5 RATIO CALCULATION
To calculate ratios, it is often necessary to annualize or average figures used. In addition,
analysts often make adjustments to the financial statements in order to calculate various ratios. The following describes methods for annualizing and averaging figures as well as the most common adjustments and how they should be applied.
Annualizing
To annualise a number (if required), the formula is: AA = [A * (12/M)]
Where:
AA = annualised amount
A = amount for the year
M = number of months in the year
Averaging
Many financial ratios require an average for a Balance Sheet account, such as the Net loan portfolio. Averages for a period (such as a year) can be calculated simply by adding a beginning amount and an end amount and dividing the result by two.
Pavg = [(P0 + P1)/2]
However, simple average calculations can result in a distorted number. This distortion is particularly true for institutions whose loan portfolios are growing quickly or for institutions that experience significant seasonal fluctuations in lending activities. Period averages are much more meaningful when they are computed on a monthly or at least a quarterly basis. When using such sub-period averages, the numerator is the opening balance plus the sum of the balance at the end of each sub-period, while the denominator is the number of sub-periods plus one. As an example, a quarterly average would be calculated as:Pavg = (P0+ P1+P2+P3) / (3+1)
Adjustments
Financial analysts often calculate a number of adjustments, most of which make analytical additions to the reported expenses of the MFI.
Three groups of adjustments are common:
- Subsidy adjustments, including subsidized cost of funds adjustments, and in-kind subsidy adjustments,
- Inflation adjustments,
- Adjustments for non-performing loans, including adjustment of loan loss reserves and provision expense, write-off adjustments, and reversal of interest accrued on non-performing loans
Subsidy adjustments
Subsidy adjustments serve two purposes. Firstly, MFIs vary widely in the amount of subsidy they receive, if any. Thus, adjustments that offset subsidies will allow for a more meaningful comparison of performance among MFIs with differing amounts of subsidy. Secondly, in the long term, MFIs should be able to operate without subsidies, relying instead on commercial sources and private investment at market rates.
An adjustment that cancels out the effects of present subsidies will reveal how close the MFI is to having a business that could expand viably in a subsidy-free commercial environment. Subsidy adjustments are not included in a MFI’s normal financial statements; rather, they are hypothetical revenues or expenses that managers and analysts use when calculating certain indicators and ratios. Two types of subsidy adjustments are common among MFIs.
Subsidized cost of funds adjustment
This adjustment looks at the difference between the MFI’s financial expense and the financial expense it would pay if all of its funding liabilities were priced at market rates. One common way of doing this is to multiply the MFI’s average funding liabilities by some shadow price (a market interest rate) and then subtract the actual financial expense. The difference is the amount of the adjustment and is treated as an expense. No single shadow rate is appropriate in all circumstances. Many analysts use as a shadow price the rate that local banks are paying on 90-day time deposits. In theory, the cost of attracting commercial equity capital should also be factored in, as private investors are motivated by retained earnings growth and dividends. In practice, however, analysts do not shadow-price equity in this way; rather they subject the MFI’s equity to an inflation adjustment.
In-kind subsidy adjustment
Development partners may provide MFIs with goods and services at no cost or at a below-market cost. Common examples of these in-kind subsidies are computers, consulting services, free office space, and free services of a manager. The in-kind subsidy adjustment is the difference between what the MFI is actually paying for the good or service and what it would have to pay for the same good or service on the open market. However, if a donor agreement requires an MFI to accept a good or service that it would not have purchased otherwise, the item is generally not treated as an in-kind subsidy in calculating this adjustment.
Some young MFIs receive free services of a highly paid manager, maybe a foreign national. If the analyst believes that the MFI will soon be able to use a less expensive manager, then she might make an adjustment, not for the cost of the donated manager, but rather for the expected cost of a local manager.
Inflation adjustment
In the private sector, equity is generally considered to be the most expensive form of financing;
investors require a greater return than lenders because they are taking greater risk. In contrast, many MFIs do not pay any direct cost for their equity funding. (Exceptions include financial cooperatives and MFIs with commercially motivated investors.) The rationale behind the inflation adjustment is that an MFI should, at a minimum, preserve the value of its equity against erosion due to inflation. Inflation produces a loss in the real value (purchasing power) of equity.
The inflation adjustment recognizes and quantifies that loss. Unlike subsidy adjustments, recording the inflation adjustment in the MFI’s normal financial statement is common in many parts of the world and has support under international accounting standards. Section 29 of the International Accounting Standards mandates the use of inflation-adjusted accounting in high-inflation countries. In low inflation countries, the inflation adjustment is seldom incorporated in the financial statements of businesses. There are many different methods of inflation adjustment. All methods involve some version of the same core approach: Net fixed assets are subtracted from equity, and the result is multiplied by the inflation rate for the period. The amount of a period’s inflation adjustment is treated as if it were an increase in the MFI’s financial expense.
If inflation adjustments are incorporated within the MFI’s financial statements and carried forward from year to year, then in addition to creating an expense on the Income Statement, it will also generate a reserve in the balance sheet’s equity account.
This reserve will reflect the amount of the MFI’s cumulative retained earnings that have been consumed by the effects of inflation.
Adjustments for non-performing loans
An MFI’s treatment of non-performing loans (that is, loans in arrears) can have a large impact on how sound its financial results appear. MFIs differ widely in their accounting policies with respect to Loan loss provision expense, write-offs, and accrual of interest income. Analysts adjust these accounts in order to compare MFIs and/or to eliminate a material distortion in financial statements resulting from unrealistic accounting treatment of the nonperforming
portfolio. There are three main types of portfolio adjustment:
Adjustment to Loan loss reserves and Provision for loan losses expense:
An analystwill often adjust an MFI’s Loan loss reserve to bringit in line with standard accounting policies, or up toa level that is appropriate for the individual MFI’srisk. In order to increase the Loan loss reserve onthe Balance Sheet, the analyst will have to make anincrease to the Provision for loan losses expensethat flows into the Loan loss reserve.
Write-off adjustment:
Analysts will often adjust the MFI’s write-offs to bring them in line with a standardized accounting policy. One frequently used standard (mentioned here only as an example) is to treat the Portfolio at risk > 180 days as if it had been written off. On the Balance Sheet, both the Gross loan portfolio and the Loan loss reserve are reduced by the amount written off.
Reversal of interest accruals:
MFIs that recognize interest and fee revenue from the loan portfolio on an accrual basis record interest when it is earned rather than when a cash payment is received from the borrower. If a loan falls delinquent, it is appropriate at some point to stop accruing Interest income and to reverse previously accrued income. Many analysts reverse all Interest income that has been accrued on loans that are presently more than 30 days late, including income that has been accrued for loans that have been written off, if the MFI has not already done this.