Financial Sustainability of Micro Financing Institutions: a Case Study of ‘Special Financial and Promotional Institution' and ‘Poverty Eradication and Community Empowerment Micro finance Institution'

Hailesillasie Tsige

Wisdom consult PLC. P.O.Box: 7876, Addis Ababa

E-mail: wisdomconsult@ethionet.et

ABSTRACT

Microfinance institutions (MFIs) have two challenges, to become viable institution that built a firm foundation for efficient operation, and how to increase outreach so that a significant number of poor have access to financial services. Both these challenges are very essential for the successes of MFIs. The purpose of the paper is therefore, to examine how outreach, financial self-sufficiency and institution building are related and to see their role in improving financial sustainability of MFIs. The primary role of MFIs is to provide financial intermediation (mainly saving and credit services). Saving is an organic complement to credit. The absence of such a link is an important factor in the lack of sustainability to many credit projects. Savings help to build up resources to increase credit and to achieve sustainability of lending without reliance to external resources. Efficient and relatively low cost operational procedures are necessary conditions for an MFI to become self-sustainable. The long-range survival of MFIs depends on their ability to earn enough revenue to satisfy their obligations and still provide a satisfactory return on the owners¢ investment. To attain a high level of outreach and self-sustainability strong institutional capability is also a very essential variable.

Introduction

In Ethiopia lack of finance is one of the bottlenecks impeding production, productivity and income of rural households. Since access to institutional credit is very limited, majority of the rural poor obtain financial services through informal channels, money lenders and others. Studies indicate that the growth of private enterprises is inseparably linked to the efficient delivery of financial services (Beroff, and et al., 2000).

The rural as well as urban poor need financial services to save small amounts to engage themselves in income generating activities like agriculture, trade and services. But commercial banks typically do not serve poor households. The reasons include high cost of small transactions, lack of traditional collateral and geographical location.

Recently, non government organizations (NGOs) in the country started providing credit to the urban and rural poor. But each NGO had its own philosophy and its own approach to credit delivery and saving mobilization in an inconsistent and fragmented way (Von Pischke et al. 1996). In line with this, in 1996 Proclamation No. 40/1996 came into force, with the purpose to legislate the licensing and supervision and to establish a regulatory framework of micro financing institutions (MFIs).

After Proclamation No. 40/1996, twenty two MFIs have been established, and are operating in different parts of the country. The development of MFIs in Ethiopia is a welcome and encouraging trend because these institutions mainly focus on poverty alleviation by serving the poor. MFIs provide savings and credit facilities to the poor that are not served by formal banks and at lower cost than the informal money lenders (Ali 2000). Besides the goal of economic growth and financial sustainability, some MFIs engage in client socio-economic empowerment and community development objectives including education, sanitation, health care, nutrition, family planning and mutual help.

Although the level of poverty in rural Ethiopia is more severe than in the urban areas, due to the relatively rapid and continuous migration into urban areas impelled by land scarcity, periodic drought and low agricultural productivity, the urban poor equally need due attention. MFIs in the country are working with both the urban and rural poor. In this study, therefore, two MFIs the Specialized Financial and Promotional Institution (SFPI) that operates in Addis Ababa , and Poverty Eradication and Community Empowerment Microfinance Institution S.C. (PEACE) that operates in the rural area were investigated.

Statement of the Problem

This study examined the financial viability and outreach of microfinance institutions in Ethiopia . MFIs are said to bring valuable services to vulnerable people, enabling them to create, own, and accumulate wealth and assets. Perhaps more importantly, microfinance enables the poor to manage the uncertainties underpinning their economic and social vulnerability such as unemployment, natural disaster, and seasonal fluctuations in income (CGAP).

Two objectives are paramount for MFIs to be successful: financial self-sustainability and substantial outreach to target population (Yaron 1994). Providing poor people with effective financial services can help them to deal with vulnerability and thereby to reduce poverty. But MFIs confront two challenges (Healey 1998):

•  How to become a viable institution that built a firm foundation for efficient operation. Only an institution operating efficiently, operationally and financially, can be instrumental in sustainable poverty alleviation efforts.

•  How to increase outreach so that a significant number of the poor have access to financial services. Without significant growth of microfinance institutions, microfinance will not be able to play a leading role in poverty reduction.

Only a financially viable MFI that provides competitive financial services to the poor offers a long-term solution to poverty. As Healey 1998 put it “several MFIs opting for outreach before achieving viability find themselves paralyzed down the road and neither goal viability nor further outreach is achieved.”

The key to rapid growth of services is the ability to maintain financial viability—controlling bad loans, holding administrative costs to manageable level, and developing a rapidly growing base of financial resource.

Both theses challenges are very essential for the successes of MFIs. However, available evidence on the relationship between financial viability and outreach is very limited in the country. This paper examines the financial viability and outreach of two MFIs: SFPI and PEACE. It assesses the outreach, the ability to reach large number of poor people, especially poor women, with quality financial services, by the MFIs (mainly PEACE and SFPI), and how outreach and financial self-sufficiency are related. The study would contribute towards the understanding of the viability of MFIs in Ethiopia .

