MODULE 5

RURAL ECONOMY AND MICRO FINANCE

Financial statement analysis of microfinance

institution
The users of financial statement
The purpose of financial accounting is to provide the
necessary financial information accurately and in a timely
fashion. It involves identifying, measuring and
communicating the financial information, regarding an
organization's or enterprise's incomes, expenses, assets
and liabilities
The important users of financial information are:
1. Equity Investors: Equity investors provide capital
to an enterprise in return for shares that gives them
ownership in the enterprise. The returns on equity
capital are not assured and depend on the
profitability of the organization. Therefore equity
capital is often called risk capital. The providers of
risk capital are concerned with the risk inherent in,
and return provided by their investments. They need
information to help them determine whether they
should buy, hold or sell equity shares.
2. Lenders: Lenders provide loans to an organization.
Micro-finance organizations depend on loans for
on-lending, ie lending to the final borrower. Lenders
in the micro-finance context include commercial
banks and financial institutions, international donors
and other micro-finance funds. These lenders are
interested in information which enables them to
determine whether their loans, and the
interestattaching to them, will be paid when due as
also if the money is used for the intended purposes.
3. Regulatory Agencies: Government, Reserve Bank
of India and its agencies are interested in the
allocation of resources and, therefore, on the
activities of enterprises. They also require
information in order to regulate the activities of
enterprises and determine taxation policies, and to
serve as the basis for determination of national
income and similar statistics.
4.Employees: Employees and their representative
groups are interested in information about the
stability and profitability of their employers. They
 are also interested in information which enables
them to assess the ability of the enterprise to
provide remuneration, retirement benefits and
employment opportunities.
5. Suppliers and other trade creditors: Suppliers and
other creditors are interested in information which
enables them to determine whether amounts owing
to them will be paid when due.
6 Clients: Clients have an interest in information
about the continuance of an enterprise, especially
when they have a long term involvement with, or are
dependent on, the enterprise.
7 Public: Financial statements may assist the public
by providing information about the trends and
recent developments in the prosperity of the
enterprise and the range of its activities.
CHARACTERISTICS OF FINANCIAL STATEMENTS
The output of the financial accounting is a set of financial
statements. The most important financial statements are
the balance sheet and the profit and loss statement. For
organizations that are not for profit, a statement of
income and expenditure is prepared. For financial
statements to be useful, these should be
1. Understandable: The financial statements should
be presented in such a manner that it is
understandable by the users. In this context,
however, the users are assumed to have a
reasonable knowledge of economic activities and
accounting issues.
2. Timely: The financial statements must be
presented in a timely fashion in order to facilitate
decision making.
3.Relevant: The information provided by the
financial statements should be relevant for its users.
The information is said to be relevant for the users
when it enables them to evaluate the present, past
and future events on the basis of the information.
4. Reliable: The financial statements presented must
also be reliable, that is it should be free from any
significant errors or biases.
5. Comparable: The financial statements presented
should also enable users to compare the
performance of the enterprise over time or with
those of other organizations.
COMPONENTS OF FINANCIAL STATEMENTS
Financial statements contain information about the
assets ( what is owned) and liabilities ( what is owed) in
terms of monetary value. These are described below:

1.Assets
An asset is a resource owned and controlled by the
enterprise from which future economic benefits are
expected to flow to the enterprise.
Following are some of the features of the assets:
• Asset must be owned by the organization: There are
many economic resources from which the
businesses can benefit like an airport or an industry
association, but these cannot be said to be the
assets of an organisation as these resources are not
owned and controlled by it.
• All the assets must lead to future benefits by
contribution to the cash flow of the enterprise
directly or indirectly. For example, the office
building of an organization is an asset which
enables the business to perform its activities and
to earn profits.
• Assets must be, generally tangible and have a
physical form. Many assets have a physical form.
However, a physical form is not essential for
existence of an asset. Hence, patents and
copyrights, for example, are assets if future
economic benefit is expected to flow from them
and if they are controlled by the enterprise.
• The assets of an organization result from past
transactions or other past events. For example, a
loan outstanding is an asset which has resulted
from the event of disbursement of loans in the
past. Intention to give loans or to purchase assets
in the future does not lead to creation of assets.
Example of assets in an MFI
• Cash and bank balances: Amount lying in the
bank accounts or as cash in hand with the MFI
• Loans outstanding: Unpaid balance of all the
loans disbursed.
• Investments: Amount invested in the various
securities like Fixed Deposits, Bonds or Shares of
other enterprises.
• Land , building and properties: Land Building and
other infrastructure owned by the MFI
 • Patents and copyrights: Patents and copyrights
are the exclusive rights of usage granted to an
inventor or author for his/her exclusive work or
invention.
• Goodwill: This is an intangible asset. Portion of
the market value of an enterprise not accounted
for by its assets and liabilities. Goodwill usually
arises only in case of an acquisition.
• Prepaid expenses: Expenses which have been
paid in advance but the benefit has to be derived
in the future.

