Financial performance measures

Empirical measures of the financial performance of MFIs have included profitability and viability indicators (Cull et al., 2007; Hartarska, 2005; Mersland & Strøm, 2008; Mersland & Strøm, 2009; Tchakoute-Tchuigoua, 2010). As this study’s sample comprises different institutional forms of MFIs, it is important to adopt a common set of performance indicators to measure financial performance. This will help interpretation and comparison among the MFIs. This study uses Operational Self-Sufficiency (OSS), Return on Assets (ROA), Yield on Gross Loan Portfolio (YOGLP), Operating Cost Ratio (OCR), Capital Asset Ratio (CA) and Portfolio at Risk (PAR) more than 30 days, as metrics of financial performance. A summary of various indicators used to measure the financial performance of MFIs follows.

4.5.1.1 Operational self-sufficiency (OSS)

Operational self-sufficiency (OSS), the most frequently observed performance measure is used to quantify MFIs’ institutional performance and sustainability (Bassem, 2009; Hartarska, 2005; Mersland & Strøm, 2009). MFIs require sufficient operating income to cover operational costs such as salaries, loan losses, and other administrative costs. OSS measures how well an MFI covers its costs, through revenues, by comparing financial revenue with financial and operating expenses, including provision for loan impairment (Lin & Ahlin, 2011; Nawaz, 2010). According to Strøm et al. (2014, p. 63) OSS is “free from bias resulting from different capital structure, access to subsidised funding and possible differences in default policies in the MFI”. Sometimes this measure is also referred to as operational sustainability and is calculated as:

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OSS = financial revenue/(financial expenses + loan loss provision expenses + operating expenses)

4.5.1.2 Return on assets (ROA)

Return on assets (ROA) measures the ability of the MFI to utilise its total assets to generate returns (Microfinance Consensus Guidelines, 2003) or to determine how effectively the MFI’s management generates earnings from its investments. Unlike

ROE, ROA measures the profitability of MFIs without considering the financial structure of the institution (Bruett, 2005; Tchakoute-Tchuigoua, 2010).

The most commonly used profitability measure for banking and commercial institutions is ROA (Gutiérrez-Nieto et al., 2007; Rosenberg, 2009). Many microfinance studies use ROA for a financial performance measure to show how it is going to be impacted by the corporate governance (Barry & Tacneng, 2014; Hartarska, 2005; Mersland & Strøm, 2009; Strøm et al., 2014). ROA uses net income after taxes but before donations, which is a non-operating income, as the numerator, and total assets for the period as the denominator. It shows how an MFI is profitable relating to its total assets, expressed as a percentage. ROA for this study is calculated as:

ROA = Net income after taxes and before donations Total Assets

4.5.1.3 Yield on gross loan portfolio (YOGLP)

Yield on gross loan portfolio (YOGLP), which is also known as portfolio yield, is an indicator of the loan portfolio’s ability to generate financial revenue from interest, fees and commissions (Microfinance Consensus Guidelines, 2003). According to Gutiérrez-Nieto et al. (2007) profitability of MFIs can be measured through the YOGLP.

YOGLP = Interest on loan portfolio + fees and commissions on loan portfolio Gross Loan Portfolio

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4.5.1.4 Operating expenses ratio (OCR)

Operating expenses ratio (OCR) is the most commonly used indicator for efficiency and productivity of MFIs (Barry & Tacneng, 2014; Gutiérrez-Nieto et al., 2007) as it measures how well the MFI masters its operations (Mersland & Urgeghe, 2011), and is also known asoperating cost ratio (Rosenberg, 2009). This proxy of financial performance measures the MFI’s administrative efficiency by comparing total operating costs to the average gross loan portfolio or to the total assets.

The most appropriate denominator for calculating the OCR is total assets. The reason for selecting total assets relates to the consideration of number of loans and loan size which could impact OCR. For example, if MFIs provide small loans to borrowers, then their operation cost is high due to the loan processing (loan preliminary assessment cost, site visit cost, loan application cost, etc.), loan monitoring expenditure (client visit cost, loan collection cost, such as fuel, and reimbursement, etc.). Technically, gross loan portfolio represents the portfolio of micro loan credit. However, there are circumstances where some MFIs provide other services, including micro savings31, micro business consultation, in which the amount is not represented in the gross loan portfolio. In that instance, it is unfavourable to compare operating cost against gross loan portfolio as it does not represent other savings balance which remains in the total assets.

