Finance - Rural Finance Learning Center

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<strong>Finance</strong> Study Guide Lesson 5 Write-offs Once it has been determined that the likelihood of a loan being repaid is remote, a write-off occurs. Write-offs only occur as an accounting entry and do not mean that loan recovery should not continue to be pursued if it makes economic sense. Writing off a loan does not mean the organization has relinquished its legal claim to recover the loan. As described in the Accounting Study Guide, write-offs are made against the Loan loss reserve previously established and therefore do not affect the net portfolio outstanding unless an increase in the Loan loss reserve is made. To determine the rate of loan losses for a specific period (annual), the Loan Loss Ratio is an important indicator. The Loan Loss Ratio refers only to the amounts written off in a period and the ratio is not related to the Loan loss reserve except in that writeoffs reduce the Reserve. To determine the amount written off in a period, calculate the difference between the Loan loss reserve from the previous period and that of the current period, and subtract the provision made during the current period. If the result is negative, this is the amount written off; if positive, a loan previously written off was recovered during the current period. Loan Loss Ratio = Amount Written Off in Period Average Portfolio Outstanding for the Period This ratio can be compared over time to see if write-offs as a percentage of outstanding portfolio are increasing or decreasing. Refer to the following Portfolio Quality Ratios which were created from the Income Statement, Balance Sheet and Portfolio Report in the Sample Account Analysis. Go through each of the ratios. (You will complete the ratios for 1995 in the “Delinquency” Exercises.) Portfolio Quality Ratios 1994 1993 Portfolio in Arrears Payments in Arrears Value of Loans Outstanding 0.13 0.19 Portfolio at Risk Balance of loans in arrears Value of loans outstanding 0.29 0.38 Loan Loss Ratio Amount Written off Avg. Loans Outstanding 0.05 0.00 Reserve Ratio Loan loss reserve Value of Loans Outstanding 0.07 0.10 Rescheduling and Refinancing Loans When a client is unable to repay her loan due to illness, disaster, mismanagement or some other crisis, there are times when it is appropriate to reschedule or refinance the loan. Rescheduling a loan refers to extending the loan term and/or changing the payment schedule. Refinancing refers to providing an additional amount of loan funds to the original loan amount. This allows the client to begin making the loan payments again and, it is hoped, continue until the loan is paid in full. Rescheduling or refinancing loans is very risky and must only be done under extreme circumstances as a way of ensuring that the entire loan is repaid. Rescheduling or refinancing loans reduces the arrears in a portfolio by converting a delinquent loan into one that is suddenly a loan with no arrears, even though the risk has not necessarily been reduced and may in fact be higher due to the rescheduling or refinancing. All rescheduled loans should be monitored separately and with additional care. They should not be reported as healthy loans in the portfolio. Calmeadow 10
<strong>Finance</strong> Study Guide Lesson 5 The Cost of Delinquency What are i) consequences to the client of late payments or default and ii) consequences to a lender of late payments or default? Delinquent loans play a critical role in a micro-finance organization’s cost structure, revenue and cash flow management. Additional efforts to decrease delinquency usually mean additional costs for closer monitoring, more frequent visits to borrowers, more extensive analyses of the portfolio, legal fees for pursuing seriously delinquent borrowers, and other costs. The more time, effort and resources that are put into controlling delinquency, the less time is available for the organization to reach new borrowers and expand services or outreach. Delinquent loans result in postponed or lost interest revenue. Loan payments that are meant to come in at a certain time to meet cash flow requirements and do not, result in additional costs to micro-finance organizations. The amount of postponed revenue can be determined by subtracting the interest received from the expected interest revenue. Expected Interest income for the period = period interest rate x amount outstanding beginning of the period The difference between the amount actually received in the period to the amount expected to be received is the amount of postponed or lost income for the period. What other costs are associated with delinquent loans? Delinquency slows down the rotation of the portfolio. If the loan principal is not recovered at the scheduled time, loans to other borrowers cannot be made because the cash available is reduced. Consider how delinquency affects cash flow management. If interest is postponed or lost, often the loan principal is also lost. This means that many additional loans must be made to make up the lost principal. For example: a P1,000 loan for 6 months with 10% flat interest would result in Interest income of P100. If this loan is never repaid, the income of P100 is lost as well as the loan principal of P1,000. To recover the P1,100 (principal + interest), it is necessary to make 11 new loans of P1,000 each earning P100 each (P100 x 11 = P1,100). This does not take into account the costs incurred to make those additional 10 loans or to follow-up on the delinquent loans. Read through the following examples illustrating the cost of default: Example 1 Initial loan amount $3,000 Interest (rate - 15% flat) $450 Loan term 46 weeks Weekly payment $75 Payments received 14 weeks ($1,050) Payments overdue 32 weeks ($2,400) Total lost income and principal = $2,400 Made up of: Lost income = $312 Lost principal = $2,088 Revenue * earned per $1,000 loan for 46 weeks = $150 [*Note: This revenue represents the interest earned per loan and does not take into account any expenses or interest costs associated with delivering the loan. This differs from the contribution margin in that no variable costs are deducted.] Calmeadow 11
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Finance - Rural Finance Learning Center

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