Review of the Literature

Studies indicate that MFIs should meet viability before opting for outreach because financial viability is a precondition for reaching large number of clients with financial services (Christen et al. 1995). According to Christen et al. (1995), all other things remaining equal, “improvements in financial sustainability leads directly and strongly, to improvements in the number of clients a program can reach and the length of time it can expect to serve them.” Therefore, before substantial outreach, MFIs have to develop financial viability.

The success of MFIs is determined by the financial self-sustainability and the level of outreach with the targeted population. But as Healey (1998) observed, both financial viability and outreach require “the orchestration of several variables to ensure the long-term success of MFI,” and among these variables is institution building.

Institution Building

Building institutional capacity is essential for attaining outreach and self-sustainability. Yaron (1994) described the lack of adequate emphasis on institution building in MFI as “common characteristics of the supply-led institutions.” The sustainability of MFI highly depends on its institutional building.

Among the fundamental issues for the success of an institution is leadership. The leadership of Dr. Yunus, the founder and director of the Grameen Bank, for example, has been instrumental for the rapid expansion and innovative services and process of the bank. His ideas and organizational capabilities helped the Bank to design lending policies, which influenced both clients and its employees (Khandker et al. 1995).

According to Yaron et al. 1997 institution capacity issues include:

•  Strong management team capable of communicating the vision and mission of the organization and translating the organizational objectives into action.

•  An organizational structure that supports the organizational objective is responsive to client needs and appropriate participation.

•  Systems and procedures that are customer friendly facilitate the smart and efficient flow of information. Accurate and timely information allows organizational members to monitor progress and take corrective action promptly.

•  For an MFI, skilled manpower is the main asset. Motivated and skilled staff has the ability to effectively execute and continuously refine and improve the operational methodology to better meet the organization objectives.

•  Financial management improvements in accounting and budgeting are often required to monitor loan portfolio quality and the growing volume of operations.

As strong institution is a factor for success, weak institutional capacity is also a reason for failure. Among the reasons for the failure or prolonged dependence of MFIs include: targeted credit without institution building, allocating insufficient fund for training of staff, clients and members (Gurand and Yaron 1994), and the imbalance between the institutions' sizable, supply-led loan portfolio and mobilization of savings. Such weaknesses would make MFIs suffer from inadequate credit evaluation, management, and monitoring and with poor loan collection (Yaron 1994).

Financial Viability

For an institution financial viability is crucial in order to provide financial services over a sustainable period. Viability would allow an MFI to maintain its operations indefinitely without reliance to charitable donations (The SEEP Network 1995). Financial viability would also help institutions to access more sources of funds from client savings. “Once viability has been achieved, concentration shifts to outreach” says Healey (1988), “not only will financial backing be assured, but clients, employees, and leadership alike are able to be more creative in addressing problems facing poverty alleviation efforts.”

Interest Rate

A study conducted on a sample of the most successful eleven MFIs in the world indicated that effective interest rate on loans proved to be the single most important variable for higher return and financial performance (Christen et al. 2000). Long-term financial viability measured in return on assets depends on the rate of interest. Similarly, another study on six rural finance institutions in Sub-Saharan Africa revealed that structured interest rate is among the three factors (administrative expenses, loan collection and cost of financial resources) which rural financial institutions depend on sustainability (Gurand and Yaron, 1994).

When determining the interest rate, several factors must be considered. A balance between what clients can afford and what the lending organization needs to earn to cover full cost must be considered when fixing interest rates (Ledgerwood 1999). Institutions should also consider the effect of subsidies when setting interest rate, to permit themselves to establish a commercial interest rate (Christen, 1997). Therefore, to reach financial viability MFIs have to charge an effective interest rate that covers all costs incurred in providing financial services to the poor.

Both savings outreach and the quality of volume of lending can benefit from a positive real on-lending rate that covers the true risk and full administrative costs associated with lending to the target group. A positive interest rate will enable an MFI to pay competitive interest rates on deposits. Paying competitive interest rates can simultaneously stimulate both savings mobilization and the volume of lending, since additional deposits can be extended as credit (Yaron et al. 1997).

MFIs should be free to determine their interest rates based on the costs and to adjust as per price fluctuations. Additionally, governmental restrictions on interest rates may block the development of self-sustaining institutions and financial markets because of the suppression of financial spreads of the MFIs.

Policy Environment

Conducive policy environment is believed to be very essential for MFIs to achieve substantial outreach and financial viability. Government economic and social policies as well as the development level of the finance sector influence the delivery of financial services to the poor (Ledgerwood 1999). Four aspects of policy environment that mainly affect MFI performance are:

•  Successful government policies reflected in high rates of economic growth, and ultimately in high levels of gross domestic product GDP per capita, may affect the ability of MFI to achieve substantial outreach and to attain financial viability.

•  Macroeconomic stability: MFI will have greater difficulty achieving financial viability and widespread client base if it has to cope with the risks and uncertainties of macroeconomic stabilities.

•  The extent of government control over interest rates. Interest rate restriction usually undermines an institution's ability to operate efficiently and competitively and to achieve substantial outreach and attain viability.

