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 Return on Assets and how it can contribute towards defining the overall quality of the portfolio.
Return on Assets
Return on Assets is an overall measure of profitability that reflects the profit margin. Simply put, it measures how well the institution uses all its assets to generate revenue. Return on Assets is a fairly straightforward measure. However, as in the case with ROE, a correct assessment of ROA depends on the analysis of the components that determine net income. Removing the profit margin component leaves taxes, special provisioning and extraordinary income and expenses. These three components provide insight to help compare the ROAs of different MFIs.
As mentioned in Return on Equity, adjustments are required when comparing the ROA of different institutions because there may be major differences in accounting practices. The adjustments include provision expenses, compensation for subsidies and revenues calculated on a cash (as opposed to “accrual”) basis, for example.
The Return on Assets calculation is the same for both MFIs and the traditional banking sector. As this ratio compares net income to average total assets, management and investors can capture insight on a bank’s profitability per dollar of asset managed.
In the next blog we will look at Portfolio Yield and how they impact the overall profitability of a MFI.