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 Debt to Equity Ratio and how it can contribute towards defining the overall quality of the portfolio.
Debt to Equity Ratio
The Debt/Equity Ratio is the simplest and best-known measure of capital adequacy because it measures the overall leverage of the institution. The Debt/Equity Ratio is of particular interest to lenders because it indicates how much of a safety cushion (in the form of equity) there is in the institution to absorb losses.
Traditionally, microfinance institutions have had low Debt/Equity Ratios, because as unregulated banks, their ability to borrow from commercial lenders has typically been limited. As MFIs transform into regulated intermediaries, however, Debt/Equity Ratios rise rapidly. Risk and volatility of the MFI (exposure to shifts in the business environment, for instance) determine how much debt can be carried for a given amount of equity.
Even the most highly leveraged MFIs still carry less debt than conventional banks because microloan portfolios are backed by less collateral and their risk profiles are not as well understood as conventional bank portfolios.
One of the strongest incentives for unregulated MFIs to leave their sheltered, tax-free existence and subject themselves to the discipline of banking laws is access to funding. With regulation and transparency comes the possibility of accessing capital markets. Regulation typically allows MFIs to achieve much higher Debt/Equity Ratios than their NGO peers. In fact, once licensed and supervised, MFIs discover that commercial lenders who previously balked at a 1:1 Debt/Equity Ratio will now gladly lend three to five times the MFI’s equity.
The Debt/Equity Ratio used to evaluate MFIs is the same as in the traditional banking sector. This ratio reveals the extent to which the bank funds operations with debt rather than equity. This allows banks to monitor solvency and analyze their capital structure. Debt/Equity ratios vary considerably depending on the type of institution. NGOs typically have lower Debt/Equity (1:1 to 3:1) levels than regulated MFIs and even lower levels than commercial banks. NGOs do not have owners. The only way to strengthen an NGO’s equity is by reinvesting profits or through grants and donations.
In the next blog we will look at Profitability Ratio such as Return on Equity, Return on Assets and Portfolio Yield and how they impact the overall profitability and efficiency of a MFI.