> Identifying the components, purpose, relationships, and importance of the main financial statement; 2. Learning the formats of income statements and balance sheets to easily separate the effect of donor funds; 3. Analyzing financial statements to monitor profitability, efficiency, and portfolio quality; 4.<br><br> Adjusting costs for inflation, subsidized cost of funds, and in-kind donations; and 5. Identifying critical factors for moving toward financial sustainability. CGAP Participant Course Materials: Financial Analysis " 5 Chart of Accounts !<br><br> !! ! A chart of accounts " Provides the structure for recording and reporting of all financial transactions for the institution.<br><br> " Classifies and determines what financial transactions can be tracked for managerial purposes and reported in the financial statements. " Transactions are organized as either asset, liability, equity, revenue (income) or expense accounts. Determ inants " The structure and level of detail of the chart of accounts will determine the type of information management will be able to access and analyze in the future.<br><br> " Management must design the chart of account and be clear about what it needs. In particular, it is fundamentally important to be able to differentiate between the grant income given by donors from the operational income earned from the MFI 9s products and services. Operational income is the basis for financial analysis, not grant income, and the importance of accurately tracking it cannot be overstated.<br><br> " Different end users of the information generated have different needs. Internal management and auditors, tax code, donors, and regulatory demands all influence how the chart of accounts is set up. " Some charts of accounts and report formats may be legislated and therefore MFIs are obligated to follow the mandated requirements in these countries.<br><br> CGAP Participant Course Materials: Financial Analysis " 6 Sam ple Chart of Accounts Assets Liabilities Equity 101 Cash 201 Short-term borrow ing 301 Paid in equity 102 Reserves 202 Client savings 302 Donated equity prior year 103 Short term investments 203 Long-term debt (commercial) 303 Donated equity current year 104 Loan portfolio 204 Long-term debt (concessional) 304 Prior year profit/ loss 105 Loan loss reserve 205 Restricted/ deferred revenue 305 Current year profit/ loss 106 Other current assets 306 Other capital accounts 114 Long-term investments 115 Property 116 Fixed assets 117 Accum ulated depreciation 118 Other assets Revenue Expenses 401 I nterest on current and past due loans 501 I nterest paid on short-term borrow ing 402 I nterest on restructured loans 502 I nterest paid on client savings 403 I nterest on investments 503 I nterest paid on long-term debt 404 Loan fees on loans 505 Provision for loan losses 405 Late fees on loans 510 Salaries and benefits 410 Donations 4unrestricted 512 Comm unications 513 Courier/ postage 514 Rent 515 Utilities 516 Equipment 517 Equipment leasing 518 Depreciation 519 Bank charges 520 Advertising and prom otion 521 I nsurance 522 Supplies 523 Maintenance 524 Travel and accom modation 525 Legal fees 526 Professional development (training) 527 Com puter softw are 528 Printing 529 Fees/ dues 530 Miscellaneous CGAP Participant Course Materials: Financial Analysis " 7 Financial Statements ! !! !<br><br> MFIs commonly use four types of financial statements: " Balance sheet " Income statement " Cash flow statement " Portfolio report Balance Sheet A balance sheet is a summary of the financial position at a specific point in time. It presents the economic resources of an organization and the claims against those resources. Assets Liabilities Equity " Represent what is owned by the organization or owed to it by others " Are items in which an organization has invested its funds for the purpose of generating revenue.<br><br> " Represent what is owed by the organization to others. " Represents the capital or net worth of the organization. " Includes capital contributions of members, investors or donors, retained earnings, and the current year surplus.<br><br> Assets = Liabilities + Equity CGAP Participant Course Materials: Financial Analysis " 8 Income Statement An income statement reports the organization 9s financial performance over a specified period of time. It summarizes all revenue earned and expenses incurred during a specified accounting period. An institution prepares an income statement so that it can determine its net profit or loss (the difference between revenue and expenses).