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Lesson 2.

1:
Reading Financial Statements

In this Lesson
The balance sheet and income statement provide the basic financial
information about an MFI and its activities. Together, they report on
the financial position of the institution and its income and
expenditures. Progressive balance sheets and income statements,
together with the portfolio report, serve as the foundation for further
analysis of the institution’s financial health, performance and viability.

In Depth
Asset base and income generation

The top, or left-hand side of the Balance Sheet reports the institution’s assets, or ‘what it owns’. Whether
financed through debt or its own equity, these assets are the income generating base for the institution. Assets
include items such as buildings, desks in branch offices, safes for secure deposits, cash on hand or in bank
accounts, and the loan portfolio. Each of these is essential to an MFI’s operations, and hence the continued
capacity to generate income. In an MFI, the largest income-generating asset is its loan portfolio. Increases in
fixed assets do not have a direct impact on revenues generated by the institution, while the size and quality of
the loan portfolio do. Portfolio quality, then, has a direct impact an MFI’s capacity to generate income and to
sustain its operations. We discuss portfolio quality in lesson 2.2..

Financial statements and disclosure

Investors, managers and board members of any institution rely on financial statements to assess the financial
health of the institution. Disclosure guidelines within an industry, such as microfinance, help to ensure that
the necessary information for sound management is available to stakeholders, and that the information is
comparable industry-wide. Disclosure pertains not only to the financial information itself, but also to the
accounting methods used to record it. Though the guidelines do not prescribe a given accounting method for
calculating, say, depreciation, they do require that the method used be disclosed with the financial statements.
Given their social mission and the fact that they are a financial service provider, MFIs must be more rigorous
about disclosure than is required under International Accounting Standards. Effective disclosure should
report on subsidies, whether cash, in-kind, or through soft loans, as well as loan portfolio quality, the extent
and methods used to report aging of loans and write-offs for bad debt.

Standard financial statement

As the microfinance industry evolves, the cumulative experience of the various microfinance institutions will
be used to develop standards in financial disclosure and in the very types of financial statements presented.
Current efforts at defining standards require that MFIs produce a Balance Sheet and Income Statement, the
two statements discussed in this lesson. International Accounting Standards require two other statements: a

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cashflow statement and a statement of changes in equity. Current microfinance standards projects do not
require these statements and this course does not cover them. As lesson 2.2 will show, however, the
information from the cashflow statement relevant to portfolio management will be found in the Portfolio
Report. For more discussion of these developing standards, refer to the CGAP Disclosure Guidelines in the
Recommended Reading below.

Soft loans

Soft or concessional loans are one type of subsidy to an MFI. As a liability, loans are claims on future
resources of the institution. In this case, it is in the form of repayments of principal. Soft loans do not require
that an MFI pay commercial interest rates for the use of the money. Rather, such loans decrease the cost of
funds below commercial rates, providing an effective subsidy to the MFI. This subsidy is calculated by
subtracting the amount of interest and fees paid on soft loans from the amount the institution would have paid
if the loans had been priced at commercial rates. Such loans should be reported separately from commercial
rate liabilities, as their interest payments do not represent the true market cost of carrying this debt. We
discuss subsidies in more detail in lesson 2.5.

Leverage and capital adequacy

An MFI mobilizes funds from the right side of its Balance Sheet (also known as Liabilities and Equity) to
finance the left side (the Assets). The MFI’s largest asset, its loan portfolio, can be funded by liabilities, such
as loans or deposits mobilized from customers, or by its own capital, its equity. The ratio of debt to equity is
known as leverage. A highly leveraged institution is one with a high percentage of debt to equity. Attracting
more debt, for a financial institution, allows it to make more loans, but if debt increases significantly as a
percentage of total funding, then the institution risks having too small a cushion of its own capital (equity) to
absorb losses. In international banking norms, the 1988 accord by the Basle Committee on Banking
Standards set the capital adequacy requirement at equity of at least 8% of of risk-weighted assets, limiting an
institution’s leverage of around 12 times its equity base. MFIs have not yet leveraged this much. In the
November 2001 issue of the MicroBanking Bulletin, only around 20 institutions, African Community Banks
and large Latin American MFIs, reported leverage as high as 6.9 and 5.7 times, respectively, their equity
base. No other categories or MFI peer groups reported average leverage this high.

Types of equity

Equity provides an important source of funds for an MFI. Institutions use it to meet capital requirements
stipulated under regulatory frameworks or as reserves in case of losses. As discussed above, equity also
provides a base for leveraging an institution and for gaining access to debt financing or deposit mobilization.
Two common types of equity include retained earnings and share capital. As an institution becomes
financially self-sufficient and covers its costs, earnings in excess of costs are reinvested in the institution,
increasing equity through retained earnings. For institutions allowed to issue shares, share capital from direct
investment in an MFI can provide another source of equity building. Most MFIs have not yet reached this
stage or institutional form. Donors have provided more traditional forms of equity and quasi-equity for MFIs
through grants for loan capital, capital expenditures or operating shortfalls. Donated equity should be
reported transparently and cumulatively on an MFI’s Balance Sheet.

Financial Terms and Formulae


The accounting balance

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The Balance Sheet presents the balance, inherent in accounting, between assets (often called the left side of
the Balance Sheet) and the sum of liabilities and equity (likewise, referred to as the right side of the Balance
Sheet), as follows:

Assets = Liabilities + Equity

The left side represents what an institution owns and the right side what financed these assets. In other words,
you can think of the Balance Sheet as stating the sources (right) and uses (left) of funds. You can also restate
the accounting equation:

Assets – Liabilities = Equity

From this perspective, the equation describes the net worth (or equity) of an institution as the total of assets
minus all claims on these assets: what the institution really owns once all claims have been paid off. For
financial institutions, this balance between different sources of funding, whether equity (from the institution)
or debt (from outside) plays an important role in capital adequacy standards determined by regulatory bodies.
See the In Depth section above for more information on leverage.

Recommended Reading
2.
CGAP. Disclosure Guidelines for Financial Reporting by Microfinance Institutions. Washington, D.C.:
CGAP. Provisional version. January 2001.
(*)

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