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 Equity and how it can contribute towards defining the overall quality of the portfolio.
Return on Equity Ratio
Return on Equity indicates the profitability of the institution. For privately owned entities, ROE is a measure of paramount importance since it measures the return on the owner’s investment in the institution. However, given that many MFIs are not-for-profit-organizations that do not distribute profits; the ROE indicator is most often used as a proxy for commercial viability and the strength of equity.
The level of leverage – the proportion of equity to debt – is a critical factor to consider. That is, if an MFI can generate a profit of 20 cents for every dollar of its assets, the ROE would be 20% if there is no debt, 40% if debt equals equity, 60% if debt is twice the amount of equity, and so on. An MFI that wants to achieve a high ROE has a strong incentive to finance most of its assets through debt.
On the other hand, a high degree of leverage also leads to higher levels of risk. Just as a profitable MFI can become highly profitable if its leverage is high, a loss-making MFI will incur crippling losses if it relies heavily on debt financing. Lenders will typically impose limits on leverage, whereas shareholders will often push for higher levels of debt. When comparing the ROE of different MFIs, it is important to take these differences in leverage and risk levels into account.
The Return on Equity calculation is the same for both MFIs and traditional banks. However commercial banks typically carry higher levels of debt – their leverage is higher – than is the case for MFIs. This led to high volatility of earnings during the financial crisis. The average ROE for US banks was -20% in 2008 –down from +15% in 2006. By 2013, the ROE of these banks had recovered somewhat to 8.8%.
In the next blog we will look at Return on Assets and how they impact the overall profitability of a MFI.