<br><br> Revenue Expenses Refers to money earned by an organization for goods sold and services rendered during an accounting period, including " Interest earned on loans to clients " Fees earned on loans to clients " Interest earned on deposits with a bank, etc. Represent costs incurred for goods and services used in the process of earning revenue. Direct expenses for an MFI include " Financial costs, " Administrative expenses, and " Loan loss provisions.<br><br> An income statement " Relates to a balance sheet through the transfer of cash donations and net profit (loss) as well as depreciation and in the relationship between the loan loss provision, and the reserve. " Uses a portfolio report 9s historical default rates (and the current reserve) to establish the Loan Loss Provision. " Relates to a cash flow statement through the net profit/loss as a starting point on the cash flow (indirect method).<br><br> CGAP Participant Course Materials: Financial Analysis " 9 Cash Flow Statement A cash flow statem ent shows where an institution 9s cash is coming from and how it is being used over a period of time. A cash flow statement " Classifies the cash flows into operating, investing and financing activities. f Operating activities: services provided (income-earning activities).<br><br> f Investing activities: expenditures that have been made for resources intended to generate future income and cash flows. f Financing activities: resources obtained from and resources returned to the owners, resources obtained through borrowings (short-term o r long-term) as well as donor funds. " Can use either f The direct method, by which major classes of gross cash receipts and gross cash payments are shown to arrive at net cash flow (recommended by IAS) f The indirect method, works back from net profit or loss, adding or deducting noncash transactions, deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows to arrive at net cash flow.<br><br> CGAP Participant Course Materials: Financial Analysis " 10 Portfolio Report A portfolio report provides information about the lending and savings operations of an MFI. It provides timely and accurate data about the quality of the portfolio. It usually also includes other key portfolio performance indicators (e.g., outreach).<br><br> " Information usually includes f Number and value of loans outstanding end of period, f Total value and number of loans disbursed during the period, f Average outstanding balance of loans, value of payments in arrears, f Value of outstanding loan balances in arrears, f Value of loans written off during period, f Portfolio aging analysis , f Information on loan terms, loan officers, savings accounts and balances, etc. " Portfolio quality ratios can be calculated from portfolio information. This information together with the aging analysis can give a picture of the health of the portfolio and can also give valuable insight into an MFI's sustainability.<br><br> " Relates to income statement in that it is the portfolio that generate s the income for the MFI. " Relates to the balance sheet in that it provides information on the value of outstanding loans portfolio and value of loans written off during the period " Relates to the balance sheet and income statement in that the portfolio data is used as an input to calculate the loan loss reserve on the balance sheet, from which the amount of loan loss provision on the income statement is calculated. CGAP Participant Course Materials: Financial Analysis " 11 Relationships Betw een Financial Statem ents Previous Year Balance Sheet Current Year Balance Sheet Current Year Cash Flow Non-Cash I tem s Profit/ Loss Current Year I ncome Statem ent Profit/ Loss Donations Loan Loss Depreciation Changes CGAP Participant Course Materials: Financial Analysis " 12 Formatting Financial Statements !<br><br> !! ! Most MFIs depend on donor funds but do not realize to what extent and that donor money is not limitless.<br><br> We want to create financial statements that will show the impact of donor funds on the MFI 9s financial position and its relationship to sustainability. CGAP's recom mended form at: " Income statement f Donor money is recorded after net operating profit. " Balance sheet Three separate sources of equity are derived from the income statement: f Retained earnings or losses (minus cash donations) f Donations f Other capital accounts 4including net non-operational income Separating donor funds is important because it allows one to see over time the proportion of equity that is from the MFI itself versus the amounts contributed by donors.