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 Financial Expense Ratio and how it can contribute towards defining the overall quality of the portfolio.
Financial Expense Ratio
This ratio measures the total interest expense incurred by the institution to fund its loan portfolio. The Financial Expense Ratio is not the institution’s credit spread, nor is it the average interest rate at which it borrows (for that, see the Cost of Funds Ratio below).
Rather, this measure is one of the three components used to help determine the minimum lending rate an MFI must charge in order to cover its funding expenses. The minimum lending rate is determined by adding the Impairment Expense Ratio, the Operating Expense Ratio and the Financial Expense Ratio. Portfolio Yield (the income generated by the portfolio) less the Funding Expense Ratio (the financial cost incurred to fund the institution itself) is the net interest margin.
The Cost of Funds ratio is related to the interest paid to the funder, which is different from the financing expense that is related to the level of debt (with or without interest payments) of the portfolio. That is, how many cents for every dollar collected is spent on interest payments for borrowed funds.
The Financial Expense Ratio is equivalent to the traditional banking sector’s Bank Expense Ratio. In practice, the Bank Expense ratio is not widely utilized. To determine a similar set of information, a bank would use the Net Interest Margin (NIM). This ratio, like the one for microfinance, calculates the interest margin between what the bank pays on its liabilities and the amount the bank charges for its loans.
In the next blog we will look at Cost of Funds Ratio and how they impact the overall profitability and efficiency of a MFI.