MF Unit 2- Evaluation of Microfinance institutions

What is Operational Risk in MFIs?

Operational risk is the risk of loss due to failed internal processes, people, systems, or external events such as natural disasters or fire. It arises from technology dependence, weak systems, low ethics, and competition.

Operational risk is “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events.”

What are the five categories of operational risk

• Human risk- errors, frauds ,collusions, animosity

• Process risk- lack of clear procedure on operations such as disbursements, day to day matters, accounting, data recording and reporting, cash handling, auditing

• System & technology risk- failure of softwares, computers, power failures

• Asset loss & operational failure due to external events- loss of property and other assets or loss of work due to natural disasters, fires, robberies, thefts, riots etc

• Relationship risk- client dissatisfaction, drop outs loss to competition, poor products

How can MFIs prevent operational risk?

• Daily backups of MIS data stored in two different locations or with two separate person.

• Daily reconciliation of accounts & portfolio

• Strong monitoring & internal audit systems to check frauds

• Disaster procedures for riots/natural calamities-Standard operating procedures should be prepared for natural disasters and

  riots. Staff should know exactly what needs to be done in such situations.

• Alternative office locations for emergencies

• Fireproof storage for important documents- Fire extinguishers can be made available in all offices. important documents such as loan files post dated cheques etc. , can be stored in fireproof cupboards.

What is internal audit

• internal audit is an independent check on the performance of the MFI. Independence is ensured by having completely separate staff team and the department reporting directly to the to the Board of directors or to the organisation’s head.

• The idea behind the internal audit is not just to catch frauds or malpractices but more constructive that is to add value and efficiency within the organisation by meeting getting the possibilities of malpractices.

• Internal audit is done by a specialised internal audit team who should be very well versed with the organisation policies and procedures.

What are the functions of internal audit?

• To detect any product or misappropriation irrespective of its size, magnitude or the staff involved in it.
  To detect any malpractice, Collusion for action on part of employees that is against the organisational policies /culture

• To see if the operational policies/ procedures

• To check an article staff behaviour

• To check the accuracy of reports,MIS and accounting, accuracy of records

• To provide feedback/ opinion related to operational risk such as staff dissatisfaction, competition, in appropriate policies aur areas of potential conflict.

What is the scope of audit?

• Financial reports

• Loan documents

• MIS reports

• Client visits

• Other observations

What is impact and impact assessment?

• Impact is the change directly attributable to microfinance programmes.

• Impact assessment is research to measure how microfinance has improved lives of target clients.

What are the levels and indicators of impact assessment?

Individual level: savings, confidence, self-esteem
Household level: food security, income, assets, education
Community level: contribution to society, change in social attitudes
Enterprise level: income, cash flow, business growth

Who uses impact assessment?

a) Policymakers
b) Donors
c) Researchers
d) MFIs

types of financial ratios?

1) Operating self sufficiency (OSS) ratio: operating income/financial expense+loan loss provision expense+operating expense

Operating income = interest and fees paid by borrower,income from investment or from other services.

Financial expense=it includes int and fees that the institution pays to commercial bank,shareholders and other investors.

Loan loss provision expense=it is the amount set aside to cover the cost of loans that a microfinance institution from other investors.

Operating expense=rent,salaries,travel etc

2) Financial self sufficiency (FSS) ratio: = Adjusted operating revenue/financial exp +loan loss provision exp+operating expense

+expense adjustment

Adjusted operating revenue= operating revenue-subsidy Expense adjustment = subsidies given to people.

3) Return on Asset(ROA) : net operating revenue-taxes/average assets

4) Portfolio at Risk(PAR) ratio:) PAR (30 days) = PAR (30 days)/gross loan portfolio

PAR is the value of all loans outstanding that have one or more instruments of principle overdue more than a certain number of days.This system includes an entire unpaid principle balance.

5) Yield on gross loan portfolio = cash financial revenue from loan portfolio/average gross loan portfolio

What are liquidity ratios?

A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities.
Three liquidity ratios are commonly used – the current ratio, quick ratio, and cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the liquid assets amount is placed in the numerator.

Given the structure of the ratio, with assets on top and liabilities on the bottom, ratios above 1.0 are sought after. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities.