<br><br> CGAP Participant Course Materials: Financial Analysis " 13 Three Ways in Which MFI s Treat Cash Donations Goals: 1. Grants are separated from operating income 2. Grants are fully disclosed in equity Most preferred because m ost transparent treatm ent of grants and equity A.<br><br> Current year 9s grants and donations are first recorded in the Income Statement, below the Operating Profit / Loss, but the restricted grants or donations for which the conditions had been met are divided according to purpose: e.g. Operations, Loan Fund or Fixed Assets. The grants and donations are then transferred according to their purposes on the Balance Sheet, separated from the Operating Profit / Loss.<br><br> Acceptable, less transparent than A B. Current year 9s grants and donations are first recorded in the Income Statement below the Operating Profit / Loss. (This would include the total amount of unrestricted grants and the portion of restricted grants or donations for which the conditions had been met that year.) These grants and donations are then transferred as one amount on the Balance Sheet, separate from the Operating Profit / Loss.<br><br> Least preferred, not com pliant w ith I AS 20 C. Current year 9s unrestricted grants and donations and the funds restricted for operations are recorded in the Income Statement below the Operating Profit / Loss. They are then transferred to the Balance Sheet, separated from the Operating Profit / Loss.<br><br> That year 9s grants or donations restricted for Loan Fund or Fixed Assets are recorded directly into equity on the Balance Sheet. CGAP Participant Course Materials: Financial Analysis " 14 Sam ple I ncom e Statement Accounting Period Operating I ncome 1. Interest and fee income from loans 2.<br><br> Income from other finance-related services 3. Income from investments 4. Total operating incom e Operating Expenses 5.<br><br> Interest and fee expense 6. Loan loss provision expense 7. Administrative expense 3 personnel 8.<br><br> Other administrative expenses 9. Total operating expenses 10. NET OPERATI NG PROFI T (LOSS) Nonoperational I ncome and Expenses 11.<br><br> Cash donations 12. Other non-operational income 13. Total nonoperational expenses 14.<br><br> TOTAL CONSOLI DATED PROFI T/ LOSS Source: Format for Appraisal of Microfinance Institutions, CGAP Secretariat, July 1999. CGAP Participant Course Materials: Financial Analysis " 15 Sam ple I ncom e Statement Account Comments About Usage Operating I ncom e 1. Interest and fee income from loans All income on loans made to clients 2.<br><br> Income from other finance-related services (indicate which) For example, fees from savings accounts 3. Income from investments Interest from bank accounts or investments in money market instruments used primarily for liquidity management 4. Total Operating I ncom e Operating Expenses 5.<br><br> Interest and fee expense Interest and fee expenses for all loans, deposits, or other liabilities funding the financial service operation 6. Loan loss provision expense Cost of creating/maintaining the loan loss reserve. 7.<br><br> Personnel expense All staff and consultant costs, including payroll taxes and fringe benefits(preferably on an accrual basis, especially in the case of major future benefits like severance pay obligations) 8. Other administrative expenses Broken out into no more than ten categories (e.g. rent, transportation, supplies, utilities, fees, depreciation, other) 9.Total Operating Expense 10.<br><br> NET OPERATI NG PROFI T (LOSS) Nonoperational I ncom e* and Expenses 11. Cash donations All cash grants/donations. Do not include in-kind donations of goods and services.<br><br> 12. Other nonoperational income (If any) Income from investments which play no role in the delivery of financial services, income from non-financial services, sale of land, consultancies, etc. 13.<br><br> Nonoperational expense (if any) Any expenses not related to the MFI 9s financial services business, such as an evaluation or impact study mandated by a donor 14. TOTAL CONSOLI DATED PROFI T (LOSS) Net operating profit (loss) plus non-operational incom e, m inus non- operational expenses * All income that does not come from financial service operations. CGAP Participant Course Materials: Financial Analysis " 16 Sam ple Balance Sheet Accounting Period Assets 1.