Profitability measures such as Return on Equity (ROE) and Return on Assets (ROA) summarize performance in all areas of the company. If portfolio quality is poor or efficiency is low, this will be reflected in profitability.
Profitability indicators can be difficult to interpret since they are an aggregate of so many factors. The fact that an MFI has a high ROE says little about why that is so. All performance indicators tend to be of limited use (in fact, they can be outright misleading) if looked at in isolation and this is particularly the case for profitability indicators.
Everyday MFIs are becoming more regulated and information is becoming more dependable and standardized. However, there are unregulated financial institutions that are able to achieve dramatic changes in their profitability with the simple resource of adjusting provision levels. Analysts who focus exclusively on the profitability are often unable to detect this.
The three indicators used to measure profitability are Return on Equity, Return on Assets and Portfolio Yield.
In this blog we will look at Portfolio Yield and how it can contribute towards defining the overall quality of the portfolio.
Portfolio Yield measures how much the MFI actually received interest and other payments from its clients during the period. A comparison between the Portfolio Yield and the average effective lending rate gives an indication of the institution’s efficiency in collecting loan repayments from its clients.
Portfolio yield is widely used in microfinance, where the true cost of loans is often much higher than the nominal interest charged. Since portfolio yield takes into account all fees, discounts and special charges it is a more reliable measure of that true cost. On the other hand, portfolio yield understates the true cost to the extent that loans are in arrears.
An effective way to determine the profit margin from operations of an MFI is subtracting the three expense ratios (Operating Expense Ratio, Impairment Expense Ratio and Financial Expense Ratio) from the Portfolio Yield.
Portfolio Yield is strongly affected by competition and loan size. In markets where competition among MFIs is still low, Portfolio Yield tends to be high. MFIs can then charge what the market will bear, without having to worry about losing their clients to competitors. As competition develops, it can happen that Portfolio Yield drops from very high levels – 60%, 80% or more – to half those amounts or less within a few years.
In the traditional banking sector, Gross Yield on Earning Assets (GYEA) is similar to Portfolio Yield. This is calculated by taking total interest income over total average earning assets. Earning assets are considered to be interest bearing financial instruments ranging from loans to trading account securities. However, the Portfolio Yield calculation is slightly different because it specifically focuses on the earning assets within the loan portfolio itself and ignores assets that are not part of the portfolio.
In the next blog we will look at Social Performance Indicators and how they impact the social performance of a MFI.