Financial Performance

The most prominent driver of an institution’s financial performance is profitability; this profitability is determined by internal factors such as the institution’s balance sheet and income statement, risk management, operations management, and technology, as well as external factors

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an MFI’s net income against the structure of its balance sheet5 _{and help investors and managers}

determine whether the funds they invested in the MFI are earning an adequate return.

Profi6tability is also a sustainability measure for financial institutions, as the costs of capital, inflation, non-cash items, and operating expenses are paid out of operating revenues only. Commercial banks become profitable by competing to attract money through deposits and through lending money out as loans. A bank’s profitability rests on its ability to attract deposits at a cost sustainably lower than the return on assets (mainly loans). MFIs are specialized financial institutions and exhibit most of these same characteristics. The MFI’s balance sheet and income statement are similar to those of retail/commercial banks and are both asset and liability driven (see Tables A3 and A4 in the Appendix for examples). Low profitability weakens an MFI’s capacity to absorb adverse shocks, which subsequently affects solvency (Muriu, 2011), while a profitable MFI’s surpluses are used to expand its outreach (Rosenburg, 2009; Ayayi & Sene, 2010; Tehulu, 2013).

An MFI’s financial performance is determined by examining its financial statements and ensuring that the items they include are consistent with generally accepted accounting principles. The Appendix includes tables that show example financial statements and definitions.

Determining profitability is quite straightforward: Does the MFI earn enough revenue, excluding grants and donations, to make a profit? Typically, three profitability ratios are used to assess a financial institution’s financial performance: return on assets (ROA), return on business

(ROB),7 and return on equity (ROE). In the microfinance literature, however, the leading measure

of profitability is ROA.

5 _{Tables A2 and A3 in the Appendix show a sample of an MFI balance sheet and income statement, respectively.}

6 _{Cash flow matters a great deal too}

7 _{“Business” refers to the result of adding assets and liabilities together and dividing by two; this ratio is useful for} MFIs that use mobilized savings to fund a majority of their assets.

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The microfinance literature defines ROA as the MFI’s net operating income after taxes divided by its assets. ROA is an important measure because it lets analysts compare the MFI's performance with that of other MFIs (Ledgerwood, 2013). It also tells investors the return they can expect from an investment in the MFI. A return should cover the risk-free rate and a markup to cover the MFI’s systematic risk (Berk and DeMarzo, 2014). Such a risk-adjusted return is hard to calculate for MFIs because only a few of these institutions are listed as publicly traded firms. The following equation is adapted from the MIX market database’s definition of ROA:

Equation 1. ROA Definition

ROA =

Averageassets

Figure 1: Decomposition of Return on Assets (ROA)

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ROA is a standard measure of an institution’s long-term health (Koch, 1992; Ledgerwood, 1999). Many researchers use it to measure how well a firm is using its assets to generate profits (Bogan, 2012). Figure 1 shows a detailed breakdown of ROA into components to help further analyze an MFI’s financial performance. This analysis reveals the sources of an MFI’s profitability and may signal areas in which the institution could improve its operations and asset management from a profitability viewpoint. In particular, it can determine the portfolio yield and the performing assets and compare them with projected returns and between periods. At a top level, ROA can be decomposed into profit margin and asset utilization. When analyzing an MFI, it is useful to break down the profit margin and asset utilization into a series of ratios and relate each to the total income or total assets. This lets analysts examine the primary source of the MFI’s revenue, along with other funding sources. The profit margin is the profits relative to total revenue earned. Further breaking down the profit margin ratio into the four costs an MFI incurs—showing each as a

percentage of total revenue—provides insight into the MFI’s risks and costs. Asset utilization is

revenue as a ratio of total assets, which can be further broken down into interest and non-interest income to assets. These two components of asset utilization indicate the MFI’s revenue source based on where the assets are invested (loan portfolio versus other investments). Breaking ROA into components shows just why this ratio is such a robust profitability measure.

Clearly, the objective of MFIs is not simply to maximize their value; they also aim to reduce poverty. However, in asserting that MFIs should rely less on donors and government funds and more on attracting commercial sources to fund their operations, many researchers have significantly boosted the idea of using ROAs as financial performance measures for MFIs (Benjamin and Ledgerwood, 1998). In the MIX market database, ROA is measured by net operating income (excluding taxes) compared to average total assets. This ratio, which is the net

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of income taxes and excludes donations and non-operating items, shows how the MFI is managing its assets to optimize profitability.