•  The regulatory environment can affect the success of MFIs. Prudential regulations and supervisions are designed to (1) avoid a banking crisis and maintain the integrity of the payments system, (2) protect depositors, and (3) encourage financial sector competition and efficiency. A key element of success is the ability of an MFI to develop techniques appropriate to their particular policy environment (Christen et al. 1990, Ledgerwood 1999).

Outreach

If an MFI is to maintain its capital holdings, it must earn profit to cover all its costs. But for MFI profitability is not an end, rather it is a means to reaching a large number of poor clients with small amount of resources (Christen 1997). Although the twin objectives of reducing poverty and earning profit may be in conflict, MFIs must try to attain financial self-sustainability at an earlier stage of operation. To facilitate self-sustainability an MFI program must have access to market resources to break even through expansions.

The study by Christen et al. (1995) on the eleven successful MFIs revealed that there is a positive connection between scale of outreach and financial self-sufficiency. According to the study, all profitable institutions achieved significant scale of outreach.

Outreach may be assessed on the basis of the type of clientele served and variety of financial services offered, including: the value and number of loans extended, the value and number of savings accounts, the type of financial services offered, the number of branches and units established, the percentage of the total population served, the real annual growth of the rural finance institution's assets over recent years and the rate of participation of women as client (Yaron 1994).

Saving

Most MFIs provide financial services to the poor or low-income clients. MFIs mainly provide credit and saving services (Ledgerwood Tilakanta (1998) 1999). Successful programs link credit supply with saving mobilization. Described saving as “an organic complement to credit” and asserted that the absence of such a link is an important factor in the lack of sustainability of many credit projects.

Yet, studies indicate that savings were the “forgotten half” of financial intermediation (Fiebeg 1994). In the earlier periods, microfinance programs were not effective in mobilizing saving deposits and showed little interest in this regard. Ledgerwood (1999) mentioned two major reasons for these: belief that the poor cannot save and regulatory constraint on license to mobilize deposit. Recent microfinance experience shows that even poor households would deposit their surplus in MFIs, provided that they get attractive interest rate (positive real return), convenience/location (priority and accessibility), security (safety of the saving option), and ease of withdrawal (Moduck 1999).

Over the last decade, it has been proved that the poor can save and work to save. When they do not save, it is because of lack of opportunity rather than lack of capacity ( Rutherford 1999). Since the 1990s there is a shift from credit (lending) and obligatory savings products to a financial systems approach that recognizes the importance of savings for the poor, for the fact that MFIs mobilizing savings have recorded better governance structure than credit-only MFIs. Vogel (1998) referred to MFIs that neglect savings as “incomplete institutions,” because more clients can be reached through savings than credit operation alone and this improves the client outreach. From the perspective of the microfinance clients, the advantages of saving include:

•  insurance against disability, illness, marriages, sudden income losses and other contingencies

•  consumption smoothing – safe guards income streams due to seasonal verdiction, i.e., savings of high-income period used to finance consumption expenditure during low-income period,

•  wealth accumulation to finance a household's long-term goals, such as purchase of household materials, agricultural implements and social obligations

•  saving for future investment

•  daily financial management: the need to keep cash safely in order to manage and deal with day-to-day expenses and occurrences, including emergencies; and

•  Development of the culture of saving Johnson and Rogaly 1999.

Appropriately designed saving mobilization is essential to reach financial self-sustainability, and to improve client outreach and help control costs (Bass, et al. 2000). Savings help to build up resources to increase credit and to achieve sustainability of lending without reliance to outside resources. Saving mobilization is also a strong incentive to improve the performance of MFIs and contribute to institutional viability and sustainability.

Effective saving programs lead to successful intermediation of financial services by building capital reserves, thereby reducing dependency on outside resources. Internal resource mobilization is a fundamental feature of MFIs. Saving services are indeed in high demand and still grossly untapped sources of funds for institutions looking to escape external financial dependency, while at the same time enhancing the services provided to clients. Saving deposit also provides cash collateral or guarantee for portfolio protection.

Lending

To reach the poor women and men MFIs needs to identify who the clients are, how poor they are and how they are going to serve them. Well-designed lending mechanism would help to achieve self-sustainability and significant outreach. Yaron (1994) described that the delivery mechanism used and procedures applied are crucial in resolving the following most common problems of MFIs:

•  how to ensure efficient and relatively low cost operational procedures in screening borrowers, processing loans, monitoring loans and mobilizing and servicing voluntary savings, and

•  how to achieve adequate loan collection to improve the possibility that continued operations are feasible without constraint reliance on state or donor concessional funds and grants.

Lending methodologies by MFIs include: individual lending and solidarity group. Individual-based lending for target groups may be a viable option for reducing overhead costs of membership mobilization, but group-based lending can also be used for social intermediation and own the account that providing social development inputs to groups is cheaper than to individuals.

The loan size depends on the purpose of the loan, the capacity of the borrower to pay the loan and the lending capacity of the MFI. MFIs must ensure that their operations are as efficient as possible. They should reduce their lending costs by using methodological, organizational and technological innovations. Otherwise, the cost of inefficiency may be burdened on the clients in the form of high interest rate because the interest rate that is charged to the clients is usually based on the cost structure.