<br><br> Cash and due from banks 2. Reserves in central bank 3. Short-term investments in money market instruments 4.<br><br> Loan portfolio 5. (Loan loss reserve) 6. Other short-term assets 7.<br><br> Long-term investments 8. Net fixed assets 9. Total assets Liabilities 10.<br><br> Savings accounts: forced 11. Savings accounts: voluntary 12. Time deposits 13.<br><br> Loans: commercial banks 14. Loans: Central Bank 15. Loans: subsidized 16.<br><br> Other short-term liabilities 17. Other long-term liabilities 18. Total liabilities Equity 19.<br><br> Paid-in equity from shareholders plus members 20. Donated equity 4prior years, cumulative 21. Donated equity 4current year 22.<br><br> Prior years retained earnings/losses 23. Current year retained earnings/loss 24. Other capital accounts 25.<br><br> Total equity 26. TOTAL LI ABI LI TI ES AND EQUI TY Source: Format for Appraisal of Microfinance Institutions, CGAP Secretariat, July 1999. CGAP Participant Course Materials: Financial Analysis " 17 Sam ple Balance Sheet Account Comments About Usage Assets 1.<br><br> Cash and due from banks Cash on hand, sight deposits, checking accounts or other instruments paying little or no interest 2. Reserves in Central Bank Relevant only for licensed financial intermediaries 3. Short-term investments in money market instruments Interest-bearing deposits and investments in financial instruments, where the principal purpose is liquidity management 4.<br><br> Loan portfolio Total outstanding balances of loans to clients, including loans past due but not written off 5.(Loan loss reserve) A negative asset account: set-aside for estimated future losses on problem loans that have not yet been written off. 6. Other short-term assets Accounts receivable, accrued interest on loan portfolio, etc.<br><br> 7. Long-term investments Other long-term, illiquid assets that earn returns 8. Net fixed assets Land, building, equipment, net of accumulated depreciation 9.<br><br> Total assets Liabilities 10. Savings accounts: compulsory Compulsory savings required as part of the credit methodology 11. Savings accounts: voluntary Liquid deposits from the general public 12.<br><br> Time deposits Certificates of deposit from the general public 13. Loan: commercial Loans to the MFI at market rates from banks or other financial institutions 14. Loans: Central Bank Rediscount or other special lines of credit from the Central Bank 15.<br><br> Loans: subsidized Concessional loans from donors, etc. 16. Other short-term liabilities Accounts payable, accrued interest to be paid on loans and deposits , e tc.<br><br> 17. Other Long-term liabilities Long term loans for property, etc. 18.<br><br> Total liabilities Equity 19. Paid-in equity from shareholders Equity contribution of owners of stock 20. Donated equity--prior years, cumulative Equity received through cash donations from sources that do not receive stock 21.<br><br> Donated equity--current year All Cash Grants/Donations (from Income Statement) 22. Prior years retained earnings/losses, not including cash donations Accumulated earnings from prior periods only 23. Current year profit/loss.<br><br> Current year operating profit/(loss) (from Income Statement) 24. Other capital accounts Any special reserves or other capital accounts 25. Total equity 26.<br><br> TOTAL LI ABI LI TI ES AND EQUI TY CGAP Participant Course Materials: Financial Analysis " 18 Financial analysis is required for m any financial m anagem ent decisions: " How to manage the finances to achieve the strategic goals of the institution " How to increase profitability " How to reach self-sufficiency/ breakeven point " How to increase efficiency especially reducing the cost per client " What is the optimum level of each different operational expense including the cost of funds " How to manage the costs of hum an resources as part of overall human resource management " How to deal with the effect of inflation " What is the loan loss reserve policy " What is the w rite-off and rescheduling policy " What interest rate should the MFI charge on products? " How to manage liquidity 4 i.e., how to keep solvent at the same time as disbursing the maximum number of loans, setting a target level of liquidity " What is the best financing structure, i.e., how much debt including from commercial sources and how much capital do you need? " What should the asset structure be?