2.Liabilities
A liability is a present obligation of the enterprise arising
from past events, the settlement of which is expected to
result in an outflow of resources from the enterprise.
• An essential characteristic of a liability is that the
enterprise has a present obligation. An obligation
is a duty or responsibility to act or perform in a
certain way. Obligations may be legally
enforceable as a consequence of a binding
 contract or statutory requirement, although it is
not essential.
• One needs to distinguish between present
financial obligations and future commitments to
do business or transaction. A commitment to
take loan from a bank does not constitute a
liability. Only when the enterprise actually takes
the loan, there is an obligation to repay
• . Settlement of present obligations usually
involves enterprise giving up resources in order
to satisfy the claims of the other party or the
creditor.
• Settlement of an obligation may occur in a
number of ways, for example, by 1. Payment of
cash 2. Transfer of other assets like fixed assets
or investments 3. Provision of services, (eg
Liability against an advance payment can be
extinguished byperforming the assignment) 4.
Replacement of that obligation with another
obligation (eg a loan can be replaced with a
debenture) 5. Conversion of the obligation to
equity (e.g. the holders of a convertible debt are
issued equity shares)
 An obligation may also be settled by other
means, such as a creditor waiving or forfeiting its
rights. This can happens when there is a dispute
regarding the amount to be paid and the creditor
agrees to accept part payment in full settlement
of his claims.
: Examples of liabilities in an MFI
• Loan from banks and financial institutions
• Savings Deposits from the clients • Outstanding
expenses: Expenses which have been incurred
but payments have not been made.

3.Capital
Capital is the own funds. It is normally equal to value
assets of the enterprise after deducting all its external
liabilities
• The amount of capital shown in the financial
statements is dependent on the measurement of
assets and liabilities. The amount of the capital (own
funds) in the financial statements rarely corresponds
to the value of the equity shares or the value that
business as a whole commends in the market. This
may also be different from the value that can be
realized by disposing off assets and liabilities in the
market. In accounting terms the capital is the sum of
equity, reserves and other funds that would get
distributed the owners in the event of winding up of
the business.
• Nature of various items under capital is
dependent on legal structure and conditions
governing specific items. For example, in the case
of companies the equity shares and the free
reserves are available for the shareholders in the
event of dissolution, but in case of the trusts and
societies grants and donations are not available
for the promoters even though both of these
would classify as capital.
• Capital represents the claim of the owners in the
business.
• In the context of MFIs, equity would come from
infusion of capital by the owners (called share
capital), or from profit generated from the micro-
finance and other activities (called retained
earnings or reserves and surplus) or from the
grants and donations received the MFI (called
donated equity).
 : Example of Capital in an MFI
• Share capital: The amount of equity capital
invested in the forms of shares of the MFI by
investors.

• Reserves and surplus: Profit which is earned but

has not been distributed in the form of dividends.
• Donated equity: Cumulative grants and
donations received by the dividend
4 Income and expenses
Income is the amount earned by way of interest, fee,
commission and other charges during the accounting
period in the form of inflows. Revaluation of assets or
decreases of liabilities that result in increases in own
funds other than those relating to contributions from
equity participants is also considered income. Generally
accounting rules distinguish income from business
activities and others such as valuations.