Methodology

Study Area

The study covers two purposefully selected MFIs: Poverty Eradication and Community Empowerment Microfinance Institution S.C. (PEACE) and Specialized Financial and Promotional Institution (SFPI). The basic criterion for selection was, to take two institutions that work with the poor, one in the rural area and the other in the urban area.

SFPI, which operates in the capital city Addis Ababa , was established in November 1997. It is the first licensed MFI to start operation in the urban area. PEACE was established in 1999 and started operation in August 2000. The major shareholder of PEACE is Agri-Service Ethiopia (ASE), an NGO which has over thirty years of experience in integrated rural development program (IRDP).

All the four branches of SFPI and five branches of PEACE were selected for data collection.

Data Collection Procedure

The data collection was designed so as to obtain information on outreach and financial performance. For outreach indicators, the data gathering focused on number of clients, number of loans, number of loans outstanding, value of loans in arrears, loan size, loan term, saving mobilization, percentage growth of saving, rate of dropouts, and percentage of women clients. The financial part focused on adjustments to the financial statements. A variety of quantitative and qualitative methods were used during the data collection.

Other data which were relevant to the study were collected from the Association of Ethiopian Microfinance Institutions (AEMFI) and the supervisory body, the National Bank of Ethiopia .

Analysis

The performance of MFIs is measured by the level of outreach to poor and by the financial sustainability (Yaron, et al. 1997). One of the best measures of financial performance of an MFI is profit. But the profit presented in the conventional accounting reporting cannot be used as an indicator of self-sustainability for an institution receiving subsidies (Yaron 1992). Because, without an adjustment, an MFI that receives subsidy may appear more profitable than the better performing subsidy-free institution. Profit figures provide partial information with respect to financial self-sustainability.

MFIs must apply financial analysis that considers real (i.e., inflation adjusted) unsubsidized profits. Although most MFIs may not perform well under such analytical framework, as Christen put it, this provides them with “a clear and meaningful financial yardstick with which to measure their progress.” There are two approaches regarding the assessment of the financial performance of MFIs. The first approach is Subsidy Dependence Index (SDI), which was addressed by Yaron. According to Yaron, “Financial self-sustainability is achieved, when return on equity, net of any subsidy received, equals or exceeds the opportunity cost of the equity funds.” SDI takes into account the subsidies received by an MFI and provide a more appropriate measure for the performance assessment. Subsidy dependence is the inverse of self-sustainability. To eliminate subsidy dependence, an MFI needs to meet at least the following major conditions:

•  have positive on-lending interest rate high enough to cover non-subsidized financial costs as well as administrative costs, to maintain the value of equity in real terms,

•  have adequate deposit interest rates so as to ensure that voluntary savings become an increasingly significant factor in financing the loan portfolio,

•  achieve a very high rate of loan collections, which eventually results in very low loan losses,

•  contain administrative costs through efficient techniques and procedures in assessing investment plans, screening borrowers, processing loans, collecting repayments, and mobilizing and servicing savings to ensure that lending rates do not become prohibitive.

In the second approach adjustment is made in the conventional financial statements so as to exclude the effect of subsidy and inflation and then ratio analysis is carried out. The two approaches are entirely compatible. Both approaches compensate the shortcomings of the conventional financial statements (Christen et al. 1995). But, the second approach is more popular and is applied by many researchers.

Financial Data Adjustment

Before analyzing the financial performance of the MFIs, the financial statements must be adjusted for analytical purposes, even though the adjustment may not necessarily be reflected in the audited financial statements. Furthermore, adjustment indicates how an MFI would look like if it operates on a commercial basis (Sheldon and water field 1998).

The common accounting problems which affect financial statements of MFIs may be grouped into two types: those that occur due to the wide variety of accounting practices or neglect of the Generally Accepted Accounting Principles (GAAP), and those that are not treated in the conventional accounting reporting – inflation and subsidies. To solve the above problems, two types of adjustments are required (Ledgerwood 1999). The first type relates to those MFIs that fail to comply with GAAP. These adjustments include: accounting for loan loss and loan loss provision, accounting for depreciation of fixed assets, and accounting for accrued interest expense. The second type treats the effect of inflation and subsidy. Adjustment is made to the financial data to make it more compatible and to remove the influence of subsidies from key indicators of profitability so as to determine the financial viability of an MFI. Since the conventional financial statements are prepared on the assumption that the monetary unit is stable to compensate the effect of inflation, adjustment is required. The subsidies MFI receives include: funds donated to cover operational costs and donations in kind, concessional loans and donated equity. When an MFI receives a grant, its net income is overstated. In such a situation, the MFI could look profitable while in reality it is not. Adjustment for subsidies removes this influence. In other words, subsidy adjustment increases the expense and lowers the net income.

