Financial Management Ratios
Financial management assures that there is enough liquidity to meet an MFI’s obligations to disburse loans to its borrowers and to repay loans to its lenders. Even though financial management is a back office function, decisions in this area can directly affect the bottom line of the institution. Errors in liquidity or foreign exchange management, for example, can easily compromise an institution with efficient credit operations and otherwise sound management.
The importance of adequate liquidity, and consequently of financial management, grows further if the MFI is mobilizing savings from depositors. Financial management can also have a decisive impact on profitability through the skill with which liquid funds are invested. Managing foreign exchange risk and matching the maturities of assets and liabilities are a part of financial management. Both are areas of great potential risk for an MFI and underline the importance of competent financial management.
In this blog we will look at Costs of Funds Ratio and how it can contribute towards defining the overall quality of the portfolio.
Costs of Funds Ratio
As its name indicates, this ratio measures the average cost of the company’s borrowed funds that are used to finance its loan portfolio. In comparing MFIs Cost of Funds Ratio it is important to distinguish the between MFIs have the ability to draw on savings as a low cost funding source. MFIs that can mobilize savings tend to have a relatively low cost of funds. However, this advantage is offset to some extent by administrative cost of providing savings products.
In many cases, the funding liabilities of MFIs include subsidized funds/grants. Such subsidies will drive the cost of funds down, when in fact the real cost of commercial borrowing for the institution is far higher. As subsidized MFIs grow, they are forced to increasingly resort to commercial borrowing to sustain their growth.
These MFIs will subsequently see a sharp rise in the cost of funds, placing severe pressure on margins. Management must then counteract the decrease in margins by cutting other costs or raising lending rates.
The country environment plays a large role in the cost of funds. Factors such as inflation or macro country risks can play a significant role. In countries with high inflation for example, the cost of financing is generally the sum of the commercial financing rate plus the rate of inflation. In countries with a low sovereign rating or with high country risk or with a volatile microfinance sector, the interest rates are usually higher, reflecting perceived risk.
The Cost of Funds is used in the same fashion as in the traditional banking sector and may be referred as the Rate Paid on Funds (RFP). This is determined by taking total interest expense over total earning assets. Earning assets are classified as interest-bearing financial instruments ranging from loans to trading account securities.
In the next blog we will look at Debt to Equity Ratio and how they impact the overall profitability and efficiency of a MFI.