<br><br> " How to manage the fixed assets, i.e., the depreciation policy, how to finance them, are they insured, are they safe? " What are currency risks and can they be minimized? " How to undertake trend analysis and to compare actual performance against planned performance Note: These decisions were the result of a brainstorming by finance managers of MFIs in Bosnia and Herzegovina.<br><br> CGAP Participant Course Materials: Financial Analysis " 19 Adjustments ! !! !<br><br> Adjustments are additional, or hidden, costs incurred by the MFI that we need to recognize for internal management purposes, for example, when calculating and analyzing efficiency and profitability ratios. They are not to be included in the audited financial statements; they are internal adjustments . Which costs does an MFI incur that are not reflected in the expenses?<br><br> " Inflation " Subsidized cost of funds " In-kind donations Inflation What is affected by inflation? Assets and liabilities that are contractual in nature carry prices that presumably include the cost of inflation or could adjust to include the cost of inflation. Inflation eats into the income earned (or expense incurred), but in general the asset or liability itself is not affected.<br><br> CGAP Participant Course Materials: Financial Analysis " 20 What is the net effect of inflation on the balance sheet? " Although equity is eroded by inflation, some of the equity is invested in fixed assets, which appreciate with inflation, thus counterbalancing the impact on equity. In other words it is only that part of equity remaining after subtracting the value of the fixed assets that is affected by inflation.<br><br> " Alternatively, inflation affects the "the difference between financial assets and liabilities." That is, inflation will affect a portion of equity. I nflation Adjustm ent = (Average equity 3 Average fixed assets) * Inflation rate Subsidized Cost of Funds Why adjust for the subsidized cost of funds? " To help managers recognize the cost of commercial sources of funds such as bank loans or savings , instead of concessional loans.<br><br> " To know how an MFI can be independent of donor funds in the long term, need to identify the subsidies CGAP Participant Course Materials: Financial Analysis " 21 Cost of Funds Adjustm ent = (Average funding liabilities x Shadow price of funds) 3 Interest and fee expense In-Kind Donations 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. May be " Technical advice " Training " Rent " Use of transport " Other foreign consultants, and so on. Substantial in-kind donations increase an MFI 9s adjusted costs and increase the time it takes to reach sustainability.<br><br> The solution is for MFI managers to ask if the y really want these in-kind donat ions. If not, the y should sa y no! CGAP Participant Course Materials: Financial Analysis " 22 Adjustm ents for I nflation and Subsidies Accounting Period 1.<br><br> Operating I ncom e 2. Unadjusted Operating Expenses 3. I nflation Adjustm ent a.<br><br> Average Equity b. Average Fixed Assets c. I nflation I nflation Adjustm ent = (a 3 b) x c 4.<br><br> Subsidized Cost of Funds Adjustm ent a. Average funding liabilities b. Com m ercial rate for funds c.<br><br> I nterest and Fee Expense Subsidized Cost of Funds Adjustm ent = (a x b) 3 c 5. I n-kind Donation Adjustm ent a. Personnel b.<br><br> Other I n-kind Donation Adjustm ent 6. Adjusted Operating Expenses 7. Adjusted Operating Profit (Loss) CGAP Participant Course Materials: Financial Analysis " 23 Indicators for Financial Analysis !<br><br> !! ! Loan Portfolio Quality Analysis " Delinquency rate 4portfolio at risk " Portfolio aging " Loan loss rate Efficiency and Productivity " Number of active loan clients per staff member " Number of active loan clients per loan officer " Outstanding portfolio per loan officer " Number of clients per branch office " Yield on portfolio " Administrative efficiency " Operating efficiency " Personnel costs as a percentage of administrative costs Profitability " Adjusted return on assets " Adjusted return on equity " Operational self-sufficiency " Financial self-sufficiency CGAP Participant Course Materials: Financial Analysis " 24 Using Ratios Ratio analysis is a financial management tool that enables managers of microfinance institutions to assess their progress in achieving sustainability.