Performance Measurement

There are several performance indicators that could be used to analyze the overall performance of MFIs. In this research, the most widely applied performance indicators developed by the Small Enterprise Education and Promotion Network (the SEEP Network) and the Consultants Group to Assist the Poor (CGAP) were used. Although it is possible to evaluate the performance of an MFI using either the SEEP Network or the CGAP approach, both approaches were used in the current study so as to supplement indicators that the other approach does not cover. The financial performance indicators are usually ratios extracted from the financial reports i.e. (balance sheet, income statement and portfolio report).

Performance indicators can be grouped in several ways. In the current study, the performance indicators were organized into four area: financial sustainability ratios, productivity and efficiency ratios, portfolio quality, and growth and outreach ratios.

Ratio analysis is the most effective means to analyze the trend of growth and to measure the overall performance of an MFI. Since the ratios represent key financial relationship, they must be analyzed together. Taken as a whole the ratios in the framework provide a multi-dimensional perspective on the financial health of the lending/saving operations of the organization (The SEEP Network 1995). However, for young institutions, the ratio analysis may be discouraging, in that the ratio for self-sufficiency could be very low. Therefore, when interpreting the ratios, the maturity of the institution must be considered.

Furthermore, as described by the SEEP Network (1995), comparing MFIs using the analysis ratios could be misleading, because, several contextual and methodological factors affect these ratios. Among these factors are:

•  the size of the institution – larger institutions have economies of scale which could reduce their cost ratios;

•  the maturity of the organization – a well established organization should perform more efficiently than a new one;

•  the growth rate of the organization – rapidly growing organizations tend to be less efficient as they observe growth;

•  the average loan size – making ten loans of Birr 100.00 is more costly than one loan for Birr1000.00

•  geographic coverage – high-density urban areas are less costly to cover than sparsely populated rural areas.

Thus, this study took into consideration the above factors when evaluating the performance of the MFIs under consideration. In addition to this, the objective of the study was not to compare and contrast the two MFIs, but to assess the performance of each MFI in the context of financial sustainability and outreach in their respective rural and urban environment.

Findings

The findings are presented in terms of the institutional capacity of the MFIs, their outreach in terms of saving mobilization and lending and their performance in terms of self-sustainability. Outreach and self-sustainability were measured using several indicators. To observe the progress made by the MFIs, the analysis conducted in June 2001 by the current author was compared with the most recent figures of December 2003.

Institution Building

Governance

In both MFIs the board is entrusted with the responsibility of providing strategic direction and policy formulation. Whereas the General Managers together with the Operations Managers and Finance and Administration Managers are responsible for the management of day-to-day activities.

Organizational Structure

SFPI has four branches. Each branch is staffed with a branch manager, accountant, cashier, messenger, 5-7 credit officers and two security guards. At maturity level a branch is supposed to have seven credit officers. The composition of branches of PEACE is quite different. So far PEACE has eight branches. Each branch has a senior loan officer, accounting clerk, cashier and three guards.

Systems and Procedures

The lending procedures of both MFIs consist of solidarity group formation, training, loan application, screening and approval and follow up. They give training or orientation to clients on the lending methodology, responsibility of members and group leaders. Group members are required to know each other, enjoy mutual trust and confidence, have similar background and bargaining power so as to exercise peer pressure on equal footing. Groups are instruments to maintain social and financial discipline and to obtain collateral. Group members are jointly liable for the repayment of loans by a member.

However, the size and function is different. In SFPI, five individuals make up a group and six groups make up a center.

PEACE uses two types of groups: a solidarity group which ranges from five to eight and an association group of three to eight federated groups with minimum of fifteen and maximum forty members. Solidarity groups are not forced to form association group. PEACE adopted both association group and solidarity group methodology for service delivery mechanism. Association group is for disbursing agricultural and business loans. On the other hand, under a circumstance where client prefers and justifies that the nature of the business demands the need to organize into a smaller group than in association, the institution may also adopt solidarity group methodology as an alternative service delivery mechanism.

Each group elects a chairperson and a secretary. In the case of PEACE, the group leadership includes a treasurer. The elected persons are key contact persons for loan officers. Recently SFPI has introduced individual and cooperative loan. It has disbursed Birr 500,000 to small farmers through cooperatives.

Loan term and size vary according to the type of business and cycle. Loan amount is determined by the policy of each institution, nature and size of business, and cycle of the loan. In addition, group members participate in the lending process. They decide on the amount of the loan considering the capacity of each client. For subsequent loans, the repayment performance of borrowers is taken into consideration.

In both MFIs, loans are tied to compulsary savings. Savings are used as indirect collateral to loans. Loan approval process is centralized in both institutions. In SFPI, initially the group approves the loan amount of individual members and then the center. The loan officer and branch manager make approvals after making the required verifications. Finally, the loan is approved by the operations manager. The branch manager as well as the operations manager make field visit when it is required. Extraordinary loans are approved by the management committee.

Human Resource Development

Efficient, appropriately trained and motivated staff can further improve operational efficiency and contain costs. The MFIs have problems in recruiting competent and skilled labor in the market. SFPI reported high staff turnover mainly due to low salary scale.

SFPI has Business Development and Promotion Unit, which provides training to its staff and clients. Branch managers and credit officers are trained for more than two weeks. This includes orientation on operation manual, in-house training, and attachment to other branch managers or credit officers. All branch mangers have also a chance to share the experiences of other MFIs abroad.