Expenses are amount spent on paying interest on

savings, borrowings etc as also other expenses
such as on wages, office maintenance, travel on
 business, postages etc. Income may arise in the
normal course of business like interest and fees
received on the loans outstanding, or it may be
an extraordinary income like profit on the sale of
assets.

11.4 THE ACCOUNTING EQUATION

The financial statements are prepared on the basis of a
fundamental mathematical equation, which states that
the sum of assets in a business is equal to the sum of its
liabilities and equity
ASSET = LIABILITIES+ CAPITAL

Accounting Principles for MFIs

Double Entry System: This principle requires that any
given transaction affect a minimum of two accounts
within assets, liabilities, or equity. If the accounting
equation is to remain in balance, any change in the
assets must be accompanied by an equal change in the
liabilities or equity, or by an equal but opposite change
(increase or decrease) in another asset account.
Conservatism and Prudence: Conservatism means
recording financial transactions such that assets,
revenues, and gains are not overstated and liabilities,
expenses and losses are not understated. It is intended
to result in the fair presentation of financial results.
Materiality: Each material item should be presented
separately in the financial statements. Material items are
those that may influence the economic decision of a
user.
Realization: Realization requires that revenue be
recognized in the accounting period it is earned, rathe
than when it is collected in cash. It defines the point at
which revenue is recognized.Matching: Organizations
incur expenses to eam revenues. Expenses should be
reported on the Income Statement during the same
period as the revenues they generate.

FINANCIAL REPORTING FORMAT

1.balance sheet
2.income and expenditure statement
 4.cash flow statement
Cash Flow Statement Cash flow statement is a financial
statement that shows an enterprise's incoming and
outgoing money (sources and uses of cash) during a time
period. Information about the cash flows of an enterprise
is useful in providing users of financial statements with a
basis to assess the ability of the enterprise to generate
cash and cash equivalents and the needs of the
enterprise to utilise those cash flows.
The economic decisions that are taken by users require
an evaluation of the ability of an enterprise to generate
cash and cash equivalents and the timing and certainty of
their generation.
The Statement deals with the provision of information
about the historical changes in cash and cash equivalents
of an enterprise by means of a cash flow statement
which classifies cash flows during the period from
operating, investing and financing activities.
It is informative to present the Cash flow statement in
terms of operating activities, investment activities and
financing activities of the MFI.
Operating Activities: Cash flows from operating activities
are primarily derived from the principal revenue-
producing activities of the enterprise. Therefore, they
generally result from the transactions and other events
that enter into the determination of net profit or loss.
The amount of cash flows ansing from operating
activities is a key indicator of the extent to which the
operations of the enterprise have generated sufficient
cash flows to maintain the operating capability of the
enterprise, pay dividends, repay loans and make new
investments without recourse to external sources of
financing. . Examples of cash flows in operating activities
for an MFI are:
1. Interest and fees income;
2. Interest expense; 3. Salaries to employees;
4. Travel expense.
Investing Activities: Cash flows in investing activities
represent the extent to which expenditures have been
made for resources intended to generate future income
and cash flows.
Examples of cash flows arising from investing activities
are: 1. Cash payments to acquire fixed assets (including
intangibles). 2. Cash receipts from disposal of fixed assets
(including intangibles); 3. Cash payments to acquire
shares, warrants or debt instruments of other
enterprises and interests in joint ventures; 4. Cash
receipts from disposal of shares, warrants or debt
instruments of other enterprises and interests in joint
ventures
Financing Activities: Cash flows in financing activities are
those that take place between an enterprise and
providers of its funds (both capital and borrowings).
Examples of financing cash flows are: 1. Cash proceeds
from issuing shares or other similar instruments; 2. Cash
proceeds from issuing debentures, loans, notes, bonds,
and other short or long-term borrowings; 3. cash
repayments of amounts borrowed.
Format of Cash Flow Statement The table below presents
how the cash flow statement of an MFI might appear:
SOME SPECIAL TRANSACTIONS

It may be worthwhile to see the accounting treatment of

some of the transactions which are specific to the MFIs.
We will discuss two such items and their treatment.

