MICROCAPITAL.ORG STORY: CGAP Microfinance Blogger Observes That Ratios May Not Accurately Reflect Real Strength Of Microfinance Institutions

In a blog posted by Mr David MacDougall on the CGAP Microfinance Blog [1] entitled ‘The answer isn’t in the spreadsheet…How to assess the real strengths of a microfinance institution’ [2], Mr MacDougall was quoted as stating that ‘The financial crisis has made investors and asset managers increasingly sensitive to risk in all areas of finance, including microfinance. Lenders and investors worry about whether MFIs can survive. They weigh the risks by applying sophisticated analysis to the MFIs’ financial performance and asset quality. A spreadsheet with numerous ratios and graphs serves as the standard tool. Unfortunately, such efforts can lead to erroneous conclusions because their focus isn’t wide enough.’ Instead of focusing on ratios, which can have a limited meaning, Mr MacDougall felt that analysts should instead focus on understanding the activities, context and management of a MFI. His thoughts are elaborated below.

Mr MacDougall is of the view that to assess the real strength of an MFI, investors and analysts need to ask ‘whether a MFI’s mission and programs focus on “real” microfinance’. He warns that under the pressure of fierce competition or of an excessively profit-minded management, some MFIs expand into products and services that deviate from the original microfinance mission. Many MFIs have strayed into other sectors such as consumer and SME lending. These products are beneficial in their own respects but as Mr MacDougall notes, ‘they do not have the same risk characteristics as small loans to micro-entrepreneurs’.

Another key consideration when assessing risk return ratios is whether an institution is mission-driven rather than profit-driven. Mr MacDougall observed that these ratios do not necessarily reflect the profit-generating capacity of an MFI. This is particularly true for non-profit MFIs or MFIs that are not profit-maximizers. He cites as an example ASA of Bangladesh which experienced a drop in its operational self-sustainability from 240% in 2006 to 185% in 2007. Mr MacDougall observed that ‘far from being an indicator of weakness, this reduction was the result of the management’s decision that it was making more than enough to meet its growth needs. So it lowered lending rates.’

MFIs also differ from conventional financial institutions in that there is a broad array of aid agencies and philanthropic investors who are keen to support MFIs that can make a difference in under-privileged communities. Such MFIs often manage to secure access to technical assistance and below-market rate funding. He cites as another example the case of a MFI that faced financial distress as a result of failing to fully hedge its foreign exchange risk. With a large portion of its equity gone, the MFI’s lenders could have accelerated the loans and forced the MFI into a bankruptcy scenario. It turned out that the lenders were eager to find ways to help the MFI overcome its financial difficulties because that MFI provided excellent services to a large number of very poor women.

To assess the strength of a MFI, one also needs to analyse its leadership and whether MFI managers and leaders have a thorough understanding of the MFI’s immediate environment and are able to adapt quickly to any changes. Staff also needs to be suitably trained and must understand the peculiar business of microfinance. That is not to say that spreadsheets full of ratios are not helpful. Mr MacDougall adds that they are better applied to gauge trends in the microfinance sector than to be used as a sole benchmark for assessing the strength of individual MFIs.

By Chinq Yee Chong, Research Assistant

Bibliography:

[1] CGAP Microfinance Blog: microfinance.cgap.org/

[2] CGAP Blog ‘The answer isn’t in the spreadsheet…How to assess the real strengths of a microfinance institution’: http://microfinance.cgap.org/2009/08/05/the-answer-isnt-in-the-spreadsheet/

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