Both PEACE and SFPI reported that they have benefited from the workshops, conferences, training programs and exchange visits that the Association of Ethiopian Microfinance Institutions (AEMFI) organized in collaboration with other agencies.

Accounting and Management Information System

SFPI uses a software (TMS) especially designed for microfinance accounting. TMS is friendly to use and it can produce a variety of reports. It is capable to produce financial as well as operational reports, such as loan tracking and client profiles. The software has good security system. The administrator of the system can define access to the staff to input data or to read only. TMS has import and export facility and it also works with Excel. PEACE has also purchased TMS, and is under preparation to implement the system.

Outreach

Savings

PEACE and SFPI mobilize savings by requiring members to make mandatory savings and encouraging them to hold voluntary savings. Savings are prerequisites for borrowing. To date both institutions do not give saving services to non-clients, because they say mobilizing public saving requires a separate window. Currently the institutions do not have adequate capacity and operational structure in place to provide saving service.

As indicated in Table 1, the number of savers as well as the value of savings has grown at significant rate (over 2001–2003). In SFPI, saving as a percentage of outstanding loans in 2001 was 49%, and in 2003 it reached 51%. The average saving per member also increased by 44%. Above 50% of the funds mobilized by the institution were generated from client savings. PEACE performed well in saving mobilization. The number of savers and value of saving increased by 120% and 322% in 2001 and 2003, respectively. But, compared with the outstanding loan, the total saving (23%) was still low. The average saving per member in PEACE is about 50% of that of SFPI.

Table 1. Savings outreach trend SFP and PEACE during 2001–2003

Lending

The number of clients served as well as the portfolio increased significantly. However, the rate of dropouts was very high in both MFIs. In all the measures considered for lending, the performance of outreach in each MFI was good (Table 2). The initial loan size was Birr 100.00 and the average outstanding loan size was between Birr 719.00–957.00.

To determine how much of the portfolio is generating revenue and how much is likely to be unrecoverable, the portfolio quality must be examined. The portfolio at risk and in arrears were 0.4% and 0.33% for PEACE and 6.3% and 2.4% for SFPI, respectively. With respect to portfolio-at-risk, which can be seen as the measure of efficiency, both institutions were within the acceptable range of 0%–10% (Gibbons and Meehan 2000). The pattern of loan utilization of SFPI included: small manufacturing, small service, retail trade and small agriculture. Since its establishment, SFPI has disbursed Birr 10.3 million. Major loan categories of PEACE were agriculture and business loans. The disbursement of PEACE was Birr 6.6 million.

Table 2. Lending outreach trend of SFPI and PEACE during 2001–2003

Both institutions were committed to address the growing demand of women clients. Thus, women accounted for 66% of their clients. The percentage of women borrowers declined by 7% in SFPI and increased by 1% in PEACE. Compared with men, women took smaller loan size. Most women were involved in retail trade and small services. The figures indicated that more women benefited from the loan than men. Among other things, the financial services enabled many women to possess assets and create own jobs.

Financial Viability

The long-range survival of a business depends on its ability to earn enough revenue to satisfy its obligations and still provide a satisfactory return on the owners' investment. Return on assets is one of the tests for profitability. The adjusted return on total assets for the most recent period was 14% for SFPI and 12% for PEACE. The trend of growth was significant (Table 3). The operating cost ratio also indicated an improvement in financial efficiency of the MFIs.

The financial self-sufficiency of both institutions was at level one, i.e. interest and fee income did not cover cash costs. The revenue they generated from operations did not fully cover the operating cost, but they were getting closer. The deficits were covered from donations. The operational and financial self-sufficiencies of both institutions had improved, though not at equal rate (Table 3). One reason for the smaller growth rate of the financial self-sufficiency was the high inflation rate (13%) in 2003.

The financial cost ratios (2% for SFPI and 1% for PEACE) indicated that the institutions were mainly financed from grants. One way of increasing financial viability is loan recovery. By minimizing default, profitability is enhanced. In this regard, the repayment performance is excellent. It was 99.6% and 98% for PEACE and SFPI, respectively.

Operational Efficiency

The productivity and efficiency figures for 2001 and 2003 (Table 4). showed that the institutions made significant improvement over the preceding years. The portfolio per loan officer and number of active borrowers per credit officer, which are indicators of staff efficiency, had improved.

Table 3. Financial Performance of SFPI and PEACE during 2001 and 2003

Table 4. Productivity and Efficiency of SFPI and PEACE in 2001 and 2003

The operating efficiency showed that the institutions improved their efficiency by reducing the cost of providing credit, cost per unit of money and cost per loan. To lend Birr 1.00 SFPI spent Birr 0.17 in June 2001 which was reduced to Birr 0.11 in December 2003. The cost of making one loan also decreased from Birr 177.13 in 2001 to Birr 165 in 2003. Similarly in the case of PEACE, cost per unit of money decreased from Birr 0.32 to 0.13 and cost per loan decreased from Birr 225.5 to 135.74.