Total assets are viewed as the most appropriate measure to mitigate disadvantage of such distortion as total assets represents gross loan portfolio, savings and other nature of assets32 which have been generated to disburse micro loan credit (Microfinance Consensus Guidelines, 2003; Rosenberg, 2009). A low ratio implies that the institution is more profitable and shows its ability to cover its costs

31 _{MFIs retain clients’ savings in their liability and corresponding cash received on client savings} are deposited in banks as term deposits. However, significant personal cost is paid for monitoring clients’ savings, which include under the administrative expenditure.

32 _{Usually, MFIs use loan tracing systems (IT software) for monitoring credit. The value of loan} tracking system is recorded under the intangible assets and amortised within specified period. That amortised cost includes under administrative expenditure. Also MFIs have given motor vehicles for their loan officers to collect repayments. Associated cost on vehicle, such as fuel, vehicle maintenance are included in the administrative expenditure.

109 effectively, which is strongly related to the sustainability of the MFI. OCR of this study is calculated as:

OCR = Annualised Operating Expenses Total assets

4.5.1.5 Capital asset ratio (CA)

Capital asset ratio (CA) provides information on the capital structure of an MFI and it signals its capital strength. CA ratio measures an institution’s resiliency against both expected and unexpected losses. This is an important factor in determining risk in financial institutions, particularly in banks (Karim et al., 2010; Tulchin, Sassman, & Wolkomir, 2009) as an explanatory variable, which indicates the risk that the institution has when there is insufficient capital to continue its operations.

The proportion of total assets financed by the MFI's equity capital is explained by the CA ratio (Bruett, 2005; Tulchin et al., 2009). They point out that CA ratio as an important measure for MFI performance in the framework for reporting, analysis and monitoring of MFI performance. Also Tchakoute-Tchuigoua (2010) and Gutiérrez-Nieto et al. (2007) have identified the CA ratio as a MFI performance measure. Institutions with higher capital assets ratios have low leverage levels and, therefore, less risk which reduces the cost of capital and increases profitability of the firm. The higher CA signifies that the institution is better positioned to meet its financial obligations and addresses an unexpected losses (Tulchin et al., 2009). Normally, the expected coefficient for capital asset ratio is a positive coefficient. It is important for an institution to comply with internally set or externally prescribed minimum capital standards, especially for financial institutions where it is calculated as a percentage of equity in relation to risk-weighted assets. Bank supervisors in Latin American countries set the limit of capital adequacy between 8% and 11% (Jansson, 2003), however in Sri Lanka, where the banks are regulated under the Central Bank’s capital adequacy ratio, the requirement is between 14% and 20% (CBSL, 2012a). In India, banks are required to maintain a minimum capital adequacy ratio of 9% on an on-going basis, however, non-bank subsidiaries are required to maintain the capital adequacy ratio prescribed by their respective

110 regulators (RBI, 2013). New RBI norms required NBFCs to have a capital adequacy ratio of 12% by April 2014.

Banks with more equity capital operate more efficiently than banks with less capital (Kwan & Eisenbeis, 1997) because they can amply offset the risk of potential losses with equity capital. This situation is relevant for other types of financial institutions such as MFIs. Accordingly, this study uses CA to measure MFIs’ financial performance. CA is calculated by using total equity capital to total assets (Tulchin et al., 2009).

CA = Total Equity Total Assets

4.5.1.6 Portfolio at risk more than 30 days (PAR)

Portfolio at risk is the standard international measure as well as the most widely accepted measure of portfolio quality in the banking and MFI sectors (Gutiérrez- Nieto et al., 2007; Rosenberg, 2009). The loan portfolio is the main source of risk for financial institutions as it is the largest asset (Mersland & Urgeghe, 2011). The repayment of loans is a vital indicator of their performance. The strong repayment patterns emphasise that the loans are of real value to the client.

Portfolio at risk (PAR) means the value of outstanding loan balances that are past due by at least one day (excluding the interest receivable on the loan, but including the entire unpaid principal balance) and have not yet been written off (Microfinance Consensus Guidelines, 2003). In microfinance, 30 days is a common breakpoint (Rosenberg, 2009, p. 6) and the most widely used PAR ratio (Mersland & Urgeghe, 2011, p. 7). This measure reflects the percentage of gross loan portfolio at risk of non-repayment by including the complete outstanding balance of loans that have payments in arrears of more than 30 days (Rosenberg, 1999). In this calculation, the value of restructured loans is also included. As a rule of thumb, PAR above 10% must be reduced quickly because a decreasing PAR is a positive signal for financial sustainability and low delinquency. PAR which is more than 30 days is calculated (Rosenberg, 1999) as:

PAR = Outstanding balance of portfolio overdue borrowers for more than 30 days Gross Loan Portfolio for Borrowers

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