A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills. In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over. A ratio of 3.0 would mean they could cover their current liabilities three times over, and so forth.

Types of Liquidity Ratios

1. Current Ratio
Current Ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.

2. Quick Ratio
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense that current assets is the numerator, and current liabilities is the denominator.
However, the quick ratio only considers certain current assets. It considers more liquid assets such as cash, accounts receivables, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.

3. Cash Ratio
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.
In terms of how strict the tests of liquidity are, you can view the current ratio, quick ratio, and cash ratio as easy, medium, and hard.

what are the Importance of Liquidity Ratios?

1. Determine the ability to cover short-term obligations

Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal.
Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.

2. Determine creditworthiness

Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

3. Determine investment worthiness

• For investors, they will analyze a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.

• Low liquidity ratios raise a red flag, but “the higher, the better” is only true to a certain extent. At some point, investors will question why a company’s liquidity ratios are so high. Yes, a company with a liquidity ratio of 8.5 will be able to confidently pay its short-term bills, but investors may deem such a ratio excessive. An abnormally high ratio means the company holds a large amount of liquid assets.

• For example, if a company’s cash ratio was 8.5, investors and analysts may consider that too high. The company holds too much cash on hand, which isn’t earning anything more than the interest the bank offers to hold their cash. It can be argued that the company should allocate the cash amount towards other initiatives and investments that can achieve a higher return.

• With liquidity ratios, there is a balance between a company being able to safely cover their bills and improper capital allocation.

What is capital adequacy?

Capital is the investment in or contribution to the business of an institution that ranks behind depositors and other creditors as to entitlement to repayment or return on investment.

capital adequacy is a ratio that can indicate a banks ability to maintain the equity capital sufficient to pay the depositors whenever they demand money and still have enough funds to increase the banks assets through additional lending

Capital adequacy provides regulators with a means of establishing whether banks and other financial institutions have sufficient capital to keep them out of difficulty. regulators use a capital adequacy ratio a ratio of a bank’s capital to its assets to assess risks.

CAR= banks capital/ risk weighted assets = tier 1 capital + tier 2 capital/ risk weighted assets

Tier 1 capital is the primary way to measure a bank’s financial health. It includes shareholder’s equity and retained earnings, which are disclosed on financial statements. As it is the core capital held in reserves, Tier 1 capital is capable of absorbing losses without impacting business operations.
On the other hand, Tier 2 capital includes revalued reserves, undisclosed reserves, and hybrid securities. Since this type of capital has lower quality, is less liquid, and is more difficult to measure, it is known as supplementary capital.
Risk Weighted assets= They are calculated by looking at bank’s loan,evaluating risk and then assigned a weight based on the degree of credit risk.

features and needs of capital adequacy

What are the revenue sources of MFIs?

• Loans

• Savings

• Insurance

• Remittances
  Income categories: interest & fees, other income
  Expense categories: funding expenses, loan loss costs, operating expenses
  

What is CVP analysis?

• Cost volume profit analysis or break even analysis is used to compute the volume level size and mix of business at which total revenues are equal to total cost. Total cost and total revenues are equal, the business organisation is said to be breaking even.

• Total variable cost are considered to be those cost that vary as the volume of operation changes.

• Fixed cost on the other hand are the cost which do not vary according to the volume of operations.

• CVP analysis is very important tool for decision-making, which enables the management to take informed decisions about MFI operations.

assumptions of CVP analysis

1. The behaviour of variable cost is linear

2.  Interest yield are constant

3.  All cost can be divided into their fixed and variable elements

4. Total fixed cost remain constant 

5. Efficiency and productivity are constant

6.  The CVP Analysis is usually performed with a single product

   in case. In case of MFIs most of the CVP analysis is performed with loan products.

Break even level of operations

measuring operating efficiency

1. Average Case Load = Number of active borrowers/No. of loan officers

2. Portfolio outstanding to a loan officer= Portfolio outstanding /No. of loan officers

3. Operating expense ratio = Total operating expenses/Average portfolio outstanding. Lower ratio will be preferable.

• Measuring Overall Efficiency : Overall operating expenses of an MFI depends on how much are its expenses in relation to its average portfolio outstanding.