Average number of loan clients per field staff, best practice for MFIs world-wide fell between 300 and 500 clients irrespective of the lending methodology employed (Gibbons and Meehan 2000). The cost per money lent was also below the acceptable range Birr 0.15 to 0.25.

Revenue and Cost Structure

The source of revenue for both institutions was interest from loan, interest on other saving and other incomes. The interest income earned from lending comprised 76.8% (PEACE) and 96% (SFPI) of the total income.

The costs were interest on deposit by clients, interest on borrowed fund and provision for loan loss and operating expenses. Operating expenses included: salary and benefits, travel cost, training and other administrative costs. The interest expense on borrowed fund of SFPI was Birr 32,000.00 and Birr 29,358.00 for PEACE.

The financial expense and provision for loan loss were very low compared to the operating expense (Table 5). The lion's share of the total cost of the MFIs was operating cost. The operating expenses varied from 82.4% to 92.6% of the total expenditure. Salary was the major expense for both MFIs. In December 2003, SFPI spent above 51% of its total operating cost on salary, and PEACE 47.2%.

Table 5. Cost structure as percentage of total expenses for SFPI and PEACE, 2001 and 2003

A study conducted by Yaron (1994) indicated financial expense and operating expense (excluding provision for loan losses), as percentage of total expense were: 24 and 76 respectively, for Grameen Bank (GB) and 63 and 33 for Bang and Bank of Agriculture and Agricultural Cooperatives (BAAC). Compared with these ratios, the performance of PEACE and SFPI indicated that the financial costs were so small and the operating expenses high. The major explanation for this could be that part of their source of income was grant or concessional loans which thus did incur financing costs.

Added together, the depreciation of vehicles and travel cost made 31.9% of the operating expenditure of PEACE. The amount was significant compared to other costs. The major reason for this might be that PEACE was operating in geographically dispersed areas and its partially decentralized lending methodology, which highly affected the operating efficiency of the institution.

Table 6 shows the personnel cost (salary) measured as a percentage of average annual assets and average annual outstanding portfolio. The salary, as of December 2003, varied from 5.9% (SFPI) to 6.5% (PEACE) of average total assets and 9.1% (SFPI) to 9.6% (PEACE) of the average annual loan portfolio. The personnel cost ratios of the institutions were comparable to that of Grameen Bank, 5% of average total assets and 9% of average outstanding loan portfolio respectively (Yaron, et al. 1997).

The staff salaries as a percentage of average loan portfolio for the most successful MFIs was from 4% to 16%. The ratio for PEACE and SFPI was thus within the range of the best performing MFIs.

Table 6. Salary as percentage of average cost of assets and average portfolio for SFPI and PEACE, 2001 and 2003

The above assessment indicated that the achievement in outreach was good. The result regarding financial operations also showed a growing trend. With the growth of outreach, the sustainability would also increase. Costs would spread and return on assets would definitely increase. During the current study the operational loss of the institutions was financed from grants. However, the result of operations indicated that with the scale up of outreach, operational self-sufficiency improved. Provided that the grant by the donors would continue for some time, further outreach would increase operational self-sufficiency. Operational self- sufficiency in turn would contribute to an increase in outreach.

PEACE and SFPI were serving the rural and urban poor. As discussed above, their saving mobilization was significant relative to their loans. The absolute value and percentage growth of the portfolio was encouraging. Repayment, one of the long-term determinant factors for institutional strength, was excellent. Serving the poor did not prevent PEACE and SFPI from achieving outreach and improving their financial sustainability. Thus serving the poor does not preclude achieving financial self-sufficiency. Therefore, provided that the institutions continue building their institutional capacity, while serving the poor both self-sufficiency and outreach could be achieved.

What factors are necessary for strong outreach and financial viability? Institution building is essential for attaining outreach and financial self-sustainability. Factors necessary for strong outreach and financial viability include, effective service delivery methodology, competent and efficient management team, organizational structure that supports the organizational objective, information system that allows the institution to process data as quickly as possible and produce timely reports for decision making and motivated and skilled staff. In order to achieve outreach and financial sustainability, institutional sustainability is a prerequisite. The profitability of an institution is determined by its efficiency. Efficiency on the other hand, is the result of strong and well-organized institution.

The highly committed management teams in both institutions contributed to their high achievement. Therefore, to attain a high level of outreach and self-sustainability, strong institutional capability is very essential.

Interest Rate

The interest rate charged by both institutions was 16% flat rate. PEACE was aware that this interest rate could not generate sufficient return to cover all costs. It also believed that since the institution cannot continue being subsidized, the rate should have been revised, though the amount was not decided yet.

The average informal lending rate in the operational areas of the MFIs was 10% month. Compared with this amount, the on-lending rate by the institutions was very low. The inflation rate in Ethiopia was usually very low for the past years but in 2003 it increased to 15%. The high inflation rate had significantly influenced the financial self-sufficiency of the MFIs.

Policy Environment

Both MFIs agreed in general terms that there was a conducive policy environment for MFI operations in Ethiopia . The main justifications for this include:

•  There was legal framework for MFIs in Ethiopia . Proclamation 40/1996 and the directives issued by the National Bank of Ethiopia (NBE) created enabling environment.