.1 Treatment of Grants and Donations

It is common for the MFIs, particularly those who are
NGOs, to get grants for the operations. The MFI should
not include the donations as part of their financial
income and should show it separately . This is because
MFIs cannot rely on such donations over the long term.
Thus, to appraise the long-term viability and capacity of
an MFI to grow without continuous infusions of donor
funds, stakeholders need to know what the MFI's
financial performance would look like without donations.
Profit or loss from financial operations cannot be
determined unless donation revenue is reported
separately. CGAP Disclosure) In the balance sheet the
grants are shown as part of capital/equity (item no 28 in
Exhibit 6). It is also prudent to separate the grant
received in the current year and grants received for
previous years. This will give an idea as to how much of
the deficit of the current year's operations is being
funded out of the grants.

2 Accounting Treatment for Loan Losses

When there is overdue It is normal for an MFI to expect
that a part of their loans outstanding may not be
collected at all. The MFI may analyze the current
performance on each loan to estimate the losses it would
expect in the future. This may be based on the
information from the past and experience of the MFI. .
This estimate of probable loss in the future is the basis of
calculating Loan Loss Reserve (item no 8 in Exhibit 6).
Net loan portfolio (Item no 9 in Exhibit 6) is calculated
after subtracting Loan Loss Reserve from Gross Loan
Portfolio (Item no 7 in Exhibit 6) The Loan Loss Reserve is
created by recognizing in the Income Statement that an
expense on account of loan losses has occurred. This
expense is called Provision for Loan Losses (Item no 9 in
Exhibit 7).
An MFI should follow the steps:Steps in accounting for
loan losses
Step 1 Determine the level of Loan Loss Reserves
required on the basis of portfolio quality
Step 2 See the existing level of Loan Loss Reserve in the
Balance Sheet
Step 3 If there is any additional amount of required in the
reserve, show Loan Loss Provision esponse in the Income
Statement
When there is Default
When there is a considerable delay in payment of
instalments, the MFI may become reasonably sure that
the amount outstanding will not come at all. This
situation is called default. As to when should an Mfi
recognize default will depend a lot on its experience and
policy.
Some MFIs may recognize default after six months of
delay, some other only after one year of delay li; the
books of accounts, the MP recognizes default by making
a Write-off.
Write-off is an accounting entry where the MIT removes
the loans outstanding for the loans which are in default
from the balance sheet When there is write-off the MIT
removes the amount of write-off from the Gross Loans
Outstanding (as well as from the Loan Loss Reserve. The
Gross Loans Outstanding decreases but the Net Loans
outstanding does not decrease
.
Rating for Microfinance Institutions
Microfinance Institutions (MFIs) cater to the population
that characteristically would not be eligible for financing
from banks and big financial institutions.
MFIs lend to them at lower rates than the local
moneylenders. The socio-economic role played by MFIs
thus, makes them an integral part of the financial
structure of India.
An MFI grading is a reflection of the sustainability of the
operations of the Micro Finance Institution. A
Microfinance Institutional Rating provides an opinion on
the long term viability and creditworthiness of a
regulated or unregulated microfinance institution
through a comprehensive assessment of risks,
performance, and market position.
The Need for Micro Finance Grading (MFI)

Micro Finance Institutions, by nature of their operations,

face high operational costs. In order to be sustainable,
they need to
Be operationally efficient
Conduct a business while meeting the margin cap set by
the regulatorInfuse funds to meet the Minimum Net
Owned funds (NOF)
Be able to convince lenders that their operations are
sustainable and profitable

MFIs face a distinct challenge when trying to encourage

prospective donors and financial markets to back their
activities.
Although evaluations and assessments are available to
MFIs from credible agencies, these tend to be expensive,
and lack a common standard that can be applied to the
entire industry.
Most of the evaluations have not been made
public,leaving the methodology and/or results unknown
to other potentially interested parties.
What is required is a credit rating system that takes into
account the nuances of the field, and sends a clear signal
to donors and investors of their sustainability.
BENEFITS
Independent Assessment - A third party independent
report on its operations, strengths and weaknesses.
Standing among Peers - A benchmark with its peers in
different geographies.
Informed Lenders & Investors - An independent report
that it can use as a part of its interactions with lenders
and investors.
( Continuation in the ppt given by Deepa miss)