What factors affect operating expenses of MFIs?

• Scale of operations

• Governance structure

• Target group

• Operational area

• Methodology

• Technology

• Expansion strategy
  

What can MFIs do to improve efficiency?

• Cost analysis

• Standardised procedures

• Larger loan sizes

• More clients per loan officer

• Incentives

• Use of technology

what is benchmarkings

Benchmarking in Microfinance Institutions (MFIs) is the process of comparing an MFI's performance metrics against industry standards or peer groups to identify strengths, weaknesses, and opportunities for improvement. It involves using various financial and operational ratios to evaluate profitability, efficiency, and outreach, enabling MFIs to enhance performance, attract investment, and drive strategic decisions. 

what is ratings

Microfinance Institutions (MFIs) receive two primary types of ratings: MFI Grading (assessing operational sustainability and scalability) and a Code of Conduct Assessment (COCA) grade (assessing adherence to industry ethical standards). These ratings use specific alphanumeric scales and are provided by credit rating agencies like CRISIL, Brickwork Ratings, ICRA, and SMERA. 

what are the analysis of financial statements?

Financial statement analysis is the process of reviewing a company's financial records to assess its performance, financial health, and future prospects. Key financial statements used in this analysis include the balance sheet, income statement, and cash flow statement. 

Purpose and Importance

The primary goal of financial statement analysis is to provide stakeholders with insights for informed decision-making. 

• Investors use the analysis to evaluate profitability, growth potential, and whether to invest.

• Lenders/Creditors assess the company's ability to pay back debt (solvency and liquidity).

• Management evaluates operational efficiency and guides strategic business decisions.

• Auditors and Regulators ensure accuracy and compliance with accounting standards. 

Core Financial Statements

Analysis is built upon three core statements: 

• Balance Sheet: A snapshot of a company's assets, liabilities, and owners' equity at a specific point in time.

• Income Statement: Summarizes revenues, expenses, gains, and losses over a period to determine net income (profitability).

• Cash Flow Statement: Details the inflows and outflows of cash from operating, investing, and financing activities over a period, highlighting cash management efficiency. 

Key Tools and Techniques

Analysts employ several techniques to interpret financial data: 

• Horizontal Analysis: Compares financial data across different periods (e.g., year-over-year) to identify trends, growth, or decline in performance.

• Vertical Analysis (Common-Size Statements): Expresses each line item as a percentage of a base figure (e.g., total sales on an income statement or total assets on a balance sheet). This is useful for comparing companies of different sizes.

• Ratio Analysis: Calculates specific relationships between different items in the financial statements to evaluate various aspects of the business. Ratios are generally grouped into categories:

  • Profitability Ratios: Assess the company's ability to generate profit (e.g., Net Profit Margin, Return on Assets).

  • Liquidity Ratios: Measure the ability to meet short-term obligations (e.g., Current Ratio, Quick Ratio).

  • Solvency Ratios: Evaluate the company's long-term financial stability and ability to meet long-term debt (e.g., Debt-to-Equity Ratio).

  • Efficiency/Activity Ratios: Gauge how effectively a company uses its assets (e.g., Inventory Turnover, Asset Turnover). 

By applying these methods, stakeholders can gain a comprehensive understanding of a company's financial profile and make sound, data-driven decisions. 

what is financial evaluation?

Financial evaluation is a comprehensive assessment of a business, project, or asset's financial health, performance, and prospects. It involves using data from financial statements (income statements, balance sheets, and cash flow statements) to make informed decisions for internal management, external investors, or lenders. 

Purpose of Financial Evaluation

The primary goals of a financial evaluation include:

• Assessing performance: Evaluating a company's past and current operational efficiency and profitability.

• Identifying strengths and weaknesses: Pinpointing areas for improvement or competitive advantage.

• Planning and forecasting: Building long-term plans, setting financial policies, and predicting future growth and profitability prospects.

• Informing investment decisions: Helping investors decide whether to buy into a company or project, or assisting management in project appraisal.

• Determining value: Estimating the objective value of a company or asset, which is crucial during mergers, acquisitions, or fundraising.

• Ensuring compliance: Verifying adherence to regulations and assessing financial risk.