•  The interest rate was fully liberalized. The institutions were free to set their own on-lending interest rate.

•  In Ethiopia the economically poor who need access to microfinancing were estimated to be six million. This indicated the high potential market for the microfinance industry.

•  MFIs in the country have established an association; namely, Association of Ethiopian Microfinance Institutions (AEMFI). AEMFI organized trainings, workshops and exposure visits. It was also expected to set standards and code of conduct for the sector and lobbying for better legal environment. These would contribute to the increase in the performance of MFIs.

However, both institutions claimed that they were facing unfair competition from some MFIs. According to SFPI, all MFIs were not at equal footing, some obtained help from mother NGOs/institutions while some others were doing by their own. PEACE was also facing a problem in one of its operational areas (Bale) due to the low interest rate (3–5%) loan grant to clients by the Region's Food Security Program Office.

Conclusions

The study indicated the institutions achieved extensive outreach. They gave financial services to the urban and rural poor. Saving mobilization was significant. The number of savers as well as the value of savings had increased. The repayment rate was very high (98% SFPI and 99.6% PEACE). Majority of the clients were women.

Both institutions were subsidy dependent. The lending interest income and fees they generated did not cover the administrative expenses. However, the trend of their financial performance demonstrated that there was a good and steady progress towards reaching operational self-sufficiency. The productivity and efficiency indicators showed that cost per unit of money lent and cost per loan decreased significantly. The result of operations illustrated that with the increase of outreach, operational self-sufficiency increased, though not at equal rates. Return on total assets improved proportionately. Operating cost decreased significantly. The financial and ratio analysis showed that financial viability helped to scale up outreach which in turn helped to improve financial viability. In other wards, there was positive interrelationship between outreach and financial sustainability.

Both institutions had qualified and committed management team and supportive board. The loan approval process was centralized in SFPI due to the misappropriations by loan officers. Similarly, the locations of PEACE's operational areas did not justify continuing the centralized loan approval process, because the practice was very expensive, both in terms of cost and time. The branches were decentralized with certain limit of money.

Recommendations

The lending interest rates may be adjusted to cover all costs. Otherwise, self-sufficiency would decline. The rate charged by both institutions did not cover their operating costs. The institutions should also reduce their operating costs using different innovations. When revising the interest rate, SFPI and PEACE should take into consideration the tough competition with other MFIs that were operating with lower interest rates.

Sufficient fund should be allocated to institution building. Motivated and skilled staff has the ability to effectively execute the operational methodology and better meet the organizational objectives. The use of incentives and rewards is a powerful tool in this regard. The MFI should consider introducing incentive system to field officers based on performance. Donors should focus on long-term support of institution building of the MFIs.

In order to reduce cost and speed up operations, further decentralization must be considered. However, to avoid misappropriation and embezzlement, strong internal control system must be designed beforehand. Competition among MFIs is getting intense; to win the game the MFIs should among other things, manage the innovation process for the introduction of new approaches, products and services. The cooperative loan introduced by SFPI is a good example.

The long-term objective of the MFIs should be financial self-sustainability. Since a significant economy of scale exists, the institutions should commit themselves to achieve operational and financial self-sustainability within a specified period of time. Increasing voluntary saving mobilization should be considered as basis for long-term financial self-sustainability, improved client outreach and control of costs. It is only a financially viable MFI that delivers competitive financial services to the poor that can significantly contribute to poverty reduction. Donor dependency may not bring solution to viability and outreach of the MFIs. Therefore, all concerned bodies, particularly donors, should assist the MFIs to attain their long-term objective, i.e., sustainability.

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Discussion

Aklilu Tafa (question):

Interest rate - The study recommends MFI can fix their interest rates. The government encourages a fixed rate for the purpose of keeping balance at macro-level. So, what is the impact of the recommendation?

Regarding development institutions and saving institutions. Have you explored the impact of these?

Getachew Worku (question):

1. What have been done to reduce poverty through PEACE and SFPI?

2. Financial input injection remains to be done for food security. Have you seen that in the study?

Aberra Abebe (question):

An MFI needs to have a mission. If micro-finance realities and mission don't go together, have you touched on this?

Haliesellassie Tsige (answer):

... on interest rate

We should be careful in fixing/adjusting the interest rate. We should consider factors like the cost of the MFI

... on the role of saving

This is related to a coordination and linkage problem. Otherwise, MFIs can be sustainable. They achieve changes from their savings, if they manage their operational problems.

... on PEACE and ASE

Sometimes PEACE appears to be business like. So, ASE clients can be served fairly while at the same time satisfying PEACE's business sense in sustainability.

... on food security

PEACE has a challenge in managing food security objectives by working with ASE clients while it has a threat of sustainability. Such trends should be monitored and managed.

... on realisticness of vision

This problem may happen. But things should be managed to smoothly run MF/s in view of their stated mission and the reality.

Financial services generally include saving and credit, though some MFIs may also engage in other services like education, health care, nutrition and family planning

Donated equity of PEACE was mainly deposited in the bank .