<br><br> They can help answer two primary questions that every institution involved in microfinance needs to ask: " Is this institution either achieving or progressing towards profitability? " How efficient is it in achieving its given objectives? Taken together, the ratios in the framework provide a perspective on the financial health of the lending/savings, and other operations of the institution.<br><br> No one ratio tells it all. There are no values for any specific ratio that is necessarily correct. It is the trend in these ratios which is critically important.<br><br> Ratios must be analyzed together, and ratios tell you more when consistently tracked over a period of time. Frequent measurement can help identify problems which need to be solved before they fundamentally threaten the MFI, thus enabling correction. Trend analysis also helps moderate the influence of seasonality or exceptional factors.<br><br> Different levels of users will require a set of different indicators and analysis. They might be summarized as follows: " Operations staff need portfolio quality, efficiency ratios, outreach, and branch level profitability. " Senior management needs institution - level portfolio quality, efficiency profitability, liquidity, and leverage.<br><br> " Regulators need capital adequacy and liquidity. " Donors/investors need institution - level portfolio quality, leverage and profitability. In addition to analyzing past trends, ratios, in conjunction with policy decisions, are helpful when preparing financial projections.<br><br> CGAP Participant Course Materials: Financial Analysis " 25 Loan Portfolio Quality Analysis The outstanding portfolio of an MFI is defined as the principal amount of loan balances outstanding. The major risk factor in the portfolio is not the payments that are past due, but rather the outstanding balance of loans with payments past due. Payments past due can be seen as a warning sign that a particular borrower is in difficulty and that the borrower may be unable to repay the remaining balance of the loan.<br><br> The entire outstanding balance is thus at risk. Comm on : Am ount Past Due = Am ount past due Outstanding portfolio Better : Unpaid principal balance of Portfolio At Risk (PAR) = all loans w ith late paym ents Outstanding portfolio CGAP Participant Course Materials: Financial Analysis " 26 Portfolio Quality and Loan Collection Ratios Ratios will allow you to examine financial relationships to diagnose the well-being of your institution. Key portfolio ratios should be monitored regularly to measure performance.<br><br> The chart which follows describes the purpose of each indicator and gives a range of acceptable ratios. I ndicator Ratio Measurement answ ers the questions: Portfolio at Risk (PAR) by Age* Unpaid principal balance of all loans w ith paym ents at least (1, 31, 61 days) past due Outstanding portfolio How m uch could you lose if all late borrow ers default? Aging separates m ore risky loans from less risky.<br><br> (The longer a loan goes unpaid, the higher the risk it w ill never be paid.) Arrears Rate Past Due Rate Am ount past due Outstanding portfolio How com m onplace is nonpaym ent? Measures am ount of loan principal that is due but not paid. Repaym ent Rate Am ount received (current and past due) 3 prepaym ents Total am ount due this period + Am ounts past due from previous periods Show s am ount paid com pared to am ount due/ expected during a specific period.<br><br> Does not provide useful inform ation about the perform ance of the outstanding portfolio. Current Recovery Rate Am ount received this period (P or P+ I )* * Am ount due this period (P or P+ I ) under original loan term s Fluctuates from m onth to m onth. I s m eaningful only for longer periods.<br><br> Can be processed algebraically to predict eventual loan loss rates. Annual Loan Loss Rate* Am ount of loans w ritten off as unrecoverable Average outstanding portfolio Useful in interest rate setting. Costs of default, m ust be balanced by higher interest incom e.<br><br> Note: Portfolio at Risk (PAR) and Annual Loan Loss Rate are the preferred ratios for analyzing portfolio quality. The other rat ios are more limited as noted in the Measurement column. * See CGAP Occasional Paper No.<br><br> 3, Measuring Microcredit Delinquency: Ratios Can Be Harmful to Your Health. * * P = principal, I = interest. CGAP Participant Course Materials: Financial Analysis " 27 Rationale for Loan Loss Provisions and Reserves Maintaining loans on the books that are unlikely to be repaid overstates the value of the portfolio.