Finance for microfinance

This Finance study guide was written by Joanna Ledgerwood and published by Calmeadow in 1996. The RFILC is grateful for the authors’ permission to reproduce it in downloadable form here. The material may be copied or adapted to meet local needs without permission from CALMEADOW, provided that the parts copied are distributed free or at cost – not for profit. Please credit Joanna Ledgerwood. 1996. Financial Management Training for Micro-Finance Organizations: Finance. Toronto, Canada: CALMEADOW for those sections copied.

The guide, together with its companion volume on Accounting, was developed to help people working in the micro-finance field to obtain basic accounting and financial management skills. It is intended for field and Head Office staff of micro-finance organizations; micro-finance consultants; and members of the donor community who would like to understand how micro-finance organizations report and monitor their activities. The guide comprises a set of seven lessons, each containing questions and exercises for which answers can be found in the accompanying Solutions to Exercises document. Unless you are already familiar with accounting theory, it is suggested that you complete the Accounting guide prior to completing this one.

As the field of micro-finance matures, more and more micro-finance organizations are recognizing that they cannot rely indefinitely on donor funding and, therefore, that they will become sustainable in the long-term only when they become financially self-sufficient. As they strive for financial viability, micro-finance organizations are realizing that their products and services must be even more responsive to the needs of their clients, the micro-entrepreneurs, and that they must constantly innovate to improve not only their products but also their operations and management.

This Finance study guide explains the key financial management tools which can be used to analyze a micro-finance organization’s financial health and improve understanding of its clients’ activities. These tools will enable an MFI to design its loan products and delivery mechanisms effectively, and to analyze the results of its operations. They will also aid the organization in its decision making regarding the sources and uses of funds and future planning. Throughout this study guide, emphasis is placed on the important inter-relationship between serving clients well and achieving institutional self-sufficiency. The main focus is on credit services and not savings, because in many countries current legislation does not permit small MFIs to offer voluntary savings products.

Currencies used in the examples and exercises include: Bolivia Boliviano (Bs); Philippines Peso (P); Vietnam Dong (VD); Bangladesh Taka (Tk); American or Canadian Dollar ($); South Africa Rand (Rd); Guatemala Quetzal (Q); Kenya Shilling (Ksh); Dominican Republic Peso (RD$).


Finance Study Guide Pre-test

Through this pre-test, you will gain a better appreciation for the subjects to be covered in this guide and your own current level of knowledge and understanding of them. You should not be concerned if you are unable to answer any or all of the questions as that is the purpose of the guide – to help you learn about finance in microfinance organizations.

Lesson 1: Principles of Credit – Meeting Client Needs

Designing loan products to meet client needs is fundamental to the success of a micro-finance organization. Understanding cash patterns of borrowers and the profitability of their businesses helps to match the loan product to their business cycles. The loan term and repayment frequency are possibly the most significant variables in micro-finance and should be suited to the borrowers' needs. The effect of an increased interest rate on the borrower is relatively less significant than increases in other costs. The method of calculating the interest rate and fees significantly influences the price of the loan.

The objective of this lesson is to highlight the effect of credit on borrower activities. Topics covered include:

  • Cash Patterns
  • Loan Term
  • Loan Utilization
  • Loan Purpose
  • Interest Rate
  • Fees/Service Charges
Lesson 2: Effective Cost of Borrowing

When clients borrow money, they incur both financial and transaction costs. Financial costs include interest, fees, forced savings, group fund and insurance fund contributions. Transaction costs include direct costs such as child care and transportation costs to attend meetings, and other indirect costs such as time away from the business, plus the opportunity cost of savings.

The objective of this lesson is to explain the effective cost to clients of borrowing and the related yield to the lender. Topics covered include:

  • Cost components
  • Effective cost calculation
  • Effective yield to an organization
  • Role of savings

This subject is covered in more detail in the separate study guide on Interest rates and self sufficiency, which also includes a financial calculator.

Lesson 3: Break-even Analysis

This lesson will provide the tools necessary to determine the break-even point for a borrower activity, for an income-generating project or for a micro-finance organization branch. Profitability can be forecast and managed when one knows: i) at what level of production a business will be able to cover all of its expenses; ii) what minimum product price is needed for the product to be viable at different levels of production; and iii) what happens if the financial estimate of costs and prices are changed.

You will learn how to calculate a break-even point for an income-generating activity and for a branch. Topics covered include:

  • Fixed costs
  • Variable costs
  • Contribution margin
  • Required break-even volume / revenue
  • Break-even portfolio size
Lesson 4: Viability of a Microfinance Organization

Micro-finance organizations are becoming more and more concerned with financial viability. This lesson discusses the costs and revenues associated with credit activities and the importance of achieving self-sufficiency and high productivity.

Micro-finance organizations are generally involved in two primary activities: credit and savings. For the purpose of this lesson, it is assumed that no voluntary savings are provided by the organization and all savings collected are simply a requirement of receiving credit. Any other activities which occur at the branch are excluded from the analysis which is explained here.

Topics covered include:

  • Revenue
  • Expenses
  • Financial viability
  • Operational self-sufficiency
  • Cost of capital
  • Financial self-sufficiency
  • Trend analysis
  • Productivity analysis
Lesson 5: Delinquency Management

Generally, the loan portfolio of a micro-finance organization is its largest asset. The loan portfolio enables the organization to continue to provide credit to borrowers and to earn revenue. It is necessary, therefore, to manage the portfolio in such a way as to limit delinquency and loan default.

This lesson demonstrates the importance of accurately measuring the portfolio risk, provides an understanding of how the quality of the portfolio affects the viability of a micro-finance organization, and offers ways to manage the credit operations to minimize the risk to the portfolio.

Topics covered include:

  • Portfolio outstanding
  • Repayment rates
  • Measuring portfolio risk
  • Aging analysis
  • Loan loss reserves
  • Write-offs
  • Rescheduling/refinancing loans
  • The cost of delinquency
  • Controlling delinquency
Lesson 6: Cash Flow Management

Central to financial management of a micro-finance organization is effective management of its cash flow. Too much cash in a branch or organization results in lost income, while too little cash results in missed loan opportunities, delayed bill payments or high borrowing costs (overdraft charges). It is important to forecast cash needs accurately to reduce the amount of idle funds yet have enough cash available for operations.

All staff members of a micro-finance organization play a role in forecasting cash needs and ensuring adequate liquidity at the branch level. This lesson discusses how to forecast cash requirements and how to calculate liquidity ratios, an effective cash management practice.

The lesson shows you how to manage the flow of cash in a branch including forecasting cash requirements. Topics covered include:

  • Forecasting cash flows
  • Cash shortage/idle funds
  • Liquidity ratios
Lesson 7: Creating a Budget

The purpose of this lesson is to provide an overview of the budgeting process and the purpose for completing a budget. A sample budgeted Income Statement is provided. Implementation and analysis of the budget is described as well as how to calculate budget variance.

You will develop an understanding of why budgeting is important and how each area of the branch is part of the budgeting process. Topics include:

  • Benefits of budgeting
  • Who completes the budget?
  • The budgeting process
  • Implementation and Analysis
  • Budget variance
Finance Study Guide – Solutions to Exercises

This document contains the solutions to the exercises in the seven lessons that comprise the Finance Study Guide.

Sample Account Analysis

This document contains the following elements from a sample account analysis of a microfinance institution, for use with the lessons in this study guide: income statement, balance sheet, portfolio report.