<br><br> cA well-defined policy that establishes a loan loss reserve and periodically declares loans non-recoverable saves a program from declaring a large amount unrecoverable all at once and thereby drastically reducing assets. d Katherine Stearns. The Hidden Beast: Delinquency in Microenterprise Programmes , Accion International, 1991. Loan Loss Reserve Loan Loss Provision Loan Losses or Write-Offs " An account that represents the amount of outstanding principal that is not expected to be recovered by a micro- finance organization " Negative asset on the balance sheet that reduces the outstanding portfolio.<br><br> (An alternative presentation is to show it as a liability.) " Amount expensed on the income and expenses statement. " Increases the loan loss reserve " Occur only as an accounting entry. " Do not mean that loan recovery should not continue to be pursued.<br><br> " Decrease the reserve and the outstanding portfolio. Source: Joanna Ledgerwood. Financial Management Training for Microfinance Organizations , CALMEADOW, 1996.<br><br> CGAP Participant Course Materials: Financial Analysis " 28 Accounting for Loan Loss Provisions and Write-Offs A provision records the possibility that an asset in the balance sheet is not 100% realizable. The loss of value of assets may arise through wear and tear such as the depreciation of physical assets, loss of stocks, or unrecoverable debts. 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.<br><br> 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 Loan losses or write-offs occur when it is determined that loans are unrecoverable.<br><br> Because the possibility that some loans would be unrecoverable has been provided for in the accounting books through reserves, 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.<br><br> CGAP Participant Course Materials: Financial Analysis " 29 Management Ratios Efficiency measures whether an institution is serving as many people as possible or at the lowest possible cost. Management Ratios: " Address efficiency in terms of average outstanding portfolio of the loans, which generate the income for the institution; " Look at the staff productivity and staff costs , usually the biggest cost in an MFI; and " Cover key aspects of both institutional and staff efficiency. The three types of management ratios are staff productivity ratios, financial productivity ratios and cost efficiency ratios.<br><br> Staff Productivity Ratios " Number of active loan clients per staff member " Number of active loan clients per loan officer " Number of active loan clients per branch " Gross portfolio outstanding per loan officer CGAP Participant Course Materials: Financial Analysis " 30 Financial Productivity Ratio Yield on Portfolio = Interest and fee income from loans Average net portfolio outstanding Cost-Efficiency Ratios Operating Efficiency = Total operating expenses + In-kind donations* Average net portfolio outstanding Administrative Efficiency = Personnel + Other administrative expenses + In-kind donations Average net portfolio outstanding Personnel Expense Ratio = Personnel expenses + In-kind personnel donations Total administrative expenses + Total in-kind donations CGAP Participant Course Materials: Financial Analysis " 31 Profitability Perform ance I ndicators Term Form ula Definition Adjusted Operating Profit Operating income 3 Adjusted operating expenses MFI 9s profit Adjusted Return on Assets Adjusted operating profit Average total assets How productively the MFI has employed its assets Adjusted Return on Equity Adjusted operating profit Average equity Return on the capital of the MFI Operational Self-Sufficiency Operating income Operating expenses Degree to which operating income covers operating expenses Financial Self-Sufficiency Operating income Adjusted operating expenses Degree to which operating income covers the adjusted operating expenses Profitability Analysis f CGAP Occasional Paper 1, Microcredit Interest Rates http:/ / w w w .cgap.org/ htm l/ p_occasional_papers01.htm l f CGAP Technical Tool Series 4, Format for Appraisal of Microfinance Institutions: A Handbook http:/ / w w w .cgap.org/ htm l/ p_technical_guides04.htm l Sustainability = Coverage of administrative cost + Loan loss + Cost of funds + Inflation + Capitalization